Anyone can tell you what to invest in—and everyone will. Most of them are wrong. Here are five investments you should never waste your time on. Bull market, bear market, and anything in between, these are reliably bad ideas that will lose you money.
1. Individual stocks.
Everybody loves that web site showing how much you’d be worth today if you’d bought Apple stock instead of that iPod. That could have been me, with $6000 in my pocket instead of an iPod mini with a dead battery.
What you want to do is find today’s Apple, the company that’s down in the dumps or little-known, and buy in before they release their iPhone. Don’t worry, plenty of commentators will alert you to such opportunities. Motley Fool, for example:
The Best Value Stocks (June 3, 2008)
I went to Google Finance and punched in their first pick, Asta Funding (ASFI), and found that from the day the article was published until the day I’m writing, two years later (at market close on June 21, 2010), it’s up 19.94%! Maybe these guys are smarter than I thought. So I pulled up the other three picks:
Celgene (CELG). Down 6.75%
Research in Motion (RIMM). Down 55.29%
BioMarin Pharmaceutical (BMRN). Down 46.89%
For comparison, the S&P 500 was down 20.51% during the same period, so Celgene actually beat the market. But I’m pretty sure the article wasn’t about how to lose slightly less money than everybody else—and if you bought all four picks, you trailed the S&P.
Not to pick on Motley Fool in particular. Flip open an old issue of Fortune or SmartMoney or Kiplinger’s, and you’ll find the same thing over and over: not only do the hand-picked portfolios almost never outperform the market, but you’ll frequently punch in a ticker symbol and find that the stock has been delisted. The company went out of business, and the stock went to zero.
“Wall Street needs you to believe that picking stocks and timing the market is the winner’s game, because it’s the winner’s game for them,” says Larry Swedroe, director of research for BAM Advisor Services and author of many books on investing. “They make money every time you trade.”
The annoying people who always drop the phrase “low-cost index fund” are right. Index funds are boring. But they work: they beat funds managed by professional money managers nearly all the time. Are you better at picking stocks than a professional fund manager? Me neither. If you like picking stocks, play a fantasy game and put your actual money in index funds.
2. Variable annuities
What do you call an investment that combines life insurance, mutual funds, low returns, high fees, and substantial penalties for early withdrawal? Frankenstein—or a variable annuity.
“The insurance company is only giving guarantees that they expect they’ll never have to pay up on. Because if they did, they’d go under,” says Tim Maurer, a certified financial planner and author of The Financial Crossroads. “Therefore, the protections that they’re offering most people are things that the actuaries at the insurance company, the smartest numbers people in the world, determined that you don’t actually need.”
Not all annuities are bad: the immediate fixed annuity, which converts a lump sum into a guaranteed fixed payment until you die, is a simple and underused tool.
Variable annuities are anything but simple. They’re loaded with hidden fees and expensive add-ons and accessories, and they’re unfavorably taxed. Never invest in something you don’t understand—and if you understand variable annuities, you’ve probably won a Nobel Prize. Put your prize money in an index fund.
3. Gold coins and other collectibles
“Collect for your love of the collectible…not because you expect high investment returns, because you probably won’t get them,” writes Eric Tyson in Investing for Dummies.
Sure, that goes for figurines and plates and your cousin’s nonrepresentational sponge paintings. But what about the darling investment of the moment, gold?
Even if you think the price of gold will continue to rise, gold coins—even circulating ones that trade at the spot price of gold—are the very definition of risky. You have to buy from a dealer and pay a markup. Then you have to figure out where to store it—in a safe deposit box? At your house, in a safe? Are you going to insure it? I want to listen in on this conversation with your insurance company.
In short, the transaction costs of dealing in physical gold are going to eat up your returns. Luckily, if you want gold in your portfolio, you can buy a low-cost exchange-traded fund (ETF), such as GLD. Low-cost index fund? Is there an echo in here?
If you’re buying gold as “apocalypse insurance”… well, I figure if the apocalypse comes, guys with guns are going to come to my house and take my gold. Your mileage may vary.
4. Hedge funds
Chances are, you’re not eligible to invest in a hedge fund. In order to buy in, you have to be an accredited investor: show the SEC $1 million in assets or $200,000 in annual income, two years in a row.
If you are thusly accredited, don’t put your substantial wealth into anything as stupid as a hedge fund.
Hedge funds continue to enjoy a clubby, smoking-jacket reputation as the place wealthy people put their money in order to turn it into more money.
In fact, hedge funds are like actively managed mutual funds on steroids. They charge astronomical fees, trade often, and take huge risks.
This would be fine if they offered huge returns, but they don’t. The classic study of hedge funds by Guarav Amin and Harry Kat asks: Do the “Money Machines” really add value? Spoiler: they don’t. The study covered the bull market period from 1990 to 2000. In the decade since, hedge funds have done even worse.
5. Equity-linked CDs
Equity-linked CDs and other structured instruments (reverse convertibles, accelerators, market-linked notes, and other shiny things with fancy names) are designed to lure you in with the promise of high returns and no principal risk. You know, like a free lunch. What is it they say about free lunches, again?
“You never have to analyze any of these securities,” says Swedroe. “You should just run away from them immediately.”
Here’s a typical scenario: a bank issues a 5-year CD indexed to the S&P 500. The CD pays no interest until maturity (so only the principal is FDIC-insured), and there’s a substantial penalty for early withdrawal. If you look at the fine print, it says you earn 90% of any gains in the S&P. But not the final value of the S&P at maturity; it’s a value averaged from a few points along the way. Furthermore, you completely forfeit any dividends paid by S&P 500 companies, which you would have received if you’d invested in an index fund.
“Who issues these securities? Big institutions: Goldman Sachs, UBS,” says Swedroe. “What’s the job of the treasurer of that company? Is it their job to raise money at the lowest cost of capital or to do you a favor and pay you a high rate of return?”
Swedroe wrote about these investments in his 2008 book, The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad, and the Ugly. No bonus points for guessing that they’re in the “ugly” category.
If you’re looking to share in some of the returns of the stock market without taking as much risk, you can do it without locking up your money for five years or more: put most of your money in a treasury bond index fund and the rest in a stock index fund.
Index fund, index fund, index fund. I’m even boring myself. I’ll console myself by going out to lunch and spending some of the money I’m not losing on “interesting” investments.
Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.