Chapter 7 Excerpt: The Myth of Financial Expertise


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Chapter 7 Excerpt: The Myth of Financial Expertise

  1. 1. “A unique voice on money, i w r d an do i l l ail d i wn fo ds, one singularly attuned to…his generation.” t e y t nt loa a c ac er I WIll h y tic act Vis u t o l tip e sp —San FranciSco chronicle o a iv it b e r s, b re i c on ads h . us h co m ee ts TEAch You by RAmIT SEThI founder and writer of ToBE No Guilt. No Excuses. No B.S. Just a 6-Week Program That Works
  2. 2. Chapter 6 THE MYTH OF FINANCIAL EXPERTISE Why professional wine tasters and stock pickers are clueless—and how you can beat them I f I invited you to a blind taste test of a $12 wine versus a $1,200 wine, could you tell the difference? I bet you $20 you couldn’t. In 2001, Frederic Brochet, a researcher at the University of Bordeaux, ran a study that sent shock waves through the wine industry. Determined to understand how wine drinkers decided which wines they liked, he invited fifty-seven recognized experts to evaluate two wines: one red, one white. After tasting the two wines, the experts described the red wine as intense, deep, and spicy—words commonly used to describe red wines. The white was described in equally standard terms: lively, fresh, and floral. But what none of these experts picked up on was that the two wines were exactly the same wine. Even more damning, the wines were actually both white wine—the “red wine” had been colored with food coloring. 143
  3. 3. I Will Teach You to Be Rich Think about that for a second. Fifty-seven wine experts couldn’t even tell they were drinking two identical wines. There’s something we need to talk about when it comes to experts. Americans love experts. We feel comforted when we see a tall, uniformed pilot behind the controls of a plane. We trust our doctors to prescribe the right medications, we’re confident that our lawyers will steer us right through legal tangles, and we devour the words of the talking heads in the media. We’re taught that experts deserve to be compensated for their training and experience. After all, we wouldn’t hire someone off the street to build a house or remove our ALL OuR LIvES, wisdom teeth, would we? wE'vE bEEN All our lives, we’ve been taught to defer to experts: TAugHT TO dEFER teachers, doctors, and investment TO EXPERTS… “professionals.” But ultimately, buT uLTIMATELY, expertise is about results. You can EXPERTISE IS have the fanciest degrees from the AbOuT RESuLTS. fanciest schools, but if you can’t perform what you were hired to do, your expertise is meaningless. In our culture of worshipping experts, what have the results been? When it comes to finances in America, they’re pretty dismal. We’ve earned failing grades in financial literacy—in 2008, high school seniors correctly answered a gloomy 48 percent of questions on the Jumpstart Coalition’s national financial literacy survey, while college seniors answered only 65 percent right. We think “investing” is about guessing the next best stock. Instead of enriching ourselves by saving and investing, most American households are in debt. And the wizards of Wall Street can’t even manage their own companes’ risk. Something’s not right here: Our financial experts are failing us. When it comes to investing, it’s easy to get overwhelmed by all the options: small-, mid-, and large-cap stocks; REITS; bonds; growth, value, or blend funds—not to mention factoring in expense ratios, interest rates, allocation goals, and diversification. That’s why so many people say, “Can’t I just hire someone to do this for me?” This is a maddening question because, in fact, financial experts—in particular, fund managers and anyone who attempts to predict the market—are often no better than amateurs. They’re often worse. The vast majority of twentysomethings can earn more than the so-called “experts” by investing on their own. 144
  4. 4. THE MYTH OF FINANCIAL EXPERTISE low-cost funds (which I’ll get to in the next chapter). So, for the average reasons for this that I’ll detail below, but I urge you to think about how you treat the experts in your life. Do they deserve to be put on a pedestal? Do they deserve tens of thousands of your dollars in fees? If so, what kind of performance do you demand of them? In truth, being rich is within your control, not some expert’s. How rich you are depends on the amount you’re able to save and on your investment plan. But acknowledging this fact takes guts, because it means admitting that there’s no one else to blame if you’re not rich—no advisers, no complicated investment strategy, no “market conditions.” But it also means that you control exactly what happens to you and your money over the long term. You know what the most fun part of this book is for me? No, it’s disbelieving e-mails I’m going to get after people read this chapter. Whenever I point out how people waste their money by investing in below-market returns, I get e-mails that say, “You’re full of it.” Or they say, “There’s no way that’s true—just look at my investment returns,” not really understanding how much they’ve made after factoring in taxes and fees. But surely they must be making great returns because they wouldn’t continue investing if they weren’t making lots of money . . . right? In this chapter, I’m going to show you how you can actually outperform the simplest approach to investing. It’s not easy to learn that reliance on so- called “experts” is largely ineffective, but stick with me. I’ve got the data to back it up, and I’ll show you a simple way to invest on your own. 145
  5. 5. THE MYTH OF FINANCIAL EXPERTISE More Examples of How “Experts” Can’t Time the Market P undits and television shows know exactly how to get our attention: with flashy graphics, loud talking heads, and bold predictions about the market that may or may not (in fact, probably not) come true. These may be entertaining, but let’s look at some actual data. Recently, Helpburn Capital studied the performance of the S&P 500 from 1983 to 2003, during which time the annualized return of the stock market was 10.01 percent. They noted something amazing: During that twenty-year period, if you missed the best twenty days of investing (the days where the stock market gained the most points), your return would have dropped from 10.01 percent to 5.03 percent. And if you missed the best forty days of investing, your returns would equal only 1.6 percent— a pitiful payback on your money. Unfortunately, we can’t know the best investing days ahead of time. The only long-term solution is to invest regularly, putting as much money as possible into low-cost, diversified funds, even in an economic downturn. USELESS NEWSLETTERS. A 1996 study by John Graham and Campbell Harvey investigated more than two hundred market-timing newsletters. The results were, shall we say, unimpressive. “We find that the newsletters fail to offer advice consistent with market timing,” the authors deadpanned as only academics can. Hilariously, by the end of the 12.5-year period they studied, 94.5 percent of the newsletters had gone out of business. Not only did these market-timing newsletters fail to accurately predict what would happen, but they couldn’t even keep their own doors open. Get a life, market timers. I’ll end with a couple of more recent examples. In December 2007, Fortune published an article called “The Best Stocks for 2008,” which contained a special entry: Merrill Lynch. “Smart investors should buy this stock before everyone else comes to their senses,” they advised. They obviously weren’t counting on it being sold in a fire sale a few months later. And in April 2008, BusinessWeek advised us, “Don’t be leery of Lehman.” I’m not sure about you guys, but I’m leery of worthless risky advice couched in cute alliteration. I think I’ll ignore you from now on, pundits. 146
  6. 6. Get the full book at About the book At last, for a generation that's materially ambitious yet financially clueless comes I Will Teach You To Be Rich, Ramit Sethi's 6-week personal finance program for 20-to-35-year-olds. A completely practical approach based around the four pillars of personal finance—banking, saving, budgeting, and investing—and the wealth-building ideas of personal entrepreneurship.