I’ll never forget my first interaction with Wall Street. I was in my early 20s, just getting started in my career, when I was introduced to a stockbroker—let’s call him Eddie. He was a pleasant fellow with a good reputation and all of the trappings of success, including a DeLorean in the driveway. He seemed like a safe choice.
My interactions with Eddie were straightforward. He would call from time to time with stock ideas. Since I worked in a different field at the time, I trusted his judgment and generally went along with his recommendations. And everything seemed to work out very nicely. Because it was the late-90s, everything he recommended rose in value—quickly. He seemed like a genius.
But our relationship didn’t go much beyond discussions about stocks. When I got married, we didn’t talk about life insurance or buying a home, and when we had our first child, we didn’t talk about saving for college. To be fair, I’m not sure if Eddie even knew that I’d gotten married or become a parent. We didn’t talk about things other than stocks. At one point, he suggested I set up a margin loan to buy a new car, but that was as close as we got to discussing financial planning.
When the dot-com crash came in early 2000, the U.S. stock market dropped by about 50%, but my portfolio did far worse; many of the stocks dropped 80% or 90%. What I later understood was that my account consisted almost entirely of technology stocks. They all moved up together during the boom, and they all crashed together in the bust.
I don’t necessarily blame Eddie as much as I blame the system. The financial services industry sometimes seems like it was designed intentionally to be as unhelpful as possible to its customer base. To be sure, it’s gotten better since the 90s, but it still feels a lot like a minefield. With college graduation season around the corner, I thought I’d prepare some recommendations to help new graduates navigate that minefield:
1. Naive diversification. My 1990s portfolio was 100% stocks, and more than 80% of those stocks were tech stocks. It doesn’t get much worse than that. Unfortunately, the investment options in many 401(k) plans today could lead you to the same result. Though it may feel like you’re diversifying when you buy more than one mutual fund, that’s not always the case. Since many funds own similar sets of stocks, you may just be doubling up on the same investments. Psychologists refer to this as “naive diversification.” I find that term condescending, but it is a real problem. My advice: First decide how much you want in stocks and how much in bonds. Then, use the free tools on Morningstar.com to research funds for potential overlap.
2. Hidden fees. Back in the 90s, traditional stock brokers made a living by charging hundreds of dollars per trade. That created incentives for dishonest brokers to “churn” accounts unnecessarily. As a result, most of the industry moved to a percentage-based model, whereby advisors no longer charge per transaction. In some ways, this has been an improvement, but now it’s more tricky to know exactly what you’re paying. There is, for example, a practice known as soft dollars. Investment advisors instruct brokers how much to charge their clients, and in exchange, the broker will pick up the tab for some of the advisor’s bills, such as their pricey Bloomberg terminals. If that sounds convoluted, it is. Fortunately, disclosure rules require advisors to tell you if they’re doing things like this. Just read their Form ADV, which you can find on the SEC’s website.
3. Unnecessary coverage. Life insurance companies seem to have a knack for hiring amiable people with wide groups of friends. Invariably, one of these people will find his or her way to your doorstep. They’ll tell you that you’re doing the right thing when you buy one of their policies to protect your loved ones. The reality is that you are doing the right thing when you buy life insurance—sometimes. But you don’t need life insurance if you don’t have anyone depending on your salary. If you’re single, or married with no children, resist all of their clever arguments (and they’ll have many) for buying a policy before you actually need it.
4. Ticking time bombs. When my broker Eddie suggested that I borrow against my portfolio of tech stocks in the middle of a bull market, he was giving me a match to light the fuse on my investments. Similarly, if a life insurance salesman suggests you borrow against the cash value of your policy, he’s constructing a very delicate house of cards. When something like this falls apart, it can wreck your investments and leave you with a tax bill. My advice: Keep doing what you’re doing right now, which is to read widely. Don’t take any one person’s advice—mine or anyone else’s—especially if that person has something to sell.