Financial Literacy

Wall Street is skilled at turning financial products (loans, leases, royalties, bonds) into securitized investment packages. Many of these turn out to be garbage which create huge losses for investors; such as: sub-prime auto loans, sub-prime home mortgages, trailer-park loans, credit card loans, and more. Some of these securities have collapsed on their own or are subsumed from an industry downturn. The most famous of which is the collateralized-debt obligations (mortgage CDOs) that were central to the 2008 financial crisis.

Since 2007, there has been an asset-backed security nicknamed SLABS (Student Loan Asset-Backed Securities). Public loans to college students are owned by the U.S. Treasury Department but private student loans are packaged and sold as SLABS. The student loans outstanding today is $1.5 trillion and growing; which some analysts are calling the next potential ‘debt bomb’ on the economy.

When interest rates are relatively low (as they have been since 2008), then some investors jump on any ridiculous and risky investment in order to gain a higher return. One of these was SLABS – they have been over-subscribed by a market that is starving for a reasonable yield. Investors that jumped in big overlooked two important factors: 33% of student loans are in deferral (not being paid currently) and 11% are in default. SLABS are a very poor risk pool with no collateral and, in my opinion, investors are not being nearly compensated enough for the risk that they are taking. Meaning that a portfolio of SLABS will most likely result in a net loss for investors no matter how well the future job market becomes. So, in 2016, it was not surprising when many tranches of SLABS were downgraded to junk credit. These ‘investments’ were issued with a high credit rating and just a few years later, their credit rating has fallen below investment grade to a junk rating.   

SLABS are an investment that you do NOT want in your portfolio. Well, how about buying the U.S. public entity servicing these student loans? Navient (that trades like a stock with ticker symbol NAVI) is a candidate which is currently yielding 4.9%. Is this something to buy? Just the opposite: there are more investors talking about shorting this than buying it. This is partly because investors want to profit like the movie The Big Short when a few smart people made a fortune from the real estate downturn in 2008. Similarly, these investors are looking at NAVI as a short candidate to profit from the student loan defaults, and then, capture profit when the economy softens and the student loan default rate will soar.

A colleague’s son is four years out of college and now has $5,300 in a new stock brokerage account. Like many kids under age 30, he has followed the herd into every problematic financial fad, such as: buying $100 in bitcoin at its peak only to watch it fall by 80%; lost $425 on a bad-credit peer-to-peer loan; opened an $250 Robinhood brokerage account (with hidden fees) to buy a weed stock after it had already tripled; and now he wants to put all of his money into Tesla shares.

Anytime a casual and uninformed investor thinks something is a good idea, it is highly likely to be a very bad idea that destroys your hard-earned money instead.  

A prudent portfolio should have a mix of investments, starting at the base with the most stable investments. These could be FDIC insured savings accounts, bank CDs, or U.S. Treasury Bills. These are locations that only go up in value with interest payments. Your portfolio will not be stable if it can be wiped out with an average-sized stock market downturn, some financial volatility, or a single investment going to zero. Only after you have this durable financial base do you consider adding a next layer that may have some small risk, such as a short-term bond with a high credit rating. Layer by layer, your portfolio is a pyramid with much of your money in stable or very-low risk assets. An imprudent portfolio is jumping straight into a single stock (let alone Tesla, a company that has never earned a penny from business operations and relies heavily upon fickle government subsidies).

Until you have saved up a meaningful amount of money, say $50,000, you do not have enough capital to make a reckless gamble with a small amount of, say $500. A recent finance Phd. concept in investing is called “Core and Satellite.” This refers to having a core portfolio of a few stock and bond index funds and maybe a couple tiny satellites which are individual speculations. The bulk of your money is prudently invested while only a small percentage is allocated to higher risk opportunities. However, if your speculative plays are generally unprofitable, then it is best to just run with a core portfolio.

There is a favorite story told by a commodity futures broker. A new potential client asked a broker if trading futures was appropriate for him. The broker responded, “Well, take the garbage disposal test. Withdraw $5,000 out of your bank account in cash. Think about how hard you worked for that money, what you missed out on to save that money, and finally how long it took you to save up that $5,000. Now, bring that cash to your kitchen garbage disposal, stuff the money in and shred it as it goes down the drain. If you and your wife are totally Ok and at ease with that, then yes, you have the capital and temperament for the volatility and risk of losing all of your money by trading a small account of commodity futures.” The same could be said of cryptocurrencies, penny stocks, option trading, and more.

If this young man had put his money into a simple savings account, he would probably have over twice the amount of money that he has right now. So before you run out and put all your money into the latest stock fad at a price peak, establish a base of stable income producing investments and then a simple core investment portfolio.

After 2008, the U.S. Federal Reserve lowered short-term interest rates to zero; responding to the largest U.S. banks becoming insolvent during the financial crisis. Over 10 years later and interest rates still haven’t moved up much. Meanwhile, some interest rates are negative in Europe as they continue efforts to stimulate their economy as well. Unfortunately, maintaining artificially low interest rates for so long is causing problems; such as individuals and institutions are forced to gamble on high-risk assets to meet their investment return objectives. Some of the unintended consequences of prolonged low interest include:

1. Pension funds have doubled their allocations to riskier stocks, private equity, and hedge funds.
2. Insurance companies have had to raise premiums and lower annuity returns.
3. Retirees have not been able to get decent yields on bank CDs, so they have migrated into dangerous junk bonds and lower-credit preferred stocks. CD rates fell by over 80% from 2007 to 2010, so anyone relying upon normal rates has suffered greatly (a wealth transfer from savers to banks).   
4. Both the bond and stock markets have been pumped up to over-valued levels – greatly increasing everyone’s risk in them. Not everyone has been invested in them for the ride up, but everyone would be impacted by their downfall.
5. Trillions in derivative financial instruments cannot be accurately priced with negative interest rates.
6. As low as rates have been in the U.S., they are high compared to Europe and Japan, so money has been flowing into the U.S. stock market and real estate, creating asset price bubbles.
7. Another side-effect has been that all government debt became artificially cheap, pushing back their day-of-reckoning for cutting spending and addressing large liabilities.
8. Inflation-adjusted yields this low have historically only occurred during periods of war, reflecting an autocratic repression of free-market interest rates.

These unintended consequences will continue for U.S., Canada, Europe, and Japan until interest rates return to a normal level without Central Bank interference. In the meantime, do not be lured into gambling with risky investments or imprudent behavior to reach for a slightly higher yield. This will place you into a very precarious financial position if there is an adverse market move, creating potentially catastrophic losses.

While at a birthday party, I was asked for an investment candidate that offered a minimum of a 12% annual return. I replied, “You have to walk very far out on thin ice to get that; you’re more likely to end up with a -30% loss instead.” He isn’t the only one thinking like this, so below is a more thorough explanation to make the point clearer.

U. S. government-issued debt with a maturity of 10-to-20 years is one of the many reference points that active investors should know. (As I write this, the yield on 10-year government bonds is around 2.7%). Once you double this risk-free rate (which would be 5.4%), then you’re nearing the limit of reasonable returns for a reasonable risk. What a surprise that preferred-stock dividend yields are coincidentally right around that rate (Ticker symbol PFF, a fund of preferred stocks has a current yield of 5.6%). You can use online stock screeners to sort for high-dividend stock yields that are 10% and higher, but these candidates will have huge fundamental problems, such as:

• The dividend is likely to be reduced or eliminated going forward from lower earnings.
• The price of the security is highly likely to plummet from a structural event (lawsuit, closing a plant, permanent reduction in profit margin, credit rating drop, etc.)
• The business model is erratic, cyclical, or semi-sustainable

In 2016, Mellon Capital did a 20-year study on investing in stocks with a current dividend yield of 10%. The result was these investors only received a 3% actual return due to capital losses and cut dividends. Meanwhile, those that had invested in stocks with a 6% dividend yield averaged a higher actual return of 5%. It is very tempting to reach for a 12% yield, but you will not experience that in an actual return for long. In another study, companies that have a dividend yield over 10% are forced to cut that dividend 65% of the time during the following 5 years. So the odds are against you receiving that 10% dividend on a sustainable basis.

Other ways to get investment returns of 12% or more involve more active participation from the investor: rental property, laundry mat, hard-money lender, rehabbing and flipping homes, or a restaurant franchise. But your actual return or loss depends upon your skill, knowledge, and effort. Even if you only put up money into an investment syndication (raising investor money for a large apartment complex or start-up restaurant) require effort and knowledge on your part, there is no easy passive investment with outsized returns. So, if you receive a glossy brochure and slick sales-pitch deck promising investment returns that no one else can reasonably deliver, then you are definitely too high on the risk scale – maybe you’ll get lucky, maybe you won’t. If you choose to invest in these, make sure it is a tiny amount of speculative money that you can afford to lose.

In the 1970s, Harry Browne popularized a strategy he called the Permanent Portfolio that he hoped would survive any calamity by addressing 4 issues:

1. Take advantage of prosperity by investing in stocks
2. Protect your portfolio from inflation by investing in gold
3. Protect your portfolio from recession with long-term bonds
4. Protect your portfolio from depression with cash or a cash equivalent

Below was his portfolio allocation:

• 25% Stock Index Fund
• 25% Gold Fund
• 25% Long-Term Bond Fund
• 25% Money Market Fund

From 1972 through 2008, this portfolio offered a more stable and slightly better return than an all-stock portfolio, 9.7% vs. 9.2%. This included re-balancing the portfolio components back to 25% once a year. But like any strategy, the permanent portfolio goes in and out of favor as the components move up and down. Other investors have adjusted it with other fund additions for fine tuning. Some of these include holding some assets in a basket of foreign currencies, natural resources, and real estate. There are funds that follow this permanent portfolio strategy and do the work for you and there are many modifications you can find online to the basic portfolio.

If you are interested in exploring the idea you can find books written on the subject as well as many Harry Browne publications on investing and libertarianism.

Aside from an actual casino, there are 4 other gambling activities where people are most likely to lose money. Let’s review some generalities:

• The poor gamble with lottery tickets – a certain loss the more you play, states only payout 50% of their lottery revenue in prizes (although each state awards at a different rate).
• The middle class gamble with stock tips and day-trading – studies show that 80-90% lose money doing this until they quit within 2 years.
• The rich gamble with private placements (equity in start-up companies) – the vast majority of start-up businesses fail within the first 5 years. You have to buy into a lot of businesses to get a lucky big winner to pay for all the floundering and bankrupt companies you bet upon.
• And the wealthy gamble with things like race horses or drilling oil wells. Oil wells can cost $5-10 million minimum investment. 10% of them will be dry holes and many never break-even; you have to buy enough wells to get a lucky “gusher” to pay for all the losing wells.

The average person who casually gambles at a casino leaves a financial loser. I knew someone who lives in Las Vegas who scratches out a minimal living at the baccarat tables, but he is a very rare exception. It is the same for these other casinos: someone determined and focused may be able to find a slight edge but, for the most part, the average gambler or speculator also leaves a financial loser.

There are other reasons to participate in 4 casinos, such as entertainment, investment diversification, oil depletion allowance, for a few examples. However, placing much money into any of these is highly likely to exacerbate your losses.

As long as I can remember, to entice new customers, investment brokerages have offered a few upfront commission-free stock trades. In the last couple decades, there have been several online broker startups with no-commission trading as a business model. Because nothing is free, there is always a downside trade-off with these companies, such as batched trades at the end of the day, poor bid/ask spread, or they quickly go out of business. Last year, one of the zero-commission firms (Robin Hood) had a couple software glitches in their options platform, messing up orders that created large losses for customers; and they called it “erroneous option execution, sorry for the confusion” Um, no thanks – I think I’ll take my business elsewhere!

Now, the big boys are entering the no-cost commission game:

• Bank of America (Merrill Lynch) offers 10 free trades per month
• Chase Bank (JP Morgan) offers 100 free trades per year
• Wells Fargo (WellsTrade) offers 100 free trades per year
• Fidelity has free trading for 25 of their iShares ETFs
• Vanguard offers free trading on their ETFs
• Schwab offers free trading on their 8 ETFs

Some of these companies have minimum requirements to qualify for these free trades, such as $25,000 or $50,000 in your account. If you do not qualify for free-commission trading, there are many firms that charge as little as $2.95 per trade. A quick online search can show you which firms and more importantly, reviews from users. For example, I used the company Interactive Brokers for a couple years because they are super cheap. But their platform was just too cumbersome for me to use quickly and elegantly with multiple accounts. If you begin trading frequently (which I do not recommend) you can always try to negotiate a lower commission rate. I knew someone that inherited an old stock account at Raymond James in 2016, along with their $175 commission rate from the 1980s. Since the Raymond James broker wouldn’t even return his phone call, he transferred the account to TD Ameritrade for $6.95 commissions and saved a fortune when he rebalanced the portfolio. As the brokerage industry landscape changes, make sure to periodically shop around to get best deal for your circumstances, and possibly no-cost commissions to reduce your costs.

The world of investing is extremely competitive, and yet people attempt to make money by casually dabbling in it on the side. Anyone financially ambitious will come across ads for books and courses about how to make money with: real estate, stock trading, bitcoin, futures, along with home-based businesses such as blogging, AirBnB, Fiverr, selling on Craigslist, Amazon, Shopify, or eBay – and many other activities. However, it is highly unlikely you can be successful at investing or a small business by treating it as a trifle.

For example, if you would like to be successful at stock trading or real estate, you must approach it like a PhD dissertation. This means full-time immersion for several years – reading, researching, studying, learning, experimenting, getting mentors, joining groups in the field, taking courses, and adapting methods to fit with your personality and situation. In order to sustain you through this, you must develop a fanatical desire and love of the subject matter in order to keep learning and experimenting. If it isn’t for you, it will become clear, which means it is time to drop that and find a different money-making activity that suits you better.  

Sure, amateurs can sometimes get lucky when they start out, but they rarely keep that profit or sustain the activity for the long-term without a solid base of knowledge to build upon. Beginners usually make all of the common amateur mistakes – which can be catastrophically expensive. You cannot avoid these costly mistakes if you do not know what they are. It takes intense and sustained focus to become competent in anything, particularly with investing and business as their landscape is always changing. In general, by the time the masses hear about a totally new opportunity the easy money is long gone. This is why so many people turn to selling courses as a guru instead of actually making money from that trading or business method.

Where to begin your study? Many people watch free YouTube videos by experts. There are many places where like-minded people chat and share information:

• For stocks there is SeekingAlpha.com or BetterInvesting.org
• For real estate there many popular blogs like BiggerPockets.com and local real estate associations
• MeetUp.com for all kinds of investing and business activities
• Run from any “guru” that only talks about their own alleged success instead of highlighting their numerous successful students with documented proof

Avoid the distraction, lost time, and lost money from dabbling in many competitive environments, let alone concurrently. Instead, slowly and carefully narrow down to a single area of interest, find a mentor with lots of highly successful students, and then immerse yourself into a long period of learning.   

One income-investment newsletter writer says it is beyond ridiculous when his customers complain that his recommendations, that they purchased, fall in price. His comeback reply, “a loss isn’t really a loss! This is because you’re still receiving the income and you can purchase more at a lower price at that point, which slightly increases your investment yield.”

My oh my. I’m afraid the reality is that: a capital loss is actually a real loss. Whether you realize the loss with a sale or not, you still have a capital loss. While he believes if you hold forever, then capital losses are irrelevant. (This is untrue, you always have opportunity costs – whether you acknowledge them or not). The fixed-income securities market is a slightly more sophisticated market than the stock market, and in general, there is usually a logical reason that a publicly-traded security, with a big following, is falling in value.

In my opinion, this newsletter writer has a dangerous blind spot from 2 investment risks:

1. Interest rate risk. When interest-rates rise on securities that are comparable to your fixed-income investment, then your investment will also fall in value. Conversely, if rates fall then your security will rise in value. When general interest rates are rising then the pricing of nearly all bonds fall. Interest rates today have been slightly rising from historic lows, leaving a whole lot of room for interest rates to rise across the yield curve. This would permanently reduce the price of any income security that doesn’t have a maturity date.

2. Impairment risk. Impairment refers to the company having a more difficult time continuing its payout rate of interest or dividends. As the potential reduction in payouts grows (and possibly a reduction in the credit rating), then the price of the security falls to reflect the potential future-reduced investment yield for current investors. This impairment may be company specific, industry specific, or from the general economy.  

As an example, I owned a REIT that only held AAA mortgages and barely moved in price for 13 years. What could be more solid? Even though their mortgages remained stable, the company imploded in 2007 from leverage: the company’s lenders called their loans and no one would offer them new funding. While the dividends from the REIT were great, when the price stumbled, I was quick to exit with only a 12% capital loss as the price continued plummeting, all the way to zero. The company ceased operations just months later. Even though the company’s assets remained solid the entire time, the capital structure of the company was not stable at all. Investors recognized this risk as the shares dropped in price. This scenario occurs all the time: seemingly stable securities, funds, or companies are stung by recessions, interest rates, lawsuits, or unusual situations, and then disappear. By ignoring capital losses on your securities, you may end up riding them all the way down to an exchange delisting and needlessly lose 100% of your investment.

This newsletter writer is not the first investor or investment professional that has this beginner viewpoint. However, if you were some kind of financial fiduciary claiming that “a loss isn’t really a loss,” that would probably prompt your compliance officer to immediately resign, your accountant and lawyer to walk out the door, and trigger the licensing authorities to take a very close look at what you’ve been doing.

Instead, I recommend acknowledging and dealing in reality by recognizing that any capital loss is a real loss at that time. Plus, take a much closer look at the security, company, or fund. Hopefully, before you made your purchase, you created some money management rules for reducing, exiting, or hedging your position to avoid any large losses. Avoiding large losses is the #1 rule for all professional investors, including Warren Buffett who considers it the only rule for investing. And you cannot avoid large losses if you “pretend” they aren’t real.

James Cordier and his partner Michael Gross trade commodity options for clients at OptionSellers.com.

They were so good at attracting clients that their minimum deposit to join ramped up to $1 million and accredited investor status (an SEC rule that you must earn $200K/year salary, or have $1 million in investments to put money into risky investments). Cordier had been interviewed several times on TV as an options expert, and wrote a best seller on Amazon, The Complete Guide to Option Selling.

A few weeks ago in mid-November, natural gas futures went against Cordier’s position and he not only lost every penny of their investment, but they had to write an additional check to the clearing exchange, creating an even larger loss for investors. Around 300 clients lost an estimated $150 million in a few hours on a market move that wasn’t that big. What in the world happened? Cordier sold options on commodities without any hedge or risk minimization strategies. When the natural gas market moved upward against his short calls (plus a losing position in crude oil), he was trading such large positions for the account size that he vaporized the entire fund, and then some, before his clearing house threw in the towel and closed his positions to stop the bleeding. One former investor Tweeted that he had lost 130% of his original investment with Cordier.

Cordier then sent out an apology video to his clients. Sadly, he mostly rambled about how losing everyone else’s money will affect him personally (and his opulent lifestyle), nothing about his clients’ situation. His analogy, “There was a rogue wave and I wasn’t able to steer clear of it and it capsized our boat.” This is untrue. It would be more accurate to say, “I steered the boat directly toward a minor wave (to sell high-implied volatility in the options) and then I loaded down our boat with so many positions that the first drop of water that might spill on the deck would have sunk any battleship. Sorry that I made every single beginner-mistake in the book with your hard-earned money.”

Was it really a “rogue wave?” It couldn’t be – 5 months earlier, James Cordier wrote a magazine article about natural gas’s high volatility. The financial industry all know that naked short selling on natural gas a “widow-maker.” Cordier’s apology video is so cringe-worthy that there are a few parody videos on YouTube about it. Exactly like the Chairman of Enron was busy with the interior carpet color of his new jet while investors were being decimated, Cordier was busy on building out a new opulent office building while his investors were losing their future.

A couple years ago, a friend of mine gave me a copy of OptionSellers’ monthly newsletter. It was several months old. In it, Cordier talked about his naked options trading method. Plus, I glanced through several of his commodity forecasts and they were horrifically wrong. I immediately threw it in the trash where this ultra-high risk gambling belonged. I have no problem with naked option selling for a speck of your account value – if you manage the position delta. But Cordier did the opposite of those two prudent actions and then borrowed money to amplify trading gains and losses.

The only question now is if Cordier acted contrary to his operating agreement or as a fiduciary that constitutes criminal behavior. Needless to say, law firms have already begun rounding up his former clients claiming: exorbitant fees, inappropriate strategies, negligence, plus (even more insane) trading with leveraged margin. It is hard to believe the firm lasted as long as it did.

Maybe Cordier could pull a “Jon Corzine.” Former NJ Governor, Jon Corzine, stole $1.2 billion of clients’ money to avoid margin calls on his failed trades and illegal accounting. He avoided any prosecution, let alone well-deserved decades in prison, by hiring Eric Holder’s law firm, while Holder was the U.S. Attorney General. And then magically, all of the federal investigations into his criminal wrongdoing and theft were terminated.

In my opinion, Cordier’s fund detonation reinforces a hard-won investing alert:

Does the investment fund manager, investing newsletter, trading course, signal service, or investing whatever – market mostly or solely to beginners?

That is a 3-alarm red alert in my view! There is a reason that very few or no professional investors placed money with Bernie Madoff, James Cordier, or any of the other big blowouts. This is because they examined the investing method, or the manager, and gave a “hard no” on placing a penny with them.

You can’t be skeptical enough before you hand money to someone else to manage; particularly if they are making promises that no one else can. If you don’t understand their method, find someone who does or skip this one. If you can’t get any details about their track record or method, skip this one. A colleague told me last night, “I have a high-traffic bank and the manager told me they still turn away 1 person/day who believes the scam that a Nigerian Prince is going to give them $20 million if they would send him $1,500 in cash up front.”