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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.






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4 Responses to On Con Men, Advanced Edition

  1. [...] Why you should avoid complex (yield) instruments.  (Aleph Blog) [...]

  2. I second your opinion on how most retail investors should really stay away from structured products, but I have to disagree on the fact this is a rigged game. The odds are clearly displayed for the vigilant eye.

    iBanks are just taking their cut, just like Wallmart does and provide these options in smaller denominations. Caveat emptor! as a big fat cut that is.

    On another note, I very much appreciate your intellectual contribution to the blogosphere. All the best with your Asset Management project and all the other charitable projects you are involved in.

    Kind regards,
    Alexandru Voicu

  3. matt says:

    Mr. Merkel:

    If you get some time this year, I would be curious to read your thoughts on estimating the cost of equity in either a single post or as part of a series.

    I have read a number of ways of doing this–CAPM, built-up, bond yield + RP, etc.–and I’m not sure how well any of them stand up to backtesting (i.e., how reliable are they?).

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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