The Three Best Things to Have before Starting to Invest - Dick Davis

Excerpt from "The Dick Davis Dividend: Straight Talk on Making Money from 40 Years on Wall Street"

If each of us left our money invested for one hundred years, we get the full benefit of the market’s long-term upward bias. But we invest for only a fraction of that time and the market's upward bias is beset with numerous interruptions. So it helps to have some other things going for us. The three at the top of my list would be luck, longevity, and deep pockets, all of which have little to do with the stock market per se. While luck, longevity, and deep pockets are not absolute requisites for successful investing, there’s no denying that having any one of these attributes gives the investor a distinct advantage.

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Luck

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Obviously, it helps to be lucky in every field of endeavor. What’s not appreciated is just how large a role [that] luck, both good and bad, plays in the stock market. Investors are advised to do their homework, to diversify, to allocate, to be patient, to be disciplined—but the best thing is to be lucky. You can be successful without luck, but there are times when you can do all the right things and it won’t matter much unless you’re also lucky.

For example, Mr. Jones’s retirement date was January 1, 2000, so he sold his long-held growth stocks a few weeks before that. Ms. Smith’s retirement date was October 1, 2002, so she sold her stocks a few weeks before that. Mr. Jones’s target date coincided with the peak of the bull market, Ms. Smith’s with the bottom of a steep bear market. There was a sharp difference in payout for only one reason—luck, pure luck. Where the market happens to be when, for example, your kids reach college age and you have to sell at least some stock, is strictly a matter of chance. Much of the gain that has accumulated slowly over the years can dissipate if you are unlucky and forced to sell when the market is depressed.

In the bubble years of the late 1990s, the tech stocks soared. Some of the players during that feverish climb weren’t old enough to be restrained by memories of brutal down markets. Their rationale for paying astronomical prices for companies with no earnings was, “This time it’s different; it’s a new paradigm.” It was like taking candy from a baby; stocks just kept going up. Buy high, sell higher. It was easy money; it was fast money; it was dumb money. To the uninitiated, having never experienced a punishing bear market, ignorance was truly bliss. Yes, the tech-heavy NASDAQ did plummet (78 percent over 31 months) but before the bubble burst, it lasted long enough for big money to be made.

Did those profits have anything to do with the exercise of patience, discipline, research, or savvy? No. What happened was that the market went to once-in-a-lifetime extremes and young, less experienced players who wanted in on the action saw it as a no-lose opportunity. Those who bought at astronomical prices and sold at even crazier prices were able to do so because of dumb luck.

The biggest money was probably made within the industry. Partners, traders, money managers, and star analysts of Wall Street firms bought mansions in the Hamptons and million-dollar paintings. When the bubble burst, these players at least were able to retain their material winnings, but not so the investor. When I think of the steep losses suffered by the public after the bubble burst, I’m reminded of the classic 1940 book by Fred Schwed, Jr., Where Are the Customers’ Yachts? (New York: Wiley & Sons, reissued 2006).

It’s No Mystery; It’s Luck—Or Lack of It

The stock market is replete with examples of investors being affected positively or negatively by completely unexpected events. It’s [a] surprise that moves stocks. If the unexpected makes the stock go up, it’s good luck; if it triggers a decline, it’s bad luck.

For example, a company you own receives a generous buyout offer out of the blue, or is added to or dropped from a major index. Perhaps a successful CEO resigns, the charismatic CEO of a small company dies, or the majority stockholder of a small company sells all his stock to pay for his divorce. Maybe a company is named the target of an SEC investigation or has to recall its major product, or a pharmaceutical giant is forced to withdraw a popular drug from the shelves. Then there’s the company spokesman—a star athlete or celebrity who is injured or disgraced or a company that receives a court decision. Perhaps Warren Buffett buys or sells a stock you own. On a broader scale, there can be stock-depressing shocks like war, assassinations, and plane crashes; or natural disasters like hurricanes and tsunamis. In all these cases your stock is subject to the vagaries of pure chance.

Sometimes the market will focus on the positive aspects of a story and other times it will react to the negative. Let’s say you buy a stock in anticipation of a good earnings report. The profits prove to be even better than expected, but sales are down. The fickle market decides to focus on the slowdown in revenues and the stock drops. Bad luck. On another day, for any of a hundred different reasons, the focus would have been on profits and the stock would have gone up. When dealing with the unknowable, luck is a powerful ally.

There are situations when you’re able to stack the odds so heavily in your favor, it’s hard to imagine a bad outcome. Let’s say you hear about a star money manager who has outperformed his benchmark 15 years in a row. You confidently buy his fund and he promptly breaks his streak. Your buy proves to be the kiss of death. Bad luck. On the other hand, benefiting from a broad upsurge, you may buy a stock and see it go up for reasons completely different than those you bought it for. A rising tide lifts all boats. You were lucky. The old maxim is that bull markets make geniuses of us all.

“It’s human nature to find patterns where there are none and to find skill where luck is a more likely explanation.”

—William Bernstein

The line where good judgment ends and luck begins is often fuzzy. It’s a gray area with crosscurrents and overlapping. Insurance mogul Robert Rosenkranz has run Acorn Partners, a fund of hedge funds since 1982. His job is to find the best hedge fund managers to include in his fund, those with the greatest investment prowess. In a Barron’s interview (October 4, 2004), he says, “It’s a very subtle, difficult thing to distinguish luck from skill in this business.” 

Nassim Nicholas Taleb is a professional trader and mathematics professor who wrote The Black Swan (Random House, 2007) and Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (Texere, 2004; Random House, 2005). The latter book deals with the question of why human beings are so prone to mistaking dumb luck for consummate skill. Taleb concludes that by nature we are designed to take our beliefs and knowledge a little too seriously. We tend to view the world as far more explainable than it actually is. We have a compulsion to look for meaning in random events. Taleb labels the typical guru as “the lucky fool in the right place at the right time. The guru attracts devoted followers who believe in his insights but he is unable to replicate what was obtained by chance” (from Fooled By Randomness, front cover flap).

If luck is such an integral part of the investment process on a professional level, what does that say about its role for the rest of us?

Dart Throwers Beat Stock Pickers

Since 1988, the Wall Street Journal has held an investment dartboard contest. Here there is no fuzzy line between judgment and luck. The outcome clearly depends on the latter. Readers pick stocks they think will go up in the next six months. They compete against stocks chosen by simply tossing darts at the listings in the newspaper. Overall, readers have gained an average of 6 percent compared with 9 percent for the darts. In the contest covering the first six months of 2005, for example, readers averaged a 9 percent loss while the randomly picked dartboard portfolio ended up 15 percent. Over a period of time, darts will lose their share of contests (9 of the past 23 contests), but the complete elimination of judgment probably gives darts the edge in all but sweeping bull markets.

If indeed being lucky is so important, how does one explain the track records of those money managers who outperform their peers on a fairly regular basis? First, there aren’t many of them. Managers who achieve outstanding results year after year are a special and limited breed (the best are highlighted in Chapter 8). Second, even they would likely acknowledge luck as a factor, albeit one they have been able to minimize with their particular approach. And third, the small group of fairly consistent outperformers would be even smaller if they were judged by absolute rather than relative returns. The portfolio manager whose fund is down 25 percent for the year is said to have a winning year if his benchmark index is down 30 percent. I think such a statistic says less about the manager’s ability to outperform than it does about the inherent difficulty of avoiding losses in a down market. The investor who is down 25 percent doesn’t feel like a winner.

Luck is often invisible. You were lucky, but you didn’t know it. You genuinely believed it was your investment prowess whereas, as Taleb explains, it was simply serendipity. This is not to say you can’t help the process along. The more homework you do (see my definition of homework in Chapter 10), the luckier you’re likely to get. Then it’s not dumb luck; it’s smart luck.

The fact that it helps to be lucky is not an earth-shattering concept. It’s just that it’s never really given its due by Wall Street. Perhaps understandably, the adviser is not going to diminish the value of his advice by adding, “if you’re lucky.” Luck is rarely acknowledged as more than a peripheral influence. However, it doesn’t hurt to be aware that sometimes, luck is more than just icing on the cake. Without it, there may not be any cake at all.

I am not suggesting you avoid investing in the stock market because too much depends on chance. On the contrary, this book is written to help you create your own luck. It will help put the odds in your favor, a far more dependable strategy than hoping to be lucky. The best way to take luck out of the equation or at least sharply reduce its importance is to invest long-term. The longer the time frame, the less luck is likely to be a factor.

“Nine-tenths of successful investing is luck. The other 10 percent is being prepared to capitalize on that luck.”

—Jim Cramer

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Longevity

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By longevity, I mean good health leading to long life. It behooves the long-term investor to be here long-term. Almost everything good that happens in Wall Street requires the passage of time. Even luck takes time to surface. The longer you hold your securities, the better the odds that nonperformers will perform. Whatever your strategy, what counts is having enough time for it to work. That’s why staying healthy is near the top of my list of the most important attributes for investment success. By doing your best to stay stress-free, by giving time a chance to smooth out the wrinkles, by taking lots of vacations away from your stock, by eating well and getting plenty of exercises, you’ll be increasing the odds of being here when the time comes to collect your rewards. (Of course, having the right genes doesn’t hurt.)

Ralph Waldo Emerson put it more succinctly: “The first wealth is health.”

Equally important is staying mentally healthy, keeping things in perspective. The pursuit of financial gain can be challenging, exciting, and gratifying. Building a nest egg for retirement or for your kids’ and grandkids’ education is an important long-term goal. But taken to extremes, the quest for profit can cause you to lose your balance and distort your priorities. Ross Perot, who at one time was the third richest man in the world, says, “There is no worse way in the world to judge a human being than by what he is worth financially.” So take good care of yourself. Staying physically and mentally healthy is key for growing your money and your soul.

“Time is the single most valuable asset you can ever have in your investment arsenal. The problem is that none of us have enough of it.”

—Richard Russell

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Deep Pockets

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If I could ask a genie to grant me one more investment wish, after luck and longevity, it would be—surprise!—money to spare. As Woody Allen says, “I never knew a situation where having money made it worse.” For those whose pockets are less than deep, let this book be your guide to just how “smart money” got that way. Wealthy investors rarely started off in that condition.

Some of the advantages of having money to spare are obvious; others are more subtle. It’s not just being able to buy more. Sometimes, more money means bigger losses (albeit more affordable ones). What deep pockets do is open up opportunities routinely denied to the less affluent.

It helps to know what those opportunities are, not as a tease, but as an incentive. If you are not already enjoying some of the following advantages, my plans call for you to do so.

For one thing, investors with cash reserves can afford to wait. If, indeed, patience is key, it’s a lot easier to be patient if you can afford to tie up your money for long periods of time. Most of us need to have our money working, generating income or capital gains. The luxury of being able to own low- or non-dividend-paying stocks and holding them for three to five years belongs mostly to those with other sources of income.

Having money available also means you don’t have to sell to buy. When funds are limited and you can only afford to buy something if you sell something else, it means having to be right on both sides of the trade. That’s tough to do. There are always positives and negatives on a stock. When you focus on the negatives of one stock and the positives of another, a switch can sound eminently plausible, even compelling. More often than not, as sensible as it may sound at the time, it just doesn’t work out. What you buy goes up, but so does the stock you sold (and you’re out the commissions). Or what you sold goes down but so does the stock you buy. And, worst-case scenario, your sold stock goes up and your bought stock goes down after the trade. The switch may look good for a while but usually not for long. It is much easier if you can buy what you want without disturbing your holdings. Having to be right only once gives you a distinct advantage.

The periodic replacement of stocks in the major averages illustrates the point. Stocks are dropped while others are added for the purpose, among others, of improving the performance of the index. In early April 2004, three stocks were deleted from the Dow Jones Industrial Average: AT&T, Eastman Kodak, and International Paper. Replacing them were three stocks considered to be better growth prospects: AIG, Pfizer, and Verizon. A year later, the three Dow newcomers had fallen an average of 21 percent while the three removed were up an average of 2 percent. According to Bill Hester, an analyst with Hussman Funds, stocks removed from the S&P 500 since 1998 have regularly outpaced those added to the index.

In another study, Terry Odean, professor of finance at the Haas School of Business at the University of California, Berkeley, looked at the results of buy and sell replacement trades of 10,000 investors at a large discount trading firm. “On average, the stocks that these investors bought went on to underperform the stocks that they sold by about 3 percent over the next year.” (Robert Julian, Your Retirement newsletter, March 2006). Bottom line: When you’re advised to replace one stock with another, it may work out, but the odds are against you.

The investor with deep pockets can buy more shares when his $50 stock drops suddenly to $30 due to problems that the investor believes are temporary. The waiting time before breaking even at $40 can be years shorter than having to hold the stock till it climbs back to $50.

The only way the investor can attempt to duplicate the outstanding performance of an adviser, a financial columnist, a newsletter, and the like, is to buy all the securities recommended, even if they’re odd lots. That takes money. Most of us can’t buy, say, all nine mutual funds in Morningstar’s monitored “Aggressive Wealth Maker” portfolio. We’re forced to pick and choose. When I wrote the Dick Davis Digest, each issue included many recommendations. They all sounded good but only some worked out. The deeper the investor’s pockets, the more choices are available.

“The safest way to double your money is to fold it over and put it in your pocket.”

—Unknown

The Smartest Work for the Richest

Speaking of choices, it’s not surprising that, rather than stocks, wealthy investors often favor alternative types of investments—the kinds that usually require big minimums and charge large fees. A study conducted by the Institute for Private Investors in New York found that wealthy families ($10 to $200 million in assets) allocated about 42 percent of their portfolios in 2004 to alternative investments such as hedge funds, private equity, venture capital, and real estate. Only some 37 percent went into equities. Are these more sophisticated investments apt to perform better than traditional portfolios? Since private pools of money don’t generally release their results, it’s hard to say. Exclusivity certainly doesn’t guarantee superior performance. However, in the investment world, what only the rich have access to usually attracts the top management talent, and thus the best moneymaking opportunities. In a money game, having more of it can only help.

Each year, Trader Monthly magazine releases its list of the top hedge fund managers ranked by how much money each made personally. In 2006, none of the top five made less than $1 billion for the year. It’s unlikely that you or I will be able to avail ourselves of the talents of John Arnold (Centaurus Energy), Jim Simons (Renaissance Technologies), Eddie Lampert (ESL Investments), T. Boone Pickens (BP Capital), or Steven Cohen (SAC Capital). But those with the wealth and connections to be an owner of any of these hedge funds were undoubtedly delighted to see their portfolio managers rewarded so lavishly. It meant there were still huge profits left over to be divided by the fund owners. Privileged indeed.

Then there are the ways that Wall Street, itself, unashamedly favors the affluent customer. The hot initial public offering goes to the biggest or most active accounts. Smaller accounts pay a bigger percentage of their assets as a management fee. Affluent investors who buy and sell bonds in round lots (one hundred bonds or $100,000 at par) are likely to get a better deal than those who trade in smaller, odd-lots. Access to the elite advisers on Wall Street, the private bankers, and the hedge funds is mostly limited to big-money clients who pay substantial management fees. (Does more expensive advice mean better advice? Sometimes.)

The media features glowing reports on successful hedge funds and the sophisticated techniques they use. Invariably, buried in the copy is the multimillion-dollar minimum investment required. Hedge funds used to be exclusively for the wealthy but with their proliferation to over 8,000 funds, some with spotty performances, investment minimums are likely to drop. However, my guess is that as long as hedge funds attract the best money managers (because running hedge funds is where managers can make the most money), it will take big bucks to access that talent. Competing with hedge funds for big-money investors are the private equity firms, which grabbed most of the buyout headlines in 2005–2006. Using money raised from cash-rich pension funds and the super-rich, private equity firms buy publicly owned companies and take them private. They then work to build up the value of the acquired company and hope to cash in at a profit by selling it back to the public via an IPO, or as an outright sale to another company. The deals have come fast and furious, culminating in the planned $45 billion takeover of TXU, the Texas utility, by Kohlberg Kravis Roberts, Texas Pacific Group, and others, the largest leveraged buyout in history. Many private equity firms have generated massive returns for themselves and their investors. Like hedge funds, they hide from the limelight and are accessible only to high net worth investors ($2.5 million minimum net worth is a typical requirement).

I know little about merger arbitrage, but John Paulson (Paulson Partners, New York City) knows everything about it. He’s so good at finding hidden values in bankruptcies, restructurings, buyouts, and buybacks that his $4 billion group of hedge funds has decisively outperformed the S&P 500 Index (13 percent compound annual return versus −2.3 percent in the years 2000–2004). According to Barron’s (May 30, 2005), Paulson has most of his own money in his funds. I would gladly pay him his fee of 1.5 percent of assets and 20 percent of profits to be a partner, but I’d have to invest a minimum of $5 million to do so. Bottom line: In the investment field, only the very, very rich can utilize the moneymaking genius of the very, very smart.

Wall Street Focuses on the Rich

Every firm on Wall Street has its elite stockbrokers. These are the super brokers, the big producers, the heavy hitters—some of whom have billions, not millions, under management. Most of these brokers handle both corporations and wealthy individuals with a net worth of well over a million dollars. These high-powered brokers often have teams of other brokers and even research people working under them. If their success is due to their superior ability to make money for their clients, then the average investor’s lack of access to their services can be called a disadvantage. If, on the other hand, the super broker’s success is due to connections or to aggressive self-promotion, then lack of access by the average investor may not be a disadvantage.

Perhaps the ultimate in investment concierge services is that offered by a growing breed of advisers unconnected to a broker or bank, who cater to the super-rich, that is, people with more than $50 million of total assets. These high-end boutiques help their clients deal with private banks, hedge funds, and venture capital partnerships. They earn big six-figure annual fees by shielding clients from Wall Street’s marketing pitches and by providing objective counseling. Apparently, what the most affluent investors want more than anything else is advice that’s independent and not tainted by conflict of interest.

Sixty years ago, Merrill Lynch pioneered efforts to bring Wall Street to Main Street. Legions of small investors signed up to buy stocks in programs like the monthly investment plan (MIP). Today the focus has shifted from stocks to the broader concept of financial planning, covering all assets of the customer. The broker’s target is the affluent investor and the goal is wealth management. There is lots of wealth to manage—some nine million American households with a net worth of $1 million or more, excluding their principal residence.

Wall Street’s focus on the high-net-worth customer doesn’t preclude success for the average investor. Financial muscle will open doors, but more money doesn’t guarantee more success. The vast majority of investors in the United States, over 90 percent of the 95 million investors, are well below the millionaire level. Yet many are able to outperform the wealthy on a relative basis, and as a result, over time, become wealthy themselves. If you’re not a deep-pocket investor, take careful note of the investment truths in the pages to come and you’ll be on your way.

How about other factors widely credited for investment success like patience, persistence, proper asset allocation, and proper entry-level (buying low)? The difference is this: Luck, longevity, and loot are not directly related to the stock market or a specific market strategy. They are the best things to have going for you before you invest. They often impact results, but they are luxuries, not absolute necessities. The other factors, like patience and asset allocation, apply once you begin the investment process, not before. And they are more than peripheral; they are essential ingredients for successful long-term investing. Everything in these pages is aimed at achieving success in the market without relying on luck. Reading this book, in my less than humble opinion, maybe all the luck you need.

“I’m living so far beyond my income that we may almost be said to be living apart.”

—E. E. Cummings