Rules of the Game: Shun Outlandish Claims

 | May 13, 2013 | 10:00 AM EDT
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It's always worth a reminder to avoid outlandish claims when it comes to investing (or, more accurately, trading) results.

This was made clear to me when I met a fellow who runs an investment group for individuals. It's one of those ad-hoc clubs that appeals to people who don't have much information about how markets work, but feel nervous about their retirement accounts.

This guy actually said, with a straight face, that his group members were expecting to get a 15% return on conservative investments.

Say what?

This is the kind of delusion and irresponsibility that the trading world is riddled with. I worked with a trading conference for a few years. I interviewed not only advisors focused on retirement, but also some fairly dangerous (in my opinion) shysters peddling trading programs to the unwary.

Here's an example: A guy who had a trading software system with a 94% success rate. It included stocks, options, foreign exchange and futures. You name it.

Yeah, right.

That's an extreme example, but even well respected purveyors of trading methodologies don't address how their system fits into a user's overall needs. I should say they can't. It's one thing to get people excited about "big winners" like Apple (AAPL), Google (GOOG) or Priceline (PCLN). It's quite another to actually analyze the amount of risk that's appropriate for an individual or couple, given their lifestyle needs and future obligations.

Buy six or seven growth stocks and hold each one until it slashes a moving average in heavy volume?

I understand the "make money" sentiment that drives this kind of behavior, but for the investor who is striving to offset future liabilities and to keep pace with inflation, it is far from appropriate.

Too many people make the mistake of confusing asset allocation with portfolio construction. They are not the same thing. Asset allocation is a piece of portfolio construction. Assets are allocated within the portfolio that has been designed to match an investor's financial plan.

Portfolio construction determines the optimal mix of equities and fixed income. (Side note: How often do you hear the trading methodologies discussing fixed income? You almost never hear that because it doesn't have that sexy "make money fast" vibe that you get with high-beta growth stocks. When was the last time you heard anybody utter the phrase "big winner" to describe fixed income?)

Why hold both? For one thing, to give you the opportunity to buy low and sell high, taking advantage of shifts in market cycles. It's also crucial to dial down risk in a conservative portfolio. Contrary to the go-go-go pitches of the stock-trading promoters, almost no investor should take on a high-risk portfolio that has no connection to his or her own lifestyle goals.

I wanted to set the stage for a discussion later this week about the why and how of portfolio construction. But the conversation with Mr. "Fifteen Percent from a conservative portfolio" set me off. There is way too much irresponsible talk out there that lures investors and traders who are unfamiliar with the concept of expected return and modern portfolio theory.

As I've said before, "making money" should not be the goal of an investor. The only reason to invest is to offset future liabilities -- and to accomplish that, you must understand what those obligations may be.

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