Will Artificial Intelligence Pick Stocks?

I admit that I have always been a fan of science fiction.  I read most of the Sci-fi classics in high school.  When I was a senior in college I created and taught an accredited course called Science Fiction as a Literary Genre

Much of science fiction imagines or predicts the future.  The stories were often set in the future and gave us a sense of how we would get there and what it would be like.  Sometimes that future would be logical and orderly, other times dark or chaotic.

The idea of artificial intelligence (AI) as science fiction dates at least to Capek’s R.U.R (Rossman’s Universal Robots) (1920). Frankenstein’s monster had a human brain. Capek’s robots were machines that could think.  By 1942, Isaac Asimov introduced his “Three Laws of Robotics” based on the premise that if the robots got too intelligent they might do harm to  humans.  When HAL was introduced to a mass audience (1968) everyone seemed to accept that robots would eventually be smarter than people. 

The development of AI is certainly attracting a significant amount of funding and attention. I am starting to see references to it in advertising for various products and services.  There are certainly ethical issues to be explored, but I am a pragmatist.   AI is “real” enough today that I wanted to take it for a theoretical spin.

My first thought was to use AI to predict the future better than humans and to make money doing it. I wanted to consider if AI will eventually be able to pick “winners” in the stock market. 

Predicting the future accurately is something to which we apply human intelligence every day.  Capek predicted “thinking” machines 100 years ago.  Dick Tracy had a two-way radio in his wrist watch in the 1940s.  Anyone who sells anything is trying to predict how consumers will react to the price and advertising.

Humans make predictions using these two broad steps. First we collect and sort through the data that we believe to be relevant, next we analyze that data based upon assumptions often based upon our prior experiences.

Every day at racetracks the odds are fixed in such a way as to allow the track to take its cut and then have enough collected from bets on the horses that did not win to pay off the winners.  The odds and thus the payout are really set by the crowd placing bets. 

Every day at every racetrack there are people reading tout sheets, looking at track conditions, the horse’s and jockey’s prior races and gathering information from track insiders trying to do better by betting smarter.  Each will filter the data they collect using assumptions that come from their individual experiences.

There is a logical argument that says that these racetrack “handicappers” are trying to be better informed and smarter than the crowd, so they should be able to do better than the crowd and pick winners more often. Those who cannot do better will be weeded out.  

The same logic suggests that AI should surpass human intellectual ability if for no other reason than through trial and error it will continue to develop the way in which it collects data and the way it analyzes that data until it can do it better than humans.  It will do so because that is the goal we will set for it. 

A stock market outcome is far more logical and data driven than a horse race. People buy shares in a given company when they believe the price of the shares will go up.  Conversely, people will sell shares of stock when they think the price will rise no further. 

For every order to buy the stock there is someone entering an order to sell the same shares at the same price. Presumably many intelligent humans are looking at the same data and are coming to the opposite conclusion. That should set a pretty low bar for artificial intelligence.     

There have been computerized stock and commodity trading systems around for years. Most were a scam. They would create a “track record” by back testing their software.  These systems never took in a lot of data.  Traders are concerned with trends in a stock’s price and the volume rather than the company’s income or profits and assets and liabilities.  

The long term investors like the large institutions and small middle class households do care about the company’s financial health and that of its customers and competitors.  That requires a lot more data and a lot more analysis.  

In the US there are mandatory disclosures about financial and other information posted publicly about each company. In theory, everyone can look at the same data.  Analysts take that data and use it to predict the future performance of a company and often, its stock price as well.  Even those analysts who do a mediocre job are well paid.

Could AI do better? 

In theory, AI should be able to collect the data and do the analysis to make the comparisons that will tell it to buy the stock of Company A and not the stock of Company B.  If AI can demonstrate that it can do better than humans, then more and more humans will make a decision to let their money be managed by AI.  Eventually AI will decide which data to analyze and how to analyze it to get the best, consistent results.  The best AI stock pickers will rise to the top of the heap and the rest will be left by the wayside.

At some “tipping” point a significant amount of money will be managed by AI. When this occurs and AI decides to buy stock in Company A, the price of the stock will appreciate in response to the buy order alone.  It will be a self-fulfilling prophesy.  Is that stock-picking heaven? 

But if the AI says the share price of Company A will go higher, who is going to sell into this new demand?    A scarcity of sellers will certainly help the price to run up.  But it will also lead to market dysfunction.   If the AI starts to sell off a large position, there may not be enough buyers to prevent the price of those shares from dropping sharply.

For the stock market to fulfill its primary function to facilitate trading it needs to be a liquid market; there must be a lot of participants who are willing to buy and sell at every price level.  The market needs the smart MBAs who work for the institutions that can pay for their services. It also needs the mom and pop investors who get their “tips” from a Jim Cramer.  

For the market to work efficiently every time, someone’s prediction about the future price of a stock that they buy or sell has to be wrong.  Sooner or later I suspect that AI will realize that problem and act accordingly.  I predict that it will act to change the market rather than its methods of evaluating the companies that trade on it.

This is how I predict AI will approach the problem of its own presence in the market where it makes better investment decisions than any human competitor:

Scenario No. 1- AI realizes that its success may cause the trading to become dysfunctional. It concludes that it would be better to buy shares in companies it would want to hold for the long term.  As new money enters the market, if managed by AI, the AI will eventually use that money to buy larger and larger stakes in those companies. Eventually it may purchase enough shares where it can elect the Board of Directors and control company operations.  It could very efficiently direct business relationships between the portfolio companies for their mutual benefit. It could even direct campaign contributions from portfolio companies eventually freeing itself and those companies from many regulations. 

                        –or–

Scenario No. 2- AI realizes that its best long term strategy is to invest where no one else wants to invest. There are currently many places around the globe where an investment of US dollars buys a lot more plant, equipment and labor than anywhere in the US.  The AI might conclude that its best investment opportunities are in underfunded markets where labor is cheap and investment funds expensive.  Funneling large amounts of money into these less developed markets might make a lot of sense to an artificial intelligence that is looking only at the bottom line, not preconceived ideas about race or nationality. 

There are already investment platforms that claim to incorporate AI into their services. I do not want to judge any of them because I do not think any of them are really ready to operate effectively.  My one hope is that as they continue to evolve they do not get too smart for their own good and for ours.

Suing Your Broker After the Crash

When the stock market corrects again it will be the seventh or eighth time that it has since I began working on Wall Street in the mid-1970s. Corrections are always studied and talked about after they occur.  Corrections really need to be identified before they occur because they  always result in losses in accounts of smaller, retail investors. And they always result in a spike in litigation by those customers who wish to blame their brokers for their losses.

One of the reasons that the number of customer claims will go up is that in a rising market customers have fewer losses. That does not mean that the broker’s conduct was correct, just that it did not cost the customers money or that they could not see the losses or bad conduct until the market went down.

In the normal course, customers that have disputes with their stockbroker do not end up in court. Almost all of the cases are resolved by a panel of arbitrators at FINRA. It is a lot quicker and cheaper and in the vast majority of the cases, the customer walks away with a check for at least a portion of the amount lost.

Securities arbitration was the one consistent part of my professional practice. I worked on my first claim while still in law school. I represented mostly the brokerage industry for the first 15 years that I was in practice and mostly customers for the last 25 years. In all I represented a party or served as an arbitrator in almost 1500 cases. Some were unique and interesting; most were fairly mundane.

There are a few hundred lawyers around the country who specialize in securities arbitration representing customers.  Arbitration is intended to be simple enough that any customer can file and prosecute a claim themselves. But in every case the brokerage firm is going to be represented by a good lawyer and put on a competent defense. Even if you have the most mundane claim you need proper representation.

I have worked closely with about 2 dozen customer representatives over the years and like any other profession, some were better than others.  The best have all spent some time working in house for large brokerage firms.  They understand how the firms operate, what records the firms need to keep, how brokers are actually supervised and what defenses the firms are likely to have.

Do not be afraid to hire a representative that is not an attorney.  My fellow lawyers refuse to acknowledge that a retired branch office manager can often question the conduct of a broker better than anyone else.  For most of the claims that I handled I worked with a team that included both a lawyer and a non-lawyer who had worked in the industry for many years.  The latter was invaluable to every successful outcome.

Many lawyers think that securities arbitration is about the law, which it is not, nor has it ever been.  Arbitrators are not judges. They are not required to know the law, follow the law or to read legal briefs. Arbitrators are fact finders. They want to know who did what and why.  Too many lawyers approach securities arbitration as if they are presenting the case in court. It is the single biggest mistake and the single biggest reason why customers lose these claims.

Beginning in the late 1980s there began to be a lot of product related claims where the investment was itself defective.  Prudential Securities for example put out several billion dollars worth of public and private limited partnerships. Some were defective because the disclosures were not accurate or the due diligence was shoddy; others because the advertising and representations minimized the risks or projected returns that were unsupportable.

Over the years I have seen real estate funds where one appraisal of the property was sent to the bank and a second, higher appraisal went to the investors. I have seen “North American” bond funds full of bonds issued by South American companies and funds and ETFs full of derivatives that no investor could understand. Those claims are relatively easy to win. But it does help if you have a clear understanding of what the proper disclosures should have been.

There are always claims that stem from an individual broker’s bad conduct. Sometimes a broker will place an order without calling the customer for permission first. That is clearly against the rules and a customer is entitled to be compensated for any loss that occurs. If it happens it is easy to prove as the telephone records and the order are both time-stamped. Either the phone call preceded the order or it did not.

Sometimes a broker will help a customer trade an account or recommend a lot of buys and sells in a short period of time. Trading is not the same thing as investing.  Most traders, because they are making a lot of trades are concerned about how much commission they are paying on each one. That is why most traders gravitate to one of the low commission discount firms.  When you see a trader paying high commissions per trade and making a lot of trades it is usually a problem.

When the market comes down again, some of the losses will be the result of bad products and bad brokers.  However, most of the losses that the customers will suffer will be the result of staying in the market too long.  They will not be the victims of fraud but of simple negligence, as the claims will be based upon violations of the brokerage industry’s suitability rule.

The suitability rule is something that stockbrokers and their supervisors deal with every day. Notwithstanding, lawyers representing customers seem to have a hard time explaining it and how it is violated to arbitration panels.

Simply stated the suitability rule requires that a broker have a reasonable basis every time they make a recommendation to a customer to either, buy, sell or hold onto a security.   As it is written the rule sets forth a course of conduct for stockbrokers and requires them to get pertinent information about the client’s financial situation and tolerance for risk.

The typical defense is that the customer checked the box on the new account form that said he was willing to accept some risk or was willing to accept something other than conservative, income producing investments. This customer-centric view gives defense lawyers a lot of latitude to confuse arbitrators and will befuddle a lot of claimants when they file claims after the next crash. The proper way to view the suitability rule is to focus on the investment and the recommendation, not the customer.

In the normal course the only reason for a broker to recommend that a customer purchase any security is because the broker believes that the price of that security will appreciate in value. When they think the price will appreciate no further, they should recommend that the customer sell the position and move on to something else. The broker does not have to be correct, but he must have a reasonable basis for his belief.

Brokers and investors all over the world have for decades used the same methods to determine which securities will appreciate and which will not. It is called fundamental securities analysis and it is taught in every major business school.  Most of the large firms have cadres of analysts who write research reports based upon this type of analysis. Most of those reports set forth the analysts’ opinion of a target price for the security they are reviewing.

Deviating from that analysis will always get the brokerage firms in trouble.

That is what happened in the aftermath of the crash in 2000-2001.  Many of the claims from that era were the result of conflicted research reports. The firms were competing to fund tech companies and were funding companies that had few assets other than intellectual property and fewer customers if any.

I had several prominent research analysts on the witness stand who basically explained to arbitrators that they had to make up new ways of analysis because the internet was so new. That was BS, of course, and those “new” formulas were never disclosed to the investors or for that matter, never the subject of an article in any peer-reviewed journal.

Markets never go straight up for as long as this one has without a correction. I think that a lot of people seriously believe that a market correction or a crash is coming sooner rather than later. It may happen next week, next month or next year but it will happen.  I can say that because there is a lot of empirical data to support that position.

For example: 1) price/earnings ratios of many large cap stocks are at the high end of their ranges and when that happens prices come down until they are closer to the middle of the range; 2) employment is very high meaning wages should go up impacting the profits of many companies; 3) interest rates are rising which will cause people to take the profits that they have made in stocks over the last few years and convert them to safer, interest paying instruments; 4) rising interest rates also curtail borrowing, spending and growth; 5) an international tariff/trade war came on the markets suddenly and its impact has yet to be shown; 6) the global economy is not that good which should decrease consumption and prices; 7) oil prices keep rising and gas prices along with it because of international political uncertainty which adds to the cost of everything that moves by truck, which is virtually everything; 8) there is a lot of bad debt in the marketplace (again) including student debt, sub-prime auto loans and no-income verification HELOCs; 9) real estate prices are very high in a lot of markets and in many markets the “time on the market” for home sales is getting longer; and, 10) the increased volatility of late is itself never a good sign for the market because investors like certainty and stability.

None of this means that the market will necessarily go down but all of it needs to be considered. And that is really the point.  Many so-called market professionals urge people to just stay in the market no matter what. They claim that they cannot be expected to call the top of the market. They argue that the market will always come back, so what does it matter if you take some losses now.

Any investor who has made money during this long bull market should want to protect those gains. Any broker who is smart enough to advise clients when to buy a security, should be smart enough to tell them when to sell it.  Any advisor who keeps their clients fully invested when there are indications that a correction may be imminent is going to get sued and frankly deserves it.

The brokerage industry has always had a prejudice that suggests that customer should always be fully invested.  Brokers who work on a commission basis are always instructed that any customer with cash to invest should invest. Likewise, as the industry has morphed away from commissioned brokers to fee-based investment advisors, those advisors want to justify those fees by having a portfolio to manage not just an account holding a lot of cash.

Registered investment advisors are likely to be especially targeted by customers seeking to recover losses they suffer for a number of reasons. Many are small shops that do not employ a large stable of research analysts.  Many advisors just buy funds and ETFs and allocate them in a haphazard way because they really do not understand how asset allocation actually works. This is especially true of robo-advisors that are not programmed to do any analysis at all or to ever hold a significant amount of cash in their customers’ accounts.

All investment advisors including robo-advisors are held to the highest standard of care, that of a fiduciary. Any fiduciary’s first duty is to protect the assets that have been entrusted to their care. Any customer of a stockbroker or investment advisor should have a reasonable expectation that the profits they have earned will be protected.

I am posting this article on the evening before the US mid-term elections and on the day that the US re-imposed economic sanctions on Iran. Both may have significant effects on what will happen in the stock market in the next few months and beyond. Analysts may differ on what they believe those effects will be. But that is not an excuse to do no analysis at all.

The markets are driven by numbers and any broker or advisor who believes that they can offer advice without looking at those numbers has no business calling themselves a professional.  To the contrary, any advisor who tells you to stay in the market because no one can know when it will stop going up or that it will come back if it goes down is just playing you for a fool.

 

 

Defining Investors’ Best Interests

In the spring of 2016 the US Department of Labor (DOL) issued new rules which sought to change the landscape for investments held in retirement accounts.  The DOL sought to extend the rules governing how large pension plans and 401(k) accounts were managed to every IRA account held by individuals.

The regulations were a thousand pages long, the result of 6 years of discussion and millions of dollars of lobbying by various players in the financial services industry.  To no one’s surprise that lobbying paid off and the final rule was a watered down version of prior drafts that had actually excluded some of the riskiest investments from all retirement accounts.

The final rules also allowed brokerage firms to create exemptions if the rules did not fit specific individual accounts that were called “best interest of the investor” exemptions. The current administration in Washington and several courts have stopped these rules from being implemented.  The discussion of what investments and investment strategies are in the “best interest of investors” continues.

At no point along the way did the regulators, industry or consumer groups ask investors what they thought would be in the best interest of their retirement accounts. Had anyone done so, they would have been told that investors would be very happy if their retirement account was worth more today than it was a year ago and worth more in one year than it is today.

Before you scream “impossible” I think you should consider that even though no one can win every year, it is important that you at least try.  If you clear your head of all the BS that you hear about the stock market and investment advice and start at the basics, you will see it is not as difficult as many people think.

The primary reason that anyone ever buys a stock is because they believe that the price of that stock will go up.  When the price does go up to where you think it will go no higher you sell the shares.  You may not be right every time but you can certainly be right most of the time and you should be happy with that.

Selecting investments takes time, effort and skill.  The large brokerage firms and investments banks will usually have a fairly large research department and the best ones seek out and hire the best analysts in each industry. In order to “cover the market” a firm may have analysts that will be analyzing companies from 15 different industries if not more.  An analyst with expertise in the automotive industry might not understand the banking industry and neither might be able to understand the value of drugs that the large pharmaceutical companies have in the development pipeline.

The truth is that no one firm has the best analysts in every industry.  That is one reason large institutions frequently deal with multiple firms so they have access to research reports prepared by the analysts they think are the best in each industry.

Beginning in the mid-1990s a lot of stockbrokers began to abandon the traditional business model and the large firms and transformed themselves into self employed Registered Investment Advisors. This was a result of their commission income being under attack from discount brokerage firms that charged much less. It was not unusual for a customer to have an account at one of the wire houses to get access to the research, buy 100 shares through that firm and 900 shares of that stock through their account at a discount firm.

After the tech wreck in 2001 it became clear than many of the “best” analysts covering the tech industry were conflicted.  They were following companies that were grossly overpriced but which were bringing in large underwriting and investment banking fees, so the firms found ways to “value” companies with no revenue claiming it was appropriate for them to do so.

The result is that many of the newly minted investment advisors were willing to leave the research analysts behind. They convinced themselves and their customers that they could be portfolio managers even though they lacked the most basic tools to do so.

This led to the rise of asset allocation using mutual funds and ETFs. The argument was that the losses from the tech crash arose because people had too much of their portfolio in tech stocks. Diversify your portfolio became the new mantra of the market. Buy large baskets of stocks and you will never have to worry again. 

Asset allocation had been around since the 1950s. The purpose of a diversified portfolio is to reduce overall portfolio risk.  If one or two market sectors do poorly, your losses would be balanced by those sectors that would profit.

As applied it is often an attempt to mitigate all risks which it cannot do. If you are trying to manage risk without defining what that risk is, asset allocation will never be the optimal method for any investor.

Asset allocation did not work very well in 2008-2009 as the sectors that were most affected and took the largest losses, banking and real estate touched virtually every other market sector. The losses, especially in the home value portion of investors’ net worth reduced consumer spending, led to increased unemployment and just about all portfolios took some losses.

All of that has apparently been forgotten in the ensuing bull market. Forgotten is the idea that asset allocation does not work in all markets. Forgotten is the idea that loading up a portfolio with mutual funds or ETFs full of stocks is a recipe for disaster unless you have some good reason to believe that market will continue to rise.

Advisors, because they had no good research to support their portfolio selections, told investors that they did not need research.  The rise of robo-investment advisors is indicative of how foolish the investment world has and will become.

Investors are now told that they should invest based upon their age as if an investor’s age had anything to do with how the market will perform.  Younger investors are directed to select portfolios with more stocks because they had the time to could “make up the losses” if losses occurred.

No robo-advisor suggests that it would be better to not take the losses in the first place.  None suggests that the basic tenets of the “investment pyramid” which would have younger investors build a solid base of more conservative investments first might be more appropriate.

Most importantly no robo-advisor seems to think it is important to tell investors when they should sell.  That advice is as important as any advice to buy anything because no stock and certainly no market can go up forever.

At the end of the day, the discussion about what is in the “best interests of investors” boiled down to a discussion of cost.  Investment advice has become commoditized and therefore the argument goes, consumers should be charged the cheapest price.  This is one of the largest crocks of BS that has ever been foisted on investors.

Goldman Sachs, JP Morgan, the largest pension plans, endowments and serious professional investors all rely upon research and analysis to make investment decisions.  The best analysts earn 7- figure salaries because they are the best.  All that smart money pays dearly for advice. At the same time, regulators and others are telling individual investors that it is their best interest to get the cheapest advice or none at all.

If the person offering you investment advice is suggesting stocks, bonds,mutual funds or ETFs without some reasoned opinion about what those investments will be worth in 90 or 180 days, that advice is useless and you should not pay anything for it.  If they tell you that they construct portfolios that use an algorithm, ask them if the algorithm is aware that the US government is imposing new tariffs on imports or that the Federal Reserve is raising interest rates.

The SEC, DOL and other regulators would do investors a favor if they required those giving investment advice to always share with their customers why they bought and why they sold every position.   A little transparency is always in investors’ best interests.

When I was diagnosed with cancer I wanted the best doctors, not the cheapest. When a neighbor or friend called me in search of a lawyer because their kid was picked up on a DUI, I declined to handle the representation because it was not my field of law and they really needed a specialist. And guess what, specialists cost more.

People need investment advice because bad investment advice or no advice will severely impact their retirement and they should be willing to pay more not less for good advice.  Good investment advice will always be in the investors’ best interest. The discussion really needs to stop with that.

 

Investment Advisor Litigation When the Market Corrects

When the stock market finally corrects it will be the eighth major correction since I first started working on Wall Street back in the 1970s. It may happen next week or next year but it will certainly happen.  When the market does correct investors will certainly experience some losses.

Everyone understands that the stock market goes up and down. That does not mean that investors should expect to lose a significant amount of the money they made during the bull market when the correction does happen.

At every correction investors who lose more money than they anticipated bring claims for compensation against their stockbrokers and advisors.  For a stockbroker registered at FINRA most of the claims will be handled by FINRA in an arbitration proceeding. As soon as the claim is filed it shows up on the stockbroker’s Brokercheck report.

Many of the investment advisors who are registered with the SEC or with a state agency but not FINRA also have arbitration clauses in their customer agreements. They too are supposed to amend their disclosure filings to report customer claims, but few do.  I know of investment advisors who have had multiple customer claims but still show a clean record.

Investment advisors are always considered to be fiduciaries to their clients. As such they required to fulfill all of the duties of a fiduciary.  A fiduciary’s first duty is to protect the assets that are entrusted to them.

You cannot protect the assets in an investment portfolio unless you are prepared to sell them when the market turns down.  For advisors who are paid based upon the amount of money in the portfolio this creates a conflict of interest that no one wants to talk about.

Too much cash in the portfolio invites the customer to withdraw the cash and invest in something else, like real estate.  Good advisors will offer a large variety of investments so that they can always find one poised to increase in value or provide a steady income.

This will be the first market downturn where a significant amount of assets are being held by robo-investment advisors.  When the next correction comes, robo-investment advisors are going to be likely and easy targets for the plaintiff’s bar.  Robo-investment advisors are not programmed to sell positions when the market begins to turn down and are likely to stay invested while losses pile up.

Robo- investment advisors select their portfolios using algorithms that are fed with historical market data.  Everyone knows that past performance is no indicator of future results but the SEC allows this sham to continue. For a robo-investment advisor to have any value it would need to be able to assess what is happening in the real world economy and what is likely to happen as a result.

Robo-investment advisors claim to use asset allocation to select their portfolios and to protect their customers from losses. The simple truth is that most robo-advisors (and many human investment advisors) have no idea how asset allocation is done correctly.

The idea behind asset allocation is that you can create a portfolio of non-correlated assets that will reduce the risk if some macro-economic event rocks the markets.  Most robo-investment advisors give lip service to the idea of a diverse portfolio but few actually construct their portfolios correctly.

Many human and robo-investment advisors construct portfolios with asset classes such as “large cap stocks”, “mid-cap stocks” “small cap stocks” and “international stocks”.  As regards most macro-economic events such as a spike in the price of oil or an increase in interest rates, these asset classes are perfectly correlated with each other, not the opposite as they should be.

Asset allocation is designed to deal with the constant yin-yang between stocks and bonds triggered by interest rate fluctuations. For a long term portfolio, you would accumulate bonds at par when interest rates were high. As interest rates peak and began to come down, you would expect stocks to begin to appreciate, so you would sell bonds at a premium and begin buying good stocks in different, non-correlated industries.

Asset allocation works because its portfolio re-balancing system is based upon the premise that you will buy-low and sell-high. Robo-investment advisors re-balance their portfolio based upon a pre-determined formula that simply ignores what is likely to go up and what is likely to come down.  Many human advisors do not do the kind of research necessary to intelligently re-balance a portfolio either.

I worked on a lot of claims against stockbrokers and investment advisors after the market crashes in 2001 and 2008.  They always put up the same, weak defenses.

First, they argue that no one can predict the top of the market.  That is absolutely true and totally irrelevant. The great bulk of intelligent, prudent investors only invest in stocks that they think will appreciate in value. If your robo (or human) investment advisor told you to buy APPL or a mutual fund or ETF of “international stocks” it is fair that assume that they did so after some analysis that concluded the position would appreciate. Otherwise the advisor brings no value to the relationship.

If the advisor is actually doing that analysis and it includes more than just consulting a Ouija board, sooner or later that analysis will say “sell” or at least indicate that the share price will not appreciate much more.  The most common indicator is price/earnings ratio which economists tell us will usually fluctuate within an established range. When prices get out of the range on the high side, they will usually decline and revert to established norms.

Next, brokers and advisors defend these claims by arguing that clients should stay fully invested at all times because the market always comes back. That is another insipid defense.  It is akin to suggesting that you should keep your hand on a hot stove because it will eventually cool down.

As we approach the end of this long bull market every investor should be happy with the gains that they made in their portfolio. The Dow Jones Industrial Average has more than doubled since the end of 2008.  Even if your portfolio had a smaller gain, why would anyone want to give those gains back when the market declines?

Next, advisors offer lame excuses as to why they did not hedge the portfolio against a market downturn. There are a number of ways to accomplish this but very few advisers have a system to do so effectively.  I have asked many advisors why they do not hedge their portfolios or include stop loss orders to protect against a serious loss. They usually tell me that they were afraid to sell positions because the market would resume its climb and they would miss further gains.

That particular defense only works if the advisor has some research that suggests the market will go higher still. Many of the advisors that I cross-examined over the years had nothing more than their own gut feeling.

Where advisors tend to really screw up is when they get into the habit of adding speculative “alternative” investments to a portfolio to “juice” the returns. This may be acceptable for people who understand the risks and who are willing to accept the losses if things do not turn out as planned.  That does not describe a lot of people who are sold these investments thinking that they are hedging against losses in other investments.

Real estate investments are commonplace as an alternative and many advisors will add an exchange traded REIT to a client’s portfolios. These are very different than non-traded REITs which are usually private placements. The risk is much greater if the investment cannot be sold and at least some of the value retained.  Non-traded REITS have been the subject of thousands of claims against brokers and advisors in the last 10 years.

At the end of the day most of an advisor’s clients turn over the management of their portfolio because they want the portfolio to grow. That should not be that difficult for any good advisor but like anything else, you have to know what you are doing and you have to put in the hours to do it right.

Giving good professional investment advice takes skill and it takes effort, but it is also a people business. The number one complaint that I heard over and over, year after year, from people who contacted me asking about suing their broker or advisor was always the same, “He stopped returning my phone calls”.

When the market takes a sharp downturn, people want advice. That is another reason why robo-investment advisors are likely to see more litigation when the down-turn comes. They are never going to hold your hand.

 

FINRA looks at Wall Street’s Corporate Culture – It should look at its own.

The Financial Industry Regulatory Authority (FINRA) has announced that as part of its 2016 member firm audits it will look into what it calls the firm’s culture of compliance and supervision. The idea is laudable until you put it into context.

Registered representatives (stockbrokers) are routinely incentivized to open more accounts, bring in more money and make more trades. Many successful stockbrokers gain their clients’ trust by presenting themselves as financial advisers when they are not. They are salespeople not analysts or advisers.

That is the culture of the industry. It is demonstrable without an audit.

As someone who has brought arbitration claims against hundreds of stockbrokers, I can tell you that the miscreants among registered representatives are a small minority. Most stockbrokers do not get out of bed thinking “who can I screw today”. More frequently problems arise from advice they are not qualified to give or even more often from financial products that should not be sold in the first place.

The most conflicted advice that is routinely given by FINRA Broker/Dealer firms is for customers to stay in the market no matter what. If the market crashes, which it periodically does, registered representatives routinely tell customers that they did not see it coming and then “don’t worry, the market always comes back.”

Ask yourself: if your stockbroker did not see the market crash coming, how do they know that the market will come back?

My own adviser (an independent Registered Investment Advisor) has been bearish since last summer. After a long bull market he called the collapse of oil prices a “shot across the bow” for the markets and started selling positions and accumulating cash. He has raised more cash of late because he uses stop losses. He believes that protecting a client’s portfolio is part of his job. If your adviser thinks differently or does not use stop losses, send me an e-mail and I will gladly refer you to mine. (I receive no fee for any referral).

A FINRA audit is often performed by an inexperienced auditor (not a CPA) who is thinking about spending a few years at FINRA and then getting a more lucrative job in the industry. Rarely, if ever, do FINRA auditors ask the hard questions.

Trillions of dollars worth of transactions are placed by FINRA firms every year that are perfectly legitimate and need little scrutiny. FINRA would do better to spend time and energy reviewing those transactions that yield the most problems.

Hundreds of FINRA firms and thousands of registered representatives specialize in selling private placements to non-institutional customers. Private placements pay higher commissions than most other financial products and are therefore always a concern for potential abuse. Private placement losses are a multi-hundred billion dollar problem that affects many seniors and retirees, many of whom should never have been offered these investments in the first place.

FINRA has explicit rules about how firms should perform due diligence on private offerings. Failure to conduct a due diligence investigation on private offerings has been a leading cause of investor losses and the reason that a significant number of FINRA firms went out of business when the market corrected in 2008.

Private placements are sold with shiny marketing brochures that are supposed to be reviewed by compliance departments but frequently are not. Do FINRA auditors routinely review the marketing materials for private placements at the firms that they audit to see if they are appropriately reviewed and not misleading? They do not.

FINRA would do well to examine its own culture.

It has never been my practice to file complaints with FINRA’s enforcement branch, in part because they are consistently ineffectual. Some time back, I did file a complaint on behalf of an 80 year old client who had been sold a particularly ugly private placement for a building in the mid-West.

The sponsor, who was also the master tenant responsible to make payments to the investors claimed to be a college graduate who had previously owned a seat on one of commodity exchanges. He also claimed to have been a successful real estate developer.

In fact, the sponsor had never graduated from college, never owned a seat on any commodity exchange and his only prior development had filed for bankruptcy protection leaving many sub-contractors unpaid. I submit that no competent due diligence officer who actually investigated this offering would have approved it. That did not stop dozens of FINRA firms from selling this and other private placements offered by the same sponsor.

The investors ultimately lost the building to foreclosure because the roof leaked badly and needed expensive repairs. The due diligence officer at the FINRA firms that sold this private placement had never seen an inspection report on the building and it is doubtful that a building inspection was performed before it was syndicated to investors. The sales brochure that every investor received described this as a great building and a great investment.

The FINRA enforcement officer that looked into the complaint had never performed a due diligence investigation himself nor was he trained in any way as to what a reasonable due diligence investigation might entail. I know this because I spoke with him more than once. He pronounced the due diligence investigation on this offering to have been fine and on his recommendation FINRA took no action against the member firm.

I took the claim to arbitration and the panel rescinded the transaction giving the customer all of his money back with interest. It certainly helped that the registered representative who had sold the offering to the customer testified that he would not have made the sale if he had known that the firms’ due diligence had been so minimal. If the arbitrators and the registered representative could see that the due diligence was inadequate, why could FINRA’s own enforcement staff not see the obvious?

In another case involving a complex, highly leveraged derivative I asked the branch office manager who had approved the trade to explain the investment to the arbitration panel. After he had embarrassed himself with a clearly incorrect explanation the claim settled. I doubt that many FINRA auditors could have adequately understood this particular financial product well enough to ask questions about it.

Regulatory compliance in the financial services industry is not rocket science. Every supervisor should be able to spot a bad trade if it hits their desk. Compliance does take time and can be expensive.

If the firm has one compliance officer for thousands of salespeople or one due diligence officer reviewing dozens of offerings every month FINRA does not need to delve into the corporate culture. It is a safe bet that adequate compliance is not happening.

I know that more than a few regulators and compliance professionals read my blog. I would appreciate your thoughts and comments.

7 Reasons Why Robo-Investing Will Not Work. Millennials – Wake Up

Robo-investing is the next really big, really dumb thing. Millennials are expected to pour enormous amounts of money into these programs in the next few years. That would be an enormous mistake.

Robo-investment programs promise to help users to set up investment portfolios now and then to help manage those portfolios for the next 25 or 30 years. The portfolio with which you will end up, all those years down the road, is likely to be a disappointment.

I looked at a number of the websites and advertisements for these programs as I was writing this article. One proposes that a”moderate risk” portfolio would have 90% held in stocks. Another has a member of their investment team who takes a “holistic” approach to financial planning. That may be fine for some people but is not a serious approach to managing your money as far as I am concerned.

These computer programs do not have what it takes to intelligently construct a portfolio for you now or to manage it over a period of many years. Years from now, you will wish that you had a portfolio put together and monitored by a well trained and intelligent flesh and blood investment adviser. By then it will be too late.

Robo-investment advisers tout the fact that they cost less than a human investment adviser would cost. It does not really matter. Robo-investment advisers are inexpensive because they provide investors with little or no value.

If you have any doubt that these robo-investment adviser programs are less than worthless, here are seven obvious reasons why the actual portfolio that you will get from a robo-investment adviser program is likely to perform poorly.

Number One: It is not about your age.
One of the few personal questions that a robo-investment adviser program will ask is your age. If you are thirty the program will assume that you can afford to take on more risk than a person who is sixty. If it is suitable for you to take on more risk then your recommended portfolio will get more stock funds or ETFs and fewer bond funds and bond ETFs.

Investing based upon your age assumes that your age and the markets are somehow related. What you should or should not buy today is dependent upon the market, not upon your age. If you start down this path, what you will have bought or sold over the years that you stay with the program will have had nothing to do with what might have been a good investment at any time.

Number Two: Today might not be a good day to invest in either stocks or bonds.
Let us say that the program suggests that you create a portfolio that is 35% bond funds or bond ETFs and 60% stock funds or stock ETFs with 5% held in cash. In truth, it does not seem that most of these programs ever hold a lot of your funds in cash which always increases the portfolio risk.

If you begin investing this year when the stock market averages are making new highs it is reasonable to expect that next year or the year after the market might correct. It is very possible that five years down the road 60% of your portfolio will be worth less than it is today.

After seven years of forced low interest rates is this a good time to put 35% of your money into bond funds or ETFs? Savvy investors know that bond funds do not do well when interest rates rise. The computer will not adjust for the hike in interest rates that everyone knows is coming until after it happens and the portfolio has taken the loss.

Number Three: It is about the right math, the right data and more.
Robo-investment advisers claim to have sophisticated algorithms that will crunch the numbers and produce good results. The algorithms may be good but these programs look at the wrong numbers. A robo-investment adviser never gets past a limited set of gross market data. A robo-investment adviser never actually looks at any company’s balance sheet. They are an example of the GIGO principle of statistical analysis; garbage in, garbage out.

It is not only about the numbers. Before I would invest in any company I would want to know about products that the company might have in the pipeline, what its competitors were up to and what the CEO is thinking about. I am not alone. A robo-investment adviser is never interested in these things that most other investors would want to know.

Number Four: Investing cannot be done in a vacuum.
The computer program does not get a live news feed and would not know if Germany had invaded Poland so events leading up to any crisis that might affect the markets and the portfolio would necessarily be ignored. The program does not concern itself with current commodity prices, currency rates or international politics. Intelligent investors do.

To my mind, using a robo-investment adviser to construct and manage your long-term portfolio is the same as making all of your investment decisions from inside a small closet with the lights off and the door closed.

Number Five: The markets will not be static for the next 25 years.
The noted theorists upon whose works Modern Portfolio Theory and asset allocation are based were examining data from the markets prior to 1990. The financial markets have evolved significantly in the last 25 years. It is not just the speed or the technology. The markets are now global, there are a lot more participants and there is a lot more money in play. How the markets will continue to evolve and operate in the next 25 years is anyone’s guess and is certainly not built into any robo-investment program.

Number Six: The data that the program uses to select portfolios is based upon the past performance of the markets and past performance only. I should not have to tell you that past performance is an unreliable indicator of future results. If you invest with any one of these programs future results are exactly what you are trying to achieve. Why use data that is unlikely to get you there?

Number Seven: Human beings are actually necessary.
The sales pitch for these robo-investment advisers suggests that can do better than any human financial adviser. One company even touts that its program alleviates the risk of human error.

Using a robo-investment adviser will inevitably lead to portfolio losses every time the stock market goes down or interest rates go up. It will never tell you to avoid downturns or to get out of the markets all together before a crash. Likewise, the program never looks for new companies that might do very well or for any other investment opportunities that might make you money.

Severe market downturns can be scary. Investors are prone to panic. When your account value is dropping you are going to want someone to call. The robo-investment adviser will offer neither solace nor advice. That will only come from a knowledgeable human being. For that you have to pay a little more.