Ep66 When (and When Not) To Listen to Investment Advice

Key Concepts

• Investment Advice Credibility: Evaluating the trustworthiness and expertise behind financial recommendations.
• Incentives: Understanding the motivations of those giving advice.
• Pump and Dump Scheme: A fraudulent investment scheme where a stock is artificially inflated and then sold off.
• Active Mutual Funds: Funds managed by professionals who aim to outperform a benchmark index.
• Portfolio Management: The art and science of selecting and overseeing a group of investments that meet the long-term financial objectives and risk tolerance of a client.
• Private Investments: Investments in companies that are not publicly traded on a stock exchange.
• Information Asymmetry: A situation where one party in a transaction has more or better information than the other.
• Competitive Advantage: A factor that allows a company to produce goods or services better or more cheaply than its rivals.
• Angel Investor: An individual who provides capital for a startup company, usually in exchange for convertible debt or ownership equity.
• Venture Capital (VC): Financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential.
• Arms-Length Transaction: A transaction in which the buyer and seller of a product or service are independent and unrelated parties, each acting in their own self-interest.
• Impact Investing: Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.
• ESG (Environmental, Social, and Governance): A set of standards for a company's operations that socially conscious investors use to screen potential investments.
• Constrained Optimization: A mathematical problem where the goal is to optimize a function subject to certain constraints.

Evaluating Investment Advice

The episode "All Else Equal" hosted by Jules Van Binsburgen (Director of the Lauder Institute and Finance Professor at the Wharton School) and Jonathan Burke (Finance Professor at Stanford Graduate School of Business) delves into how individuals should critically assess investment advice. They argue that while financial advice is ubiquitous, discerning credible recommendations from potentially misleading ones is crucial.

The Internet and Message Boards

The discussion begins by examining advice found on online platforms like chat rooms or message boards. The primary argument against taking advice from these sources, especially specific stock picks, is the incentive structure.

• Pump and Dump Schemes: If an individual genuinely believes a stock like Tesla is undervalued after thorough research (corporate valuation, present value of cash flows), their incentive is to invest their own capital or manage funds for others to profit from their skill. Advertising this on a message board, with the sole motivation of driving up the price to sell their own holdings, is identified as a pump and dump scheme. This relies on convincing others to buy, thereby inflating the price, allowing the initial advertiser to exit at a profit before the price inevitably falls.
• Lack of Competence: Alternatively, if the person on the message board lacks genuine research skills, their advice is inherently unreliable.
• Better Monetization of Skill: The professors contend that individuals with true stock-picking ability would not primarily use message boards to monetize their skills. The most lucrative avenues for such talent lie in managing substantial capital, either through personal investment or by becoming portfolio managers in investment banks or mutual funds. The fact that individuals are on message boards suggests they are not skilled enough to command significant capital or achieve outperformance in more professional settings.

Financial Advisors and Stock Picks

The same logic extends to financial advisors who offer specific stock picks.

• Capital Constraint: If a financial advisor possesses exceptional stock-picking skills, they would ideally be managing large pools of capital (e.g., through mutual funds) to leverage their ability. For individual investors with limited capital, the advisor's impact is constrained. The argument is that if they were truly superior stock pickers, they would be working for entities that can deploy significant capital, allowing them to capture the full benefit of their skill.
• Focus on Value-Added Services: The professors suggest that financial advisors can provide valuable advice in areas beyond stock picking, such as diversification, retirement savings strategies, and tax management. These are considered "optimal individual choices" that do not rely on predicting market movements or individual stock performance.

Private Investments

The opacity and illiquidity of private investments present unique challenges.

• Information Asymmetry and Opacity: Private markets are less transparent than public markets, with less readily available information and no constant price signals.
• Capital Deployment Incentive: If a private investment opportunity is presented to an individual investor, the question arises why the deal is not being offered to larger, more sophisticated investors. The professors argue that if a private investment manager is approaching smaller investors, it often signifies that they have been "turned down by the big money," suggesting a potential lack of quality.
• Skill in Manager Selection: While large institutional investors like pension funds are increasingly allocating capital to private equity and hedge funds, the success in this space is not solely due to the asset class itself. The skill of the investor in selecting capable managers is paramount. The example of David Swensen at the Yale endowment highlights this, where his success was attributed to his ability to differentiate between good and bad private equity investors, not just the act of investing in private equity.
• Risk for Uninformed Investors: For individuals lacking the expertise to select managers or investments in opaque private markets, the advice is to stick to widely diversified portfolios, potentially in indexed spaces, as they likely lack a competitive advantage to generate superior returns.

Angel Investing and Early-Stage Investments

The prospect of investing in a friend's or acquaintance's startup as an angel investor is also discussed.

• Informational Advantage: A potential justification for investing in a startup by someone you know (e.g., a student) is if you possess a unique informational advantage. Professors observing students' academic performance and reasoning might feel they have insight into their capabilities. However, even this level of familiarity may not be sufficient compared to the expertise of professional venture capitalists.
• Selection Bias: The fact that a startup is seeking investment from friends and family, rather than established venture capital firms, can be a strong indicator of a weaker business proposition or a lack of confidence from professional investors. This is a significant selection bias that is difficult to overcome.
• Arms-Length vs. Non-Arms-Length: The discussion highlights the advantage of arms-length investing. Investing in friends and family can lead to emotional biases, making it difficult to make rational decisions, such as cutting losses when an investment performs poorly. Loyalty can lead to overlooking underperformance and making excuses.
• Subsidy vs. Investment: Investors should distinguish between providing a subsidy to help someone they know and making an investment expecting a fair return. If the expectation is a fair return, the same principles of competitive advantage and market efficiency apply.
• Co-Investment Model: A potentially better approach for individuals without a strong competitive edge is to co-invest alongside reputable lead investors who have a proven track record in selecting managers or investments. This allows individuals to "free-ride" on the expertise of the lead investor.

Impact Investing and ESG

The concept of impact investing, where investments aim to generate both financial returns and positive social/environmental impact, is met with skepticism.

• The Trade-off: The core argument is that there is likely a trade-off between doing good and achieving higher returns. If a manager could achieve higher returns and do good simultaneously, they would have already been doing so by investing in those "good" stocks previously.
• Constrained Optimization: Restricting investment choices to only those that meet ESG criteria inherently limits the investment universe. This is a form of constrained optimization, which, by definition, leads to a lower optimum compared to an unconstrained approach where any stock could be chosen.
• Suspicion of Dual Claims: Managers claiming to deliver both superior returns and positive impact should be met with extreme suspicion. The professors suggest that if a manager cannot outperform in an unrestricted market, it's highly improbable they can do so when their choices are further restricted by ESG criteria.

Conclusion and Actionable Insights

The overarching conclusion is that for most individuals, the advice is to "don't listen to investment advice" when it pertains to specific stock picks from unverified sources or individuals without demonstrable track records or committed capital.

Instead, the recommended approach for the average investor includes:

• Diversification: Holding widely diversified portfolios.
• Index Investing: Considering passively managed index funds.
• Focus on Financial Planning: Seeking advice on broader financial planning aspects like retirement savings, tax management, and portfolio diversification, rather than speculative stock picks.
• Skepticism towards "Too Good to Be True" Claims: Be exceptionally wary of any investment proposition that promises high returns with no risk, or claims to achieve both financial outperformance and significant social impact simultaneously.
• Understanding Your Own Competitive Advantage: If you do not have a demonstrable competitive advantage in selecting stocks, managers, or investments, it is generally advisable to avoid complex or opaque investment strategies and stick to simpler, diversified approaches.
• Arms-Length Transactions: Prioritize investments made at arm's length to ensure rational decision-making and the ability to exit underperforming investments.
• Co-Investing with Experts: If considering private investments, look for opportunities to co-invest alongside reputable investors with proven expertise in manager selection.