ERROLD F. MOODY
JR.
April 29, 2008
John Larkin
Communications Director
California Society of CPAs
1235 Radio Road
Redwood City, CA 94065
RE: California Financial Literacy Summit
Dear Mr. Larkin,
Under no circumstances nor under any conditions is the video of the
“Nike Kid” to be ever shown to anyone- certainly to a class
of young students nor to the elderly as part of any effort for
investment insight. That has to be one of the most egregious breaches
of duty by an organization involved in education I have seen- and the
worst of any professional entity.
I do not dismiss the effort for budgeting, credit card discipline,
saving et al and almost anything in that direction should be applauded.
However, I was appalled that anyone would have allowed the
dissemination of material the violated one of the basic tenets of
investing- diversification. And then it treaded further into other
violations. A fluffy piece for television may be nice to induce an
interest in investing but it is totally wrong footed. This is the type
of trivia that was directly instrumental in the Dotcom mess and
subsequently to the real estate debacle we now face.
This is not an ego trip. I have taught more varied classes in finance
than anyone else- securities training, real estate and insurance
continuing education, university classes for financial planning,
etc. My curriculum vitae is at http://www.efmoody.com. The site
contains more than 4,000 pages of info that has been researched to
address what people need to know to avoid the scams that others cause-
and that they cause to themselves. But within that is the distinct
research that the fundamentals of investing have never been taught to a
broker. Alpha, beta, correlation, standard deviation, etc.- all the
real elements of investing are not even touched upon in licensing
training and never have been. Not in continuing education either. Worst
yet is the risk exposure of the lack of diversification. It is not the
superfluous commentary of “not putting all your eggs in one
basket’ That has no statistical merit and is effectively useless
in any legal arena- though repeated with regularity by those who have
never studied the industry and are clueless to risk and reward. The
question is, “how many stocks must you have in a portfolio in
order to insulate it from unsystematic risk?” Or, more
colloquially, “how many stocks to you need to have in a portfolio
for it to be properly diversified?”
Unfortunately not one attendee apparently knew because they would now
be writing with the same position and attitude that I am now taking.
And as I have written for years, “if you do not know
diversification you cannot determine risk. If you do not know risk you
cannot determine suitability.”
At this point every reader has probably attempted some number to the
above. Are you close? The minimum is at least 50 up to 350 stocks in a
singular portfolio. (Actually, the review has to cover
correlation- a mind numbing and very intense issue in order to buy any
stocks or bonds and to do any type of asset allocation.) For the
purposes of those with limited background (certainly when instructing
the complete novice) one chooses the higher limits- 350. And when
you get that far, you might as well use the S&P 500 or a Total
Market Index fund. There is no way that any type of focus toward single
issue securities should be considered. That Nike stock may have looked
valid for a frivolous TV piece, but the risk of this position is 100 to
500 times greater than the market itself . No rational teacher would
ever suggest such a ludicrous position. But that is if they knew of the
problem. The symposium had a duty to be sure the correct information
was imparted.
Here are the numbers that have to be researched at a minimum for Nike-
http://pages.stern.nyu.edu/~adamodar/pdfiles/cfexams/Nikepres.pdf.
I defy literally anyone to interpret the numbers including David, his
mother, the kids he teaches- AND the people who interviewed him.
If all it takes, per the video, is simply the P/E ratio or
earnings per share, go ahead, give it a shot. But you must
address the viability of a singular position and as such you must
consider this quote from Professor Benoit Mandlebrot, Professor of
Mathematics at Yale University regarding the calculations necessary to
figure out an element of risk-"First, as Markowitz himself pointed out,
it is not certain that using the bell shaped curve is the best way to
measure stock market risk; it is easy but not necessarily right. Second
to build efficient portfolios, you need good forecasts of earnings,
share prices, and volatility for thousands of stock. Otherwise garbage
in, garbage out. Finally, for each stock, you must laboriously
calculate its covariance with, or how it fluctuates against, every
other stock. For a thirty stock portfolio, about the minimum needed to
make the numbers work well, that means 495 different calculations of
mean variance and covariance. For the entire NY Stock Exchange, 3.9
million calculations. And because prices change, the exercise needs
constant repetition."
Now, any pundit of my commentary must have a statistical rationale that
directly contradicts the above. (Clue- there isn’t any.) Why is
an entire audience of people trying to help the young and elderly
submitted material that is suggesting a risk up to 500 times that
of the market overall. Just what is the point of getting kids to
save if you are sending them to Las Vegas ?
In separate discussion at lunch and the later round tables, no one knew
what the risk was. A couple of women nodded their heads in agreement
when I mentioned how wrong the video was. They indicated that it did
not seem right but could not directly figure out the problem. I
approached Mr. Gallagher to ask for clarification. He either was
clueless to what was going on and/or didn’t care. Either way, it
is indicative of the problem. Ms. Krueger was a broker- yet anyone who
worked on this symposium HAD to have known that the fundamentals of
investing have never been taught to a broker. That there was a PBS
show, that Chatsky was with Oprah, what is your point? As CPAs,
including PFS, you have a fiduciary duty to recognize what is being
presented and whether it reflects a knowledge base of investing. That
the fundamentals are not taught to brokers, consumers et. al., - is
that not the point of a symposium to make sure they do the right thing?
This was- and is- an egregious fault on the developers to
initiate/perpetuate the foolish error of attempting to utilize single
issue portfolios- or even those with two, three, four issues. An
organization of this supposed quality, integrity and knowledge has
fallen woefully short of its fiduciary obligation to PROFESSIONALLY
INSTRUCT.
I have no personal animosity to Gallagher or Krueger. But if you are
going to have representatives for Financial Literacy expounding on how
to approach investing, then they must be literate in the subject. You
do not use a broker untrained in the fundamentals of investing nor
someone else who says they don’t care to understand money. It may
be considered acceptable for PBS fluff - it is not acceptable when our
children and the elderly, in particular, are involved. The
developers of this symposium- who are touting their background and
capabilities in investing- should have known better. Where was the
insight? Where was the homework?
The above is factual commentary. There is no rationale to orient
differently. Don’t put the most vulnerable in a position to be
taken advantage of.
The following is a suggestion. It has been posted at my site for over
10 years and was requested for use by the Association for Investment
Management and Research (providers of the CFA designation) in their
licensing seminar (every attendee should be made aware of the
background in securities analysis these entities have). It is somewhat
flippant but it will help anyone avoid about 90% of all scams and
bad investments simply because of the lack of knowledge base by
the adviser.
“Never, NEVER, NEVER GIVE MONEY TO ANYONE UNLESS THEY HAVE AND CAN EFFECTIVELY UTILIZE A FINANCIAL CALCULATOR
If you or your adviser does not have and cannot use a financial
calculator, then he/she does not understand money. You are committing
financial/economic suicide when you entrust money to someone who
doesn't know how it works.
Use of a financial calculator is NOT taught in traditional training
classes to securities brokers, insurance agents, attorneys or many
others who say they know money and investments. It is not even being
offered as a basic continuing education course for securities or
insurance agents. An attorney might have one for use as a door stop.
It's certainly not taught to bank employees. It is taught to Certified
Planners, ChFC's, CFA's, MBA's and the like but you must make sure they
have stayed current in its use. Admittedly, computer programs can do
some of the calculations (Quicken and the like), but the personal
capability is mandatory if you don't want to get screwed.”
It is within that context that one of the best things to use for
instructing students is the financial calculator. When dealing with
budgeting and saving, a teacher can simply ask, for example, “if
you wanted to buy a house in 10 years and were saving $200 a month,
what would you have if you put it in a bank at 6%”. A few key
strokes, 10 seconds and $32,940.
Or one could ask “if you went to a check cashing store to get
money now for a $200 check from your uncle, how much are you going to
pay?” It’s 12% in California so that is $24. The fees for
all states are at
http://www.fisca.org/CheckCashing%20Summary%2007%208.5x11.pdf. What
about the set up fee of $10. Now what is the percentage you pay? A
couple of key strokes and it is 17%.
What about advance loans. Here is the article from the Federal Trade
Commission http://www.ftc.gov/bcp/edu/pubs/consumer/alerts/alt060.shtm.
The problem, quite obviously, is that no one is going to read this
report- certainly not students. But a couple of keystrokes and a bit of
commentary about savings will do it all in just a few minutes. For
example the teacher asks “If you needed some money FAST, you can
get a loan at an advance loan store. Say the amount was $100. You might
pay $15 to get the $100. At the end of the 14 day loan you pay it off.
What is your annual interest rate? 180%!
Say you could not pay it off then but needed to extend it another two
weeks- for another $15. What are they charging you?” 360%! (I did
not annualize the interest rate and I submit it is not necessary to
make the point .)
Difficult for a teacher to do? Nope. A 15 minute video would allow even
someone with no background in math the ability to do these numbers. It
immediately helps students see what a real life example is by the
person standing directly in front of them. Admittedly you can get far
more involved with such a calculator, but it is unnecessary for the
basics. Effectively anyone can do it- but all the calculators would
have to be the same so that the video instruction would be identical.
They probably can now be had for around $5 per calculator in bulk.
This is a great way to orient almost anyone to the value of budgeting
and saving- or to put the fear of the financial gods in their minds and
hopefully deter them- or their parents- from ever considering the use
of products or services that violate common sense.
Lastly I did look at the brochures for teaching investments, including
asset allocation, that were on display. Are you kidding me? Some of the
charts were so convoluted I doubt I could understand them. If you want
to teach this stuff correctly, avoid the issue of single issues
altogether and provide a couple “simple” graphs on
allocations for long periods of time. Does it work? Theoretically. Will
it work for the future? Completely unknown. And that is what the
students need to hear. What happened in the past can be a poor
guideline to the future. But since the material needed to develop a
proper allocation requires so much detail- particularly as regards
correlation- there is effectively little one can do other than start
them on something that has a possibility of producing returns over the
long term, reducing risk and completely negating an attempt to buy
individual stocks. For those pundits who think an allocation is so
easy, certainly regarding the ability to determine correlation, I point
them to
http://www.fpanet.org/journal/articles/2007_Issues/upload/56354_1.pdf.
You either include this in total for a full orientation towards risk
and reward (not a chance) or make it ‘simple’ by focusing
on the fundamental principle of how an allocation “might”
work. The instructors need to be careful here because of the inherent
difficulties in mastering the statistics of risk and reward but they
can suggest further readings on the subject for those who inquire- or
allow another ‘course’ for those who have more interest and
intellect.
In summary I had hoped the powers to be were going to provide accurate
insight to the problem of investing. It did not happen nor do I believe
that the parties had the requisite skills to do so. You need to
reorient your efforts to real life entities that understand how
investing is supposed to work. A broker, per se, is incapable of
providing the insight. The fundamentals of investing have never been
taught in any licensing course. The focus on single issues is rampant
with excessive risk and should never be exposed to a novice. NEVER! The
video is a terrible instructional presentation for the real world. I
admit that it might get a young audience involved- but it is telling a
story that is akin to gambling. If anyone wishes to dispute that they
can do so- but only if they have a financial calculator in their hand.
We can then really discuss risk.
A requirement to all is a minimum knowledge base is the ability to use
a financial calculator. The basic ability to use this can be taught to
almost any teacher in any area of the U.S. As such it brings to life
the necessity of budgeting and savings and the ability to quickly see
that the many supposed services to many are at interest rates that no
one can absorb.
If you provide them the above info in a real life atmosphere where the
teacher is directly involved, you can completely change the incorrect
orientation to money. But if you continue the direction established,
these students will be caught up in another DotCom or credit mess all
over again.
I repeat, if you do not know diversification, you cannot determine
risk. If you cannot determine risk you cannot determine
suitability. The Society has a duty to reorient it’s
efforts to be sure the correct presentations are made.
Very Truly,
Errold F. Moody Jr.
CC: All major contributors
See also: Investment Malfeasance And Breach Of Fiduciary Duty http://www.experts.com/showArticle.asp?id=184