Five Reasons Why Investing is Dead | Forbes

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Jay Shah

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Dec 7, 2011, 3:44:14 AM12/7/11

12/05/2011 @ 9:35AM |1,317 views

Five Reasons Why Investing is Dead

The basic idea behind investing is that you funnel money left over after covering your expenses into financial instruments whose value rises faster than inflation. When you stop working, you live off the appreciated value of those financial instruments.

That quaint idea is dead. The simple reason is that with inflation roaring at 3.5%, there are no financial instruments in which you can reliably invest that will out-earn inflation. (Sure it’s always possible to cite statistics from Jeremy Siegel at Wharton on how stocks out-earn all other forms of investment — over the long-run. But there are plenty of people who won’t be alive that long.)

Here are five reasons investing is dead:

Stocks down. The S&P 500 has fallen 1% so far in 2011, not exactly a spectacular performance. And in the last five years, the S&P 500 has lost 13% of its value. To be fair, it’s easy to pick a period for which stocks are up — 10 years ago, the S&P 500 was 9.2% lower than it is today — but that’s an underwhelming 0.7% annual growth rate.
Real estate down 31%. Another place where people used to be able to make a return on their investment was real estate. Real estate prices are down 31% since the peak in mid-2006, according to Standard & Poor’s/Case-Shiller index. But PIMCO thinks they will fall another 8% in 2012. Needless to say this makes people feel poorer even if they are not selling their houses at below-peak value. And for those who might be tempted to use the dip as a time to buy, there’s no way for them to get in if they can’t borrow to buy.
Money market funds yielding next to nothing. With the U.S. 10 year government bond yielding 2% and money funds paying out at most a far-more-paltry 0.2%, the best that can be said about these so-called risk free investments is that they are not going down in value on an absolute basis. But if you put your money here, you are losing ground against inflation.
High frequency trading (HFT) is 70% of volume. If you’ve had any training in investment analysis, you know that it features ideas like analyzing a company’s income statement and balance sheet to estimate its prospects and liquidation value. If the company’s stock price is less than the present value of its future cash flows or its value after liquidation, then you buy the stock. But if you invest, you’re competing with HFT computers located a stone’s throw from the NYSE computers. Flash traders — a kind of HFT – profit from split-second pricing errors they find by analyzing orders they intercept on their way to the exchange. And since HFT computers dominate the market and don’t use traditional investment analysis, you can’t beat the already declining market.
Record volatility. Thanks to the Chicago Board Options Exchange, we can measure how much stock prices are going up and down. And here is one sure-fire way to win — betting that volatility will rise – the CBOE VIX index has risen 164% in the last five years. Unfortunately, not even the VIX rises steadily — to really make money, you’d need a VIX based on the VIX.

Here are two important footnotes:

With few exceptions, the smart money is dumb. John Paulson got famous for making $4 billion selling sub-prime mortgages short. But his funds are down 30% to 50% in 2011. James Simons‘ Renaissance Technologies is the only firm I know of that regularly beats the market, as its Medallion Fund has since 1990. It runs HFT computers and charges a fee of 44% of the profits (most funds charge 20%).
Financial advisors are worthless. If you are looking to get help from financial advisors — think again. As I wrote in October, at least one Nobel-Prize-winning researcher concluded that financial advisors have no economic reason to exist.

Finally, I think there is one way to beat the market but it only works occasionally — as John Paulson found out. And that is to sell short shares of public companies that are poised to go bankrupt.

The problem — of course — is finding those companies and betting on their decline before everyone else figures it out. I made a short call in December 2006 — arguing that Novastar Financial (NOVS), then a high-flying sub-prime lender would fall from its then-$106 a share. It’s now down at $0.44. That worked out well and is a pretty good example of how to think about making money shorting stocks.

Needless to say, this is very risky because you can be wrong in your analysis and even if you are right, you can be too early and get whipsawed.

Sure Warren Buffett seems to keep making money — but he has enough capital and clout to negotiate preferred stock deals to rescue distressed companies in exchange for no-lose deals that give him a 6% guaranteed return with the chance for upside in the stock, as he did with Bank of America (BAC) in August.

But for ordinary people, investing is dead. And given the gap between the need for beating inflation and the absence of investments that do so, there is a big opportunity for anyone who can figure out how to revive it.