February 23, 2010
You write in The Little Book of Safe Money about investing in emerging markets. Do you feel these are safe bets?
One of most common things that I still hear when I talk to financial advisors is, “We’re overweight emerging markets because we know they’re the fastest-growing economies in the world.” What most of them don’t realize is that there’s essentially no correlation whatsoever between GDP growth and future stock market returns. People find this absolutely shocking. Over the past 10 or 20 years, for example, the Asian emerging market economies have done far better than, say, Latin America. Their stock markets have not.
In the future, it’s quite likely that emerging market economies will do about as well as people expect. But the question of whether their stock markets will do as well as people expect is a much more complicated one to answer, mainly because people expect them to do so darn well. To be overweight something that is so obvious that virtually every investor in America knows about it is a very risky thing to do.
I don’t think most financial advisors understand that at all. That concerns me.
Your most recent book is about keeping your money safe. You remind the reader that risk is something that you should avoid at almost all costs. What is your definition of risk? Is it exclusively the potential loss of capital, or should investors think about things like volatility?
I’ve spent my whole working life trying to answer the question “what is risk.” For advisors, risk may have a slightly different meaning than for an investor who is working on his own without professional advice. A pretty good definition of risk – a functional definition – would be: you think you understand something when you don’t. It could be that if we redefined risk that way, it would become a little more frightening, particularly to advisors. After all, if there’s one reason your client hired you, it’s to understand the things he or she either can’t or isn’t willing to try to understand. It’s really your job as an advisor to explain the way the financial world works to your client. You’d better make sure you understand the things you’re explaining.
Above all else, if you ever find yourself saying the words, “studies have shown that…” I highly recommend that you have read the studies. If, for some reason, you can’t understand everything in the study, then find somebody else who can and get them to explain it to you. I can’t tell you how many times financial advisors have said to me studies have shown that something-or-other and after asking a couple of questions it’s become evident to me that these people have not actually read the studies. It’s a lot like talking about a movie when you’ve only read the review or seen the trailers. You’re on really dangerous ground if you haven’t really done the homework.
You recommend Treasury Inflation Protected Securities (TIPS). Their “real” yields are pretty low. Would you advocate for them as the best way to hedge against inflation?
If I had to write the book all over again, I might tone down my praise of TIPS a little because, just like anything else, in the hands of overenthusiastic people, TIPS can do some damage. TIPS aren’t perfect. If interest rates rise faster than inflation, somebody who holds TIPS is not going to be very happy. They’re definitely not perfect. Are they the best way of combating inflation? I guess I would say, in general, they probably are, but there are big exceptions.
One area where advisors can play a huge role is helping people become more sophisticated in controlling the risks inflation poses to their own human capital. I’m pretty critical of commodities as a general rule, but there are many people whose jobs and the health of their company depend on the price of a particular commodity.
For example, a lot of the inputs in the chemical business are petroleum-based. If you work at DuPont, you are vulnerable to higher oil prices, because when oil prices go up, the price of your company’s raw materials go up. For somebody like that, whose job would be hurt by oil prices, investing in oil makes a lot of sense. While TIPS are good general way to combat inflation for the typical investor, most financial advisors would agree with me there’s actually no such thing as a typical investor, because everyone’s situation is different.
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