There’s a Secret Your Broker Isn’t Telling You (And It Can Save You Money)

The following is adapted from FOOLISH .

After years of working in financial services, I’ve come to realize something: even more than big returns, investors like the action. When a broker pitches the advantage to be gained, showing clients the algorithms and the illusion of the upper-hand, their clients love it.

Why? They love the complexity. They love feeling like there’s a super-secret magic formula. Most of all, they love believing they’ve found the guy smart enough to unlock it all. It’s almost like a little magic black box. You put it all in, shake it all up, and bam! You’ve got yourself a magic trick.

It might seem strange, but given human nature, it’s understandable. In a lot of ways, it’s like taking a vacation to Las Vegas. People don’t go to Vegas just to win. People go to Vegas to play the game. They hope to come out ahead, but walk in knowing that if they lose money, at least they’ll gain entertainment.?

Wall Street exploits the same human tendencies that Vegas does. Yet, most investors don’t realize the complexity is used as a part of a carefully crafted ecosystem.?

You have an advantage, though, because I’m happy to lay the secrets bare. And once you know how it all works, you’ll be armed with what you need to succeed.?

The Secret

Just like with gambling, people get entertainment value from investing, but they also expect to win at it, at least occasionally. The problem with “entertaining” investors is that, unlike gamblers in Vegas, an investor often has more than $1,000 on the line. They may even have their life savings up for ante.

Knowing this, Wall Street has its light show ready to mesmerize. Brokers say they can predict what tomorrow will look like. They carefully wordsmith the story to get you to sign on the dotted line. They know exactly how to play their cards to get you to buy what they’re selling.

However, they don’t have enough information to know what’s going to happen tomorrow. Yes, people get lucky, but if you believe your broker when they say they can predict the future, ask them if they are willing to be paid based on the alpha they generate.?

Gaining Alpha

Let’s look at what’s actually going on here.?

At the core, the risk of participating in the market is simply called “beta.” If the market is up 1 percent, and 100 percent of your investable funds are in the market (a beta measure of 1.0), you should expect your account to be up 1 percent as well.?

You might hear a money manager say, “I can provide you something more than beta! If you put your money where I tell you to, I can provide you a higher return level.” They won’t guarantee that, of course. It’s all conceptual, back-tested, and hypothetical. Maybe it will materialize, maybe it won’t. Chances are, it’s not liable to, but if it does, that extra above beta is known as “alpha.”

Alpha can be achieved in a couple of different ways. One is by getting the same return as the market while taking on less risk. Another is by taking the same risk as the market and achieving a higher rate of return. But is alpha repeatable? Is it merely luck? Is it excessive risk-taking that just hasn’t gone bad yet?

The answer to those questions is the secret your broker won’t tell you: there’s not a single person out there that can consistently achieve alpha generation. The methodologies they use—for example, buying small companies that show a certain growth rate over time—are really just ways for them to narrow down how they select securities. The algorithms and methodologies don’t guarantee alpha generation. All they do is get you to focus on the possibility of achieving excess returns.

Brokers Should Put Their Money Where Their Mouth Is

I think any money manager who rides on his ability to generate alpha should be willing to get paid only for the alpha he generates. Advisors, including those at my current firm, don’t get paid based on whether or not they can generate alpha because they don’t have confidence that they’ll be able to generate it, or they are delivering other value-added services separate from alpha.?

If they’re not confident in their ability, it’s because excess return often depends on factors outside of the advisors’ control, and the entire community loathes admitting that. They want to convince you how smart they are so they can tack on commissions and fees, which make excess returns even more elusive.?

Just to be clear, I’m not talking out of both sides of my mouth here: my firm does not pitch our ability to generate market-beating returns on a client’s investments. We do thrive by generating returns in excess of those advisors who say they can beat the market.?

How? Because we don’t earn commissions or charge insane fees. We know we can rise to the top of the heap simply because methodologies that attempt alpha-generation have such high costs and our costs are so low.

Everyone Gets It Right Occasionally

Every year, Standard and Poor’s (S&P) publishes a scorecard called the SPIVA Report. It reviews money managers, categorized by methodology, and compares them to each other and the benchmark (100 percent beta) for that same grouping.?

The vast majority of managers consistently underperform. There is routinely a narrow subset that outperforms, but research shows that few are able to repeat that outperformance in the subsequent year.?

Any money manager who sticks to his knitting is going to have the stars align at some point. Lo and behold, the year he’s able to do that will be shown on the marketing materials he presents to you just to show how smart he is.?

The fact of the matter is, this alpha concept eludes actual investor results more than 90 percent of the time. I don’t know about you, but to me, when 90 percent of investors never see alpha, and when the cost of alpha is greater than the benefit you can derive from it, it’s clear that going for beta makes way more sense.?

Money-Makin' Secret

I was never able to reconcile the way brokerage firms present themselves as the key to unlocking the financial market complexity, especially when I realized the firms create the complex ecosystem in the first place. The true money-makin’ secret is avoiding the complexity architecture altogether. Instead, you should temper your desires to “beat the market” and aim to match it. In doing so, you will minimize your costs, save yourself a load of disappointment, and flip the age-old rhetoric on its head.

For more advice on how you can create a winning investing strategy while saving money, you can find FOOLISH on Amazon .

Gil Baumgarten , one of the nation’s top financial advisors, is the Founder and President of Segment Wealth Management , an RIA financial advisory firm. Since its inception in 2010, Segment Wealth Management has grown to a top-ten firm in Houston, as recognized by the Houston Business Journal, with over a billion dollars in client assets under advisement. Gil is also a nine-time recipient of the Top 1,200 Financial Advisors distinction and has been ranked among the thirty-five best advisors in Texas by Barron’s. Distinctions aside, Gil’s affinity for precision and detail reveals itself in his daily life as well. He is an avid outdoorsman, award-winning woodworker, and attentive family man, friend, and colleague.