On Con Men, Advanced Edition

The core discipline of value investing is not buying it cheap, but margin of safety.  Margin of safety means you aren’t going to lose too much if you are wrong, and face it, we make mistakes.  I do, and you do.  It goes back to the two rules: 1) Don’t lose money. 2) Don’t forget rule #1.

In my last piece On Con Men, I dealt with irregulars.  And even in my more recent piece, Avoid Investment Scams and Bad Advice, Web Edition, I dealt with irregulars.  By irregulars, I mean those that don’t come through a regular channel for investing.  These are people that try to attract those that want something off the beaten path, for either high return, or high safety.

But not all con men are irregulars.  Some are regulars, with all the trappings of success — they work for a well-known firm.  They dress well, speak well, and are aware of most major trends, and the concerns of investors.  They have seemingly well-designed financial plans that the firm’s models produce.  They have clever ways of helping you meet your income goals.  Everything about them says, “We can assure financial security for you.”

I have interacted with some of these fellows (no ladies yet) on boards that I have been on.  (Oddly, when I was a corporate and mortgage bond manager, the people I interacted with were far less slick.  I think the bond market tolerates people that are more down-to-earth than the equity market does.)  I usually have to bite my tongue, because  they are front men.  They know the limited bits that they have been fed by sales management, but they really don’t know much beyond that.

On rare occasion, I will take the floor and rant at the salesman.  I try not to; I only do it if they lie (as I see it).  Usually, they’re just trying to earn a living, and there is nothing to be gained by making fools of them.  But occasionally, they try to lure people into investments that are not in their best interests.

I have often said that the lure of free money brings out the worst in people.  I think that one key area of that is the seeking of yield.  I will say it plainly: Wall Street can give you whatever yield you like, if you don’t care about preservation of principal.  Yield is the oldest scam in the books.

Wall Street has a wide variety of yield products, and I highlight this now, because we are in a low yield environment, and they will bring these products out more often as a result.  One example that I have talked about before is structured notes.  What I would like to talk about tonight are reverse convertibles.

One easy way to enhance yield is to sell an option against your positions.  The problem with that is that the option could come into the money, and you suffer a capital loss as a result, often exceeding the extra income “earned.”

With convertible bonds, you have the best of all worlds.  The holder is long an option.  If things go well, it is convertible into stock.  If things go, badly, you have the downside protection of a bond (which can still default, but hey, you are higher in the bankruptcy pecking order.  Maybe you’ll get something?).  The cost of the best of all worlds is a lower yield than one would get on straight nonconvertible debt.

Reverse convertibles are the worst of all worlds.  The holder is short an option.  When things go well, it remains a bond.  If things go badly, it converts into stock, usually at a low price that delivers a capital loss.  But, the equalizer here is that if it remains a bond, you get a high yield.

That’s a big “if.”  My counsel to almost everyone is avoid complex products.  If you can’t get the yield that you need through ordinary vanilla products that are transparent, then either reduce your spending or consume a little capital.  Wall Street and insurance companies thrive on complexity, because you can’t price it or do comparisons.  You are playing their rigged game; they may not be trying to skin you, but just nick you.  Nicking you means they win, but you continue to play the game, so that they can nick you again.  It is like playing in a casino; the edge of the house is fixed, and will wipe anyone out that does not have an advantage (card counting in blackjack), but it does it so slowly and with volatility, that players do not perceive it.

Complex products are not created to do you a favor, but to cheat you on average.  Think about it: if you are invited to play a game for money, as an amateur, do you want to play against professionals?  I thought not.  But if you feel that way, why do you buy products from Wall Street that they know a whole lot better than you?

This goes back to my rule: don’t buy what others want to sell you; buy what you have personally researched and want to buy.  But what if I can’t understand enough to do anything with investing?  Then what?

Find your friend who knows the most about investing.  Ask him for his friend who knows the most about investing.  Repeat a third time if needed, but get to someone who can give you intelligent impartial advice.  If all else fails, go to Vanguard, and take their advice.  They will not harm you, though they might not help you a lot.

But be wary of those that offer easy solutions.  What is free is seldom cheap, as the Ferengi would say.  Get trustworthy intelligent third parties to look over your investments, and avoid slick salesmen with clever products that are hard to understand.