Tuesday, March 24, 2009

The Worst Finance Book Ever?

I didn't think I would find a source of financial advice worse than CNBC, but I was wrong. "Conspiracy of the Rich", at least in its present form, should be retitled "Robert Kiyosaki gives you financial advice that is somewhere between negligent and completely destructive to your financial health, while advertising his other books and trying to push your buttons."  Kiyosaki has one good point: we (Americans) are terribly uneducated, financially speaking.  Reading his book will only make the problem worse.

The book is available for free online (if you have an email address you don't mind giving up) - it is very possible that the page numbers I quote will have changed; I don't intend to spend any more time reading it.  Here's just some of what horrified me in the introduction:
"The old rule of diversification tells you to buy a number of stocks, bonds, and mutual funds. Diversification, however, did not protect investors from a 30 percent plunge in the stock market and losses in their mutual funds." (p. 7)
Either this is a gross straw man, or Kiyosaki doesn't understand what diversification means. Diversifying into a broad index of stocks rather than one or two stocks protects you from a particular stock doing something particularly bad. Diversification means that you don't get totally wiped out when Bear Stearns goes down. Diversification among stocks does not protect you from the entire market going down, and no investment advisor with more than 3 brain cells would ever say it does.

Diversification across asset classes protects you from strong movement in one asset class, sometimes. Investors who held both stocks an bonds saw less of a dip than investors entirely in stocks. For a thorough and correct discussion of the capital asset pricing model (which is at the heart of modern portfolio design) see A Random Walk Down Wall Street; for a discussion of why things sometimes still blow up, see Fooled By Randomness.

At the heart of the issue with stocks is not diversification, but volatility. Stocks as an asset class have a history of sometimes getting killed, and now is no exception. The issue at hand is risk tolerance, e.g. if your investments lose half their value, are you going to be okay?
In the end, diversification is a zero-sum game at best. If you are evenly diversified, when one asset class goes down, the other goes up. You lose money in one place and make it in another, but you don't gain any ground. You are static." (p. 8)
This is wrong too for two reasons:
  1. Diversification lowers the volatility of your portfolio. If an investor diversified into bonds and lost only 15% when everyone else lost 30%, I can assure you the investor who lost only 15% will be happier than the one who lost 30%. When looking at investments, the "expected" (average) return is not the only thing you care about, and it's probably not even the most important. Diversification makes the worse case a lot less worse, which is hardly "static".
  2. The investor who lost only 15% has more money, and now is in a much better position to exploit low stock prices than the investor who lost 30%.
Which brings me to the next quote:
"Rather than diversify, wise investors focus and specialize. They get to know the investment category they invest in and how the business works better than anyone else." (p. 8)
and later
"Don't diversify."
This is where Kiyosaki goes from simply wrong to dangerous. Telling an investor not to diversify is, to me, about the same as saying "why don't you bet your entire house on this hand of black-jack. It's a really, really stupid thing to do. It is astounding that he would put this in a personal finance book.

Of course, when you read what comes next...
"During this current financial crisis I took a few hits, but my wealth remainded intact. This is because my wealth is not dependent upon market valuesgoing up or down (a.k.a. capital gains). I invest almost exclusively for cash flow.

"For example, my cash flow decreased a little when the price of oil came down, yet my wealth is strong because I still receive a check in the mail every quarter. Even though the price of the oil stocks, capital gains, game down, I'm not worried because I receive cash flow from my investment. I don't have to worry about selling my stocks to realize a profit."
In other words, Kiyosaki invested in oil stocks, but he didn't lose his wealth when those stocks tanked, because he doesn't consider them to be part of his wealth. If this doesn't seem like the stupidest thing you've ever read, you need to read a book on basic accounting.

Now there is a grain of truth to this. If you have enough money to buy an investment that pays cash periodically and you never need that money back again, you only care about the cash it pays. But this strikes me as making a small fortune on wall street by starting with a large fortune. Let's imagine that Kiyosaki's oil stocks pay a 4% dividend. (That is a rich dividend, by the way!) If he doesn't count the principle (the stocks themselves) but only his cash flow, he will BREAK EVEN on the investment in just over 17 years. In other words, in order to truly ignore the value of the stock, he needs to hold the stocks for 17 years.

Of course, this ignores two huge problems: companies can cut dividends - they can go out of business. All sorts of things can go wrong. A bet that his dividend will stay at 3-4% for 17-24 years uninterrupted is a bad bet to take. The second problem is that there is an opportunity cost. Kiyosaki could have put his money in 2% TIPS (those are inflation-protected government bonds). In those 17 years, his TIPS will probably have doubled his money while he has only made up what he spent on the stocks with his oil stocks.

This is all a fancy way of saying that all investors with half a brain care about what happens to the principle, that is, the money they put in to start the game. It's too big of a chunk of money to ignore. There is no investment that pays such good cash flow that the principle is moot.

But my favorite is on page 10:
"The problem is that very few people know what derivatives are. To keep things simple, I explain derivatives by using the example of an orange and orange juice. Orange juice is a derivative of an orange - just like gasoline is a derivative of oil, or an egg is a derivative of a chicken. It's that simple: If you buy a house, a mortgage is a derivative of you and the house you buy."
Kiyosaki is correct about only one thing in that paragraph: apparently very few people know what derivatives are - and Kiyoaski is not one of them. I do know what a derivative is, and it's not that. A financial derivative is not a "processed" product like orange juice to oranges. A derivative is like a calculus derivative - an investment whose value is based on the change of a property of another investment.

(A stock option is a derivative - its value is based on how much a stock's value goes up - or down, depending on the type of market. A mortgage is not a derivative - it is a non-recourse loan. Fortunately web sites like investopedia can help.)
"Some of these new derivatives had exotic names such as collateralized debt obligations, or high yield corporate bonds, a.k.a. junk bonds, and credit default swaps." (p. 10)
Of the financial instruments on that list, only credit default swaps are actually derivatives. (A credit default swap's value goes up and down depending on the credit worthiness of a bond, that is, how likely is it that the bond is repaid.)

I think this quote from page 5 says it all: 
"Most people cannot tell a good financial advisor from a con man." 
Kiyosaki is 100% correct about that -- ironically it's why he may be able to sell this book.

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