The job of a financial analyst is simple: they write reports and issue an investment recommendation to either buy, sell, or hold a stock. To me, that sounds like an exciting job that would pay an honest wage. Unfortunately, a guy by the name of Henry Blodget was exposed for all that is not-so-exciting and dishonest about this trade.
Blodget rose to fame during the dot-com years when he predicted the share price of Amazon, a new Internet retailer, would hit $400. His predication rang true as the stock shot up 128% just one month later. The Amazon call received a lot of attention, and he soon left his job for a generous offer from Merrill Lynch, quickly becoming the most followed Internet expert in the world.
With his huge salary at Merrill Lynch, he was obligated to recommend many Internet companies as strong buys. These stock picks were making tons of money for his investors and for Merrill Lynch, and everyone was happy with income of easy money. However, in private company emails, Blodget was calling the same strong buys “crap”, “junk”, and “pieces of shit.” (Remember Pets.com?)
The situation was a massive conflict of interest that no one seemed to pay much attention to except Eliot Spitzer, the Attorney General and Governor of New York. Blodget was charged with civil securities fraud by the U.S. Securities and Exchange Commission and eventually agreed to a ban from Wall Street and a $4 million dollar fine.
While Blodget got caught for his false recommendations, analyst opinions continue to drive coverage of the stock market. Ordinary investors continually see news articles about companies they invest in. For example, after Apple last reported quarterly earnings, a Goldman Sachs analyst noted that guidance was far worse than feared and lowered his price target from $575 to $500, maintaining a “buy” rating. A Piper Jaffray analyst thought Apple might trade higher in 2013, maintaining his price target of $688 and an “overweight” rating.
Should we pay attention to these so-called financial experts? The simple answer is no. Countless studies, such as Inside the ‘Black Box’ of Sell-Side Financial Analysts, have shown that stock recommendations and the opinions of analysts like Blodget are of little value to ordinary investors and they shouldn’t rely on the information to make investing decisions.
Here’s the behind-the-scenes game that’s being played: institutional investors (e.g. hedge funds, mutual funds) need to decide which firm they want to buy their stock research from, and they highly value if the firm and analysts have direct access to the management of the companies they cover.
This means that analysts need to maintain good relations with management, which puts pressure on them to make positive remarks and recommendations, even when their own research doesn’t support it. An analyst that loses access to management means that the firm loses revenue from institutional investors, and the analyst loses compensation while at the same time putting their career in jeopardy.
So if ordinary investors can’t trust Wall Street, what should they do with their money?
Easy: become a passive investor. First, reject the highly paid analysts. They don’t care about you, and they want you to trade in and out of stocks to line the pockets of themselves and their firms. Second, implement a long-term buy and hold strategy. (Surprisingly, this is the approach Blodget now recommends.)
To implement a buy and hold strategy is quite simple, but you need to decide what types of investments you want. I believe you only need three to create a well-performing portfolio:
- Broad diversification across the whole stock market.
- Real Estate Investment Trusts (REITs)
Investing in the stock market (1) will provide growth that inherently comes with volatility. Bonds (2) and REITs (3) serve to balance that volatility, because they are inherently more stable. Additionally, bonds and REITS complement each other. If interest rates rise, the value of bonds decrease but at the same time, REITs become more profitable.
Vanguard, a favorite mutual fund company of buy and hold investors because of their extremely low management fees, offers funds for the three investment types outlined above. Here’s a sample allocation with their funds:
- 60% in Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
- 30% in Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX)
- 10% in Vanguard REIT Index Fund Admiral Shares (VGSLX)
*management fees: VTSAX 0.06%, VBTLX 0.10%, VGSLX 0.10%
The sample portfolio of three funds is simple and easy to manage. If the investor is willing to shoulder more risk for more growth – perhaps retirement is years away for them – they simply dial up the percentage of VTSAX and decrease the percentage of VBTLX and VGSLX. Similarly, if the investor wants more stability and income – perhaps they are retired and need to generate income – they dial down the percentage of VTSAX and increase the percentage of VBTLX and VGSLX.
For many ordinary investors who trade in and out of stocks regularly on news and tips, forever chasing the next big thing, the buy and hold strategy will be extremely boring. However, it’s the passive investor who creates wealth and best of all, doesn’t need to listen to the lies and disinformation coming from Wall Street; instead beating them at their own game.