Selected Book Excerpts


(From “Holistic Financial Wellness — How to Survive in Complex Financial World“)

Chapter 8: Charlatans, Fools and Snake Oil Salesmen

Do you believe in magic?

I don’t know about you, but I love magic shows. It’s not just the amazement I feel watching someone do something that seems impossible and wondering, “how in the world did he do that?!” It’s more than that. It is something primal and exciting. Watching a true master of these dark arts, I become a little kid who wants to believe that it really is magic that I’m watching and that the mysterious man on stage has tapped into forces that truly exist but no one but him can use. Of course I know better, but when someone explains how a trick is actually done, I can’t help but be a little disappointed as the world returns to spinning in its normal, if confusing, way.

In fact, we all secretly want to believe in magic, and I think that is particularly true when it comes to financial matters where we often feel imprisoned and want desperately to be able to magically shed our shackles and escape our predicament. It’s that desire that many of the purveyors of financial advice are tapping into. And just like the kid who, after watching Houdini do it, thinks he can jump into a lake with a strait jacket on and escape without drowning, we need to recognize the reality of what we are watching and not try to do it ourselves until and unless we thoroughly understand exactly how the trick is done and have developed the skills to actually “perform” the magic that we see on stage.

So, at the risk of disillusioning many of you who are looking for miraculous escapes from financial troubles, I am going to explain some of the techniques that financial wizards (particularly the ones you see on tv) use to fool you into thinking there is an easy solution to your financial issues.

Just like any good magician, financial advisors are adept at psychological manipulation as in any magic trick it is essential to get the audience looking in the wrong place and/or focusing on the wrong object. As we will see in the next section, when it comes to financial matters, it is relatively easy to misdirect and mislead us. Not only are we not rational financial decision makers, being prone to strong emotional biases as well as basic fear and greed, we are hard wired to have cognitive biases and make systematic errors, all of which an advisor can take advantage of. When we talk about these “human factors” it will be clear why we are taken in by the many advisors out there interested in telling you how to manage your financial life. What I want to do now is talk about how they do it.

The first, and in some ways, least interesting technique that you will come across is the “smoke and mirrors” that surround many financial strategies. Before telling you about the strategy, the advisor will often provide a lot of seemingly important information that is actually irrelevant to your basic financial issues. If you pick up any best-selling book from your local book store you will find a depressing amount of this worse than superfluous material in almost every volume. For example, if you start reading Ric Edelman’s most recent book, “The Truth About Your Future: The Money Guide You Need Now, Later and Much Later” (currently the number 2 best-selling personal finance book in America) you will find that Ric spends literally the first half of the book telling us about the wonders (and dangers) of our future technological world. He discuss in great detail issues like; Big Data, Robotics, Nanotechnology, Virtual Reality and many others. The ostensible reason for doing this is the proposition that in order to make good financial decisions you need to understand the world around you and know where it’s going. That rationale might sound reasonable and Ric’s writing about the future is certainly entertaining, but there is a big problem with the logic. As we learned in Section II, no one can predict the future; not the direction of future technology and certainly not the impact such technologies will have on a system as complex as the global financial system let alone Society in general. Ric seems like a very smart man and he has clearly done his research, but his speculations on things like “the dark side of AI and Machine Learning” and its impact on our financial system are, in my view, pure guesswork. Personally, if I want to imagine what Society will look like in 30 years I would rather read a good Science Fiction book. At least I will know what I am getting.

But Ric is not one to be deterred by the intractability of the future. Having spent almost 200 pages beguiling his readers into thinking that they now know what the world will be like in the coming years, Ric then proceeds to tell them what to do about it. It’s an effective technique, and millions of readers of the book likely believe they are getting expert financial advice, but in my opinion, all they are getting is some speculation based on an illusion of knowledge created by a master of misdirection.

Another, and potentially more harmful form of misdirection used by financial advisors, is representing correlation as causation. This is a big problem and it has plagued scientists and other “Truth seekers” for thousands of years, so its prevalence in the financial planning world is not surprising. The difference is that where scientists are always on guard against confusing the two and go to great lengths to avoid making this mistake, financial planners seem either unaware of its existence or happily take advantage of their audience’s weakness in detecting the difference.

To give one blatant example of confusing correlation with causation, consider Chapter 1 of “You can Retire Sooner than You Think” by Wes Moss (# 18 on Amazon’s personal finance best seller list). In this chapter Wes attempts to give his readers some advice on how to be a “happy retiree”. To do this, he first does “research” As Wes says, “In my comprehensive survey of 1,350 retirees across 46 states I was ruthless in my quest for answers”. He even “went to the Georgia Tech Department of Mathematics and had the data’s ‘confidence and significance’ verified by the former president of the GA Tech Math Club, along with one of her former math professors” And what did he come up with? Well, it seems that among his “significant” findings was that happy retirees “don’t drive BMW’s, but unhappy retirees often do.”  On the basis of this “research”, Wes then advises you to “Ditch the BMW and stick to Asian brands”. Hopefully it is clear that Wes is mistaking correlation for causation. In particular, it may be that unhappy retirees own BMW’s, but that is much different than saying that buying a BMW will cause you to become unhappy.

While buying the right car is not going to make the difference between a happy and an unhappy retirement, one other conclusion Wes draws from his survey that also confuses correlation and causation goes right to the heart of how to manage what is, for most people, their biggest financial asset. Specifically, he finds that happy retirees “didn’t have a mortgage (and) if they did their payoff was in sight.” He then concludes that to be happy in retirement, one should strive to own one’s home free and clear. Wes incorporates this “insight” into his recommended financial strategy. He even calls it “Secret #3” in his “5 Money Secrets of happy Retirees”. Describing this part of his “5 Secrets” based financial strategy, he says that you should do what’s necessary to “pay off your mortgage in as little as 5 years”. Again, it may very well be that having no mortgage correlates with being a happy retiree, but that doesn’t mean that paying yours off will make you one. How to handle this significant asset and the typically very large liability (i.e. the mortgage) that goes along with it is a very complicated question and one that simply can’t be answered outside of the context of your entire financial situation. We will talk much more about this in Section V, but for now it’s just important that you realize that the strategy that Wes outlines, (including Secret #3) is based on a flawed premise and to be aware of this dangerous and misleading trap than can get you to mistake the manifestation of good financial decisions for the method of making good choices.

There are plenty of other psychological tricks that advisors utilize in misleading you, and we will come to some of them in Section IV. Now, however, it’s time to get a bit technical and talk about some of the specific “money technologies” that will allow you to understand the “magic” that is part of the performance of many of the financial “gurus” you read, listen to or watch.


Inside the black bag of tricks — Interest, Leverage and “Backfitting a ‘winning’ strategy”

Almost since the invention of the concept of money earning “interest” over a thousand years ago, people became aware of its remarkable ability to turn modest sums of money into fortunes. Albert Einstein called compound interest the “eighth wonder of the world” and said famously that “he who understands it earns it … he who doesn’t pays it”. Mathematically, the concept is very simple. If I can earn 10% annually on my money and invest $1000, after one year I will have $1100, but after two years I will have not $1200, but $1210. This extra $10 comes from the fact that there is interest earned on the interest itself. While this difference is initially small, over time it becomes very significant. If I earn 10% interest for 10 years, rather than have $2000 ($1000 plus ten times the $100 of interest I earned in the first year) I will have about $2600. The emergence of this extra “interest on the interest” often seems like magic, and in the hands of a unscrupulous advisor can be used to devastating effect.

Consider Dave’s Ramsey’s example discussed earlier. He described how by simply setting aside a modest $1995 per month it was possible to accumulate $1 million in only 15 years and $5.5 million in less than 30 years. How did he do it? Well, he took the concept of compound interest and used three of its inherent properties to make his demonstration even more dramatic than it otherwise would have been. First, rather than tell you that you were actually investing over $350,000 (15 years of monthly payments of $1995) to accumulate your first million, he broke the investment into very small periodic payments. Using periodic payments with compounding will often make for much more dramatic comparisons as our minds tend to focus on the huge difference between the $1995 and the $1million rather than thinking about the fact that in this case you will have to make 180 separate payments of $1995 to get there.

But there are two other “dials” Dave used to make his example so striking. First he used an interest rate of about 12% instead of a more “normal” investment return on stocks of say 7% or 8% percent (I put quotes around the word normal because I actually don’t believe there is such a thing as normal when it comes to returns on something as complex and volatile as the stock market). But the important point is that if Dave had used 8% instead of 12%, your $350,000 of payments would have only turned into a little more than $750,000. This is still a nice return, but not as “magical” as what Dave is saying. It goes without saying that the higher the interest rate, the more spectacular the accumulation of money looks, but what many people fail to realize is how sensitive to small changes in interest rates that accumulation is. So it is important whenever you see an illustration of some investment compounding over a long period of time, that you scrutinize the assumed interest rate very carefully. And this brings me to the final aspect of Dave’s example – the time period over which the accumulation occurs. In the investment world 15 years is a very long time, and to assume that you will get any consistent rate of return (particularly when you are talking about a volatile investment like stocks) over that period is, in my view, very risky. And just like the interest rate, the amount of money that you end up with is highly sensitive to the period over which you are investing. For example, in Dave’s example, even using a 12% return, after 10 years (vs 15) you would have only $440,000 and not the $1 million he promises.

There is perhaps no better example of how compound interest can mislead than the famous “Give up your daily Starbucks Latte and retire early” advice first put forth by David Bach. David suggests that by giving up your daily Latte you can save $3 per day. This translates to $20 per week and $1000 per year. David suggests (just like Dave Ramsey) that you can then invest this $1000 per year in the stock market and after a few decades have a significant supplement to your retirement savings. He even calls it “the Latte Factor” in the retirement strategy he recommends. In a sense he has taken this magic trick to its logical extreme, breaking the investment into even smaller pieces than Dave Ramsey and having it accumulate over an even longer period of time.

If compound interest was the only trick that financial advisors had, it would be a relatively straightforward task to deconstruct and understand the advice of your financial advisor, but unfortunately there are two other more sophisticated techniques that advisors use to seduce you into using financial strategies that are either far more risky than they appear or simply won’t work. The most dangerous of these is what is known as “leverage”.

The idea of leverage is relatively straightforward and combines compound interest with debt in a way that can truly create some dazzling visions of potential riches for gullible consumers. In its purest form, leverage simply means borrowing at a low interest rate and investing the proceeds at a higher rate. So, for example, there are many investment brokers who will be happy to set up a “margin” account for you which will allow you to borrow money at a relatively low rate (as I write this, Fidelity Investments is advertising “margin rates as low as 4.25%”) and then invest it in something (e.g. stock mutual funds) that will earn a higher rate (e.g. 7% or 8%). Typically the only restriction that a broker places on this loan is that the loan can never be more than actual funds you have on deposit (e.g. if you have $5000 invested you can borrow any amount up to another $5000). The reason it is called “leverage” is because in order to get this opportunity you need to invest a certain amount of money which is then leveraged by borrowing against it to turn it into more money than you could by simply investing your original sum. It is analogous to using a mechanical lever to lift a weight that you could not lift with your hands. So for example, let’s say you open up an investment account at Schwab with $1000. If you were to invest that sum in a stock mutual fund, you could perhaps expect to earn 8% per year over the long term. After 10 years you would have about $2150. However, let’s say that instead of doing that you decided to “leverage” that initial investment by borrowing another $1000 “on margin”. Let’s assume that Schwab will charge you 5% for that money and you don’t have to pay it or the interest back until you close your account. Now you can invest $2000 in that mutual fund (your original $1000 plus the $1000 you borrowed). After 10 years your account will grow to $4300, but you will only owe Schwab $1600 (your $1000 loan plus 10 years of interest at 5% per year). Let’s say you now decide to pay back the loan and close your account. You will walk away with $2700 instead of the $2150 you would have had if you just invested the $1000 without “leveraging” it. By this “magic” trick you have converted a pretty ordinary 8% return into a much more spectacular 10.4% annual return.

Is there a catch? You bet. First of all, for leverage to work, you must be absolutely sure you can invest the money you borrow in a way that will earn you more than the interest rate you are being charged on the loan. That, in and of itself, is no easy task as Banks and others that will lend you money are trying to make a profit and if they could earn a higher rate on their money than they could by lending it to you, they may very well might. But let’s say they are not in a position to do so (e.g. Schwab might not be allowed to invest their own corporate funds in stocks that they also broker). Even so, you might not earn the expected 8% return every year, and in those years where your investment doesn’t perform as expected, you will be left owing a greater percentage of your investment account than you anticipated. This is dangerous for two reasons; first because it exposes to further drops in value that could wipe out your entire investment, and secondly, even if it doesn’t wipe you out it can disrupt your investment strategy. For example, in this case it could subject you to a “margin call”, where Schwab will insist that you sell your stocks in order to pay back the loan. This will come at exactly the wrong time, i.e. after there has been a drop in the stock market and before it has had time to recover.

This basic trick has many variations and there are many investment strategies where leverage is hard to observe and its operation (and risks) can get very complicated to figure out. For many years during my career as an actuary I consulted with companies who had entered into “collateral assignment split dollar insurance programs” where leverage was the key to “supercharging” the investment returns on normal life insurance policies to fund executive retirement benefits. These deals were so complicated and the risks so well hidden, that even some of the most sophisticated financial executives in America were surprised when the programs “crashed and burned” leaving both the executives and the Company with losses that they never anticipated. My point is that anyone can get fooled by leverage, and you need to very suspicious when you hear about an investment strategy that you don’t fully understand and appears to generate returns much greater than you can get otherwise.

This is not to say that leverage is a bad thing. Quite the contrary, it can be a very good thing and there is one area of most people’s financial lives where leverage is often appropriately present. But this is also the area where some of the most egregious and misleading strategies have been proposed by financial planners. And that is in the area of real estate. Given that our current President made his fortune this way and given the uncountable number of books, workshops, TV shows etc. that were produced before and after the real estate collapse of 2008-9 hawking the idea that to become wealthy all you needed to do was borrow money to invest in real estate (rental, commercial or residential), this warning is probably redundant. By now, almost everyone has heard (and hopefully rejected) the get rich quick schemes associated with buying real estate with “no money down” (essentially being infinitely leveraged), and then “flipping” the house for “free money”. Robert Kiyosoki is perhaps the most infamous of these snake oil salesman, but there are many others making essentially the same pitch.

However, along with that warning (please remember house prices can go down as well as up), it is useful to not throw the baby out with the bathwater. If you know what you are getting into, accepting leverage can mean that buying a house (even a second home) could be one of the best (but not risk free) investments you ever make. In the final Section of this book, when we discuss how debt should be viewed in the context of your entire financial picture, we will also dig deeper into how to prudently use this “magic trick”.

“Backfitting”, however, is an entirely different matter. In my view this is one of the most abused and little understood sleights of hand that financial advisors use to give consumers misguided confidence in their investment strategy. A backfitted strategy is an investment strategy that has been developed by looking at investments that have been successful in the past and naively assuming that that strategy will be successful in the future. There are (literally) almost an infinite variety of ways to do this, and that is exactly the point. As we saw in Section II a great many failed predictions arise from economists and others developing models that reproduce the past but have nothing meaningful to say about the future. Similarly it is pretty easy to comb through the historical data and find a (sometimes very complicated) investment strategy that would have produced spectacular returns in the past, but that is not the same as developing a strategy that will generate good returns in the future.

The simplest and most common version of a backfitted strategy was described earlier by Dave Ramsey when he put forth the proposition that any “decent broker with the heart of a teacher”  could find you  “funds with long track records averaging over 12%”, and therefore by investing in those funds you can assume you will earn 12% in the future. This statement illustrates the two fundamental problems with backfitted strategies. First and most importantly, as noted above, the past is no guarantee whatsoever for what will happen in the future. Beyond that there is significant “survival bias” at play when you look at “track records” for specific investment managers or funds. To see this, note that even if all the stock funds you looked at had a decent historical return, you are still being overly optimistic, because you are not considering the funds that had such a poor return that they did not survive to the present. I remember watching one of the clearest demonstrations of survival bias many years ago when I attended a large lecture on the subject. There were several hundred of us in the audience and the lecturer asked all of us to stand up, take a coin out of our pocket and flip it. Those who got “heads” were asked to remain standing while those who got “tails” were asked to sit down. Then he repeated the process several more times. After seven flips there was one man still standing who had gotten 7 straight “heads”. The lecturer then addressed him and asked “What’s your secret?”

I hope the example above is enough to convince you that there is no magic to those funds that your advisor tells you are “special” because of their stellar track records. But as noted earlier, backfitted strategies can get much more sophisticated than simply finding a manager who has been lucky enough to have “outperformed” his/her competitors. The strategies themselves can be extremely complex and are often presented in a way that is designed to make you feel that there is a great deal of “science” behind the method. In fact, many of the “algorithms” that certain Hedge Funds use have been developed in this way. And these are funds that Institutions often invest millions of dollars in, hoping to receive the same kind of returns in the future that the algorithm has generated in the past.

There are other “tricks of the trade” that advisors use to fool you, but the ones described here are the basic ones and should give you the confidence and skepticism to be entertained, but not fooled, by the magic show that the personal finance advisor industry is currently performing

So far, by design, I have focused on the more popular and “mass market” personal finance advisors, but when it comes time to sit down with someone and decide what to do with your money (and then actually implement financial decisions) you need to understand more clearly how the professionals in the financial services industry operate, both in terms of the recommendations they give you and how they get paid. That is the subject of our next and final chapter about financial advice you get.