My Tip #6 is to only buy investment products where the financial interests/incentives are fully aligned with your own. Recently I read the Big Short by Michael Lewis, and he made the same point by quoting Charlie Munger. Here’s the full passage:
So here are a few examples…Michael Lewis in ‘the Big Short’ wrote: Warren Buffett had an acerbic partner, Charlie Munger, who evidently cared a lot less than Buffett did about whether people liked him. Back in 1995, Munger had given a talk at Harvard Business School called “The Psychology of Human Misjudgment.” If you wanted to predict how people would behave, Munger said, you only had to look at their incentives. FedEx couldn’t get its night shift to finish on time; they tried everything to speed it up but nothing worked-until they stopped paying night shift workers by the hour and started to pay them by the shift. Xerox created a new, better machine only to have it sell less well than the inferior older ones-until they figured out the salesmen got a bigger commission for selling the older one. “‘Well, you can say, ‘Everybody knows that,’” said Munger. “I think I’ve been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little further.”
1) Buy Vanguard Bond Funds, not Fidelity (actively managed) bond funds! Fidelity’s actively managed bond funds' higher expense ratios incent them to take more risk to try to beat their drag on performance. In the recent credit-crisis period the results were not pretty. For example Fidelity Intermediate Bond fund and Fidelity Investment Grade Bond fund lagged the Barclays Aggregate Bond index in 2008 by 11% points and 12% points respectively. Fidelity even stuffed its TIPs fund with subprime bonds- in 2007 it lagged the TIPs index by 2.5%. By contrast Vanguard, with its low expenses and full alignment with its investors, avoided those dodgy subprime and other bonds. Here is a NPR piece which mentions Mabel Yu, a Vanguard bond analyst:
http://www.npr.org/templates/story/stor ... =104962188
2) Buy Credit Union CDs not Bank CDs! Many investors rightly worry that if interest rates rise sharply their bonds might take a big price hit (price hit ~=duration * interest rate move). Longer term CDs often offer an attractive combination of a spread over treasuries plus the ability to withdraw early at a small penalty of a few months interest. If rates rise sharply you can withdraw early and reinvest at the higher rates. But watch the fine print! May banks have clauses in their CD contracts that reserve their right to deny early withdrawal requests. Pentagon Federal Credit Union doesn't have this fine print- at worst you may just have to give them 2 months written notice to withdraw early.For a bond to get a AAA rating, it is supposed to have passed a particularly strong test. The rating agencies would simulate a worst-case scenario and see how the bond held up. But those scenarios were sometimes perplexing to outsiders. Mabel Yu analyzed bonds for Vanguard, which manages $400 billion in bond investments. The new deals would land on her desk, with their AAA ratings. She says she could never get a straight answer about what the worst-case scenario really was.
"I got names of the rating agency analysts, and I asked them lots of questions," she says. "In the beginning, the questions would be 15 minutes to half an hour. But then it turned into hours, and many hours." She asked them about the possibility of house prices falling, of interest rates rising, of people not being able to refinance their mortgages. "If all of those things happen at same time, what would happen to our investment? I could not get a straight answer."
Yu says she was told repeatedly that she worried too much. "I felt so dumb," she says, adding that she was told, "Don't worry about it. Have a life."
3) Buy Vanguard ETFs, not Ishares ETFs! One of the advantages of broad index fund investing is that you end up owning (through the index fund) hard to find securities that other investors may want to short. Funds can often realize significant income by lending these securities out. But as this article points out, while Vanguard passes on all of the securities lending income to its funds, Ishares somehow thinks they are entitled to half of it!
http://www.news-to-use.com/2010/01/gett ... -etfs.html
4) Buy common equities, not corporate bonds! Here is what David Swensen has to say about corporate bonds:
http://registeredrep.com/mag/finance_un ... _approach/#
5) Buy common equities not preferred equities! Common shareholders are typically well compensated if the company goes private. In contrast, preferred shareholders may not be and risk being simply ignored by new management-i.e. they may find out the hard way that their interests are not properly aligned. This is called being “Waldenized”- you can read about it here:David Swensen wrote:Corporate bond investors find the deck stacked against them as corporate management's interests align much more closely with equity investors' aspirations than with bond investors' goals. A further handicap to bond investors lies in the negative skew of the potential distribution of outcomes, limiting the upside potential without dampening the downside possibility...IBM illustrates the problem confronting purchasers of corporate debt. The company issued no long-term debt until the late 1970s, as prior to that time IBM consistently generated excess cash. Anticipating a need for external finance, the company came to market in the fall of 1979 with a $1 billion issue, at the time the largest-ever corporate borrowing. IBM obtained a triple-A rating and extremely aggressive pricing on the issue, which resulted in an inconsequential yield spread over U.S. Treasuries and (from an investor's perspective) underpriced call and sinking fund options. Bond investors spoke of the “scarcity value” of IBM paper, allowing the company to borrow below U.S. Treasury rates on an option-adjusted basis. From a credit perspective, IBM debt had nowhere to go but down. Fourteen years later, IBM's senior paper carried a rating of single A, failing to justify both the rating agencies' initial assessment of IBM's credit and the investors' early enthusiasm for IBM's bonds. Bond investors had no opportunity to lend to the fast-growing, cash-generative IBM of the 1960s and 1970s. Instead, bond investors faced the option of providing funds to the 1980s and 1990s IBM that needed enormous sums of cash. As IBM's business matured and external financing requirements increased, the quality of the company's credit standing eroded.
http://boards.fool.com/quotwaldenizedqu ... e#28160296
6) Buy companies that are "buying" back their shares, not "selling" in an IPO! If management is selling, why are you buying? Studies have shown that IPOs underperform in the long term. For example see:
Part of the trouble is that company management knows more than you do (asymetry of information). They are unlikely to sell the company when the market for stocks in their industry is low. Rather they will wait and try to sell at the top. A recent egregious example of this is the 2007 IPO of Blackstone- a private equity shop. Blackstone's CEO Steve Schwarzman took the company public in mid 2007, just before the credit bubble (which fueled private equity transactions) burst. So IPO investors were basically betting against Schwarzman's knowledge of the private equity market and how overextended it was- a dangerous thing to do. This chart shows that since its IPO Blackstone underperformed the S&P 500 by about 40%, or about 10% per annualized.
http://finance.yahoo.com/echarts?s=BX+I ... =undefined
So remember, only buy investment products where the financial interests/incentives are fully aligned with your own.
Here are the previous 5 installments in this 10 part series:
Tip #1: Take your risk on the equity side.
http://www.bogleheads.org/forum/viewtop ... 1296349581
Tip #2: Use Cash to dampen portfolio risk
http://www.bogleheads.org/forum/viewtop ... 1296349639
Tip #3: Index, Index, Index! But...
http://www.bogleheads.org/forum/viewtop ... 1296349812
Tip #4: Rebalance Early and Often.
http://www.bogleheads.org/forum/viewtop ... highlight=
Tip #5: To keep real wealth, skip Gold, Buy TIPs
http://www.bogleheads.org/forum/viewtop ... highlight=