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05 May 2016

Why Dave Ramsey is Wrong

Many financial "gurus" like Dave Ramsey advise their clients to "Buy and Hold"; buy investments regardless of current market conditions and hold them for a long period. My personal favorite flavor of Buy and Hold is Dollar Cost Averaging where you pretend you didn't overpay for a particular investment.
Other advisers say to invest in actively managed portfolios with the (poorly thought out) idea of beating the market. Still others recommend investing in indexes that attempt to follow one or more of the popular markets and take advantage of the market's positive bias.

They are ALL wrong

They are wrong because they are either intentionally dishonest, or more likely, willfully ignorant.


What does a hedge fund manager do?


Imagine someone has a million dollars in stock. They want to protect their million dollars. So they "hedge" their million by buying an investment whose value is inverse to their stock. They could buy a Put option on their stock, and if the stock goes down, the option goes up. They can exercise the option and gain roughly the amount they lost on the stock. But the option itself has a cost. The hedge fund manager conducts these transactions for the stockholder, and in many cases they are the "Market maker"; the one who sells the stockholder the option.
This scenario IS a Zero Sum Game. Someone gains, someone loses. It sounds like a bad deal for the stockholder (it is), but more importantly, it's a very dangerous game for the hedge fund. Sooner or later,  hedge funds collapse. 
In the real world, hedging is not limited to options, futures, and futures option. The Now Even Bigger too-big-to-fail firms create derivative instruments so complex even they can not decipher them at times.*

The Financial Sector


There is no doubt some people make money in the financial sector. We all hear of the success stories. But we seldom hear of the millions who lose. That's just human nature, the winners are celebrated and the losers are forgotten. But the winners all have one thing in common - they have an edge or angle. Where does the wealth of the multi-billionaire hedge fund managers come from? Does it come from growth? Added Value? No, the majority comes from the losers. That isn't to say the economy is Zero-Sum; it isn't. But economic growth can not account for all of the wealth accumulated by the top winners.

The Unpredictable Market


The US stock market has dropped in excess of 40% five times in the last 80 years. None of these declines were predicted mathematically. In fact, According to the models used by financial advisors, those declines were impossible. Impossible as in even one of them could not happen in billions of years. But they happened. I explore the reasons why in other posts.

As a result of this phenomenon most (all?) successful managers destroy more wealth than they have ever created.  

This wealth destruction happens because investors entrust successful managers with more money as they become more successful. The few managers who make money do so not because they are highly competent, but because they are simply lucky with favorable timing.

Why Dave Ramsey and most all other so-called experts are wrong.


Financial experts fail their clients by not taking into account or informing their clients of the true nature of risk. Whatever their favorite advice, they always discount risk. They happily plod along, advising their naive clients, and some of them make outstanding returns. Then something like Black Monday happens and all the gains they previously made are wiped out. But, the expert shrugs his shoulders and says that's life, no one could have seen that coming. 

No one could have seen that coming. 

And that's exactly the point. Because they can not properly quantify the risk, they ignore it. Because of this omission, investors are guaranteed to always lose unless their execution timing is exactly right. We know that is impossible. 

This exact phenomenon has been recurring over and over since markets have were invented. And it will continue.

There is a better way. 

* This was an aspect of the so-called Housing Bubble in 2008. Investment banks fraudulently created derivatives so complex they could not decipher them. The government stepped in, and they nor the contractors they brought in could not decipher them. In the end, taxpayers paid off the investment banks and their insurance companies the amount they claimed to have lost. A real-life example is a poker game, where one person wins all the money on the table. Then the government comes in and repays all the losers whatever they claimed to have lost -with no proof.