Self-Direct or Use Professional Advisors?

There are two classes of investors:  those who hire professionals to manage their money, and those who manage their own portfolios.

I'm intentionally omitting short-term traders from this discussion.

Self-directed investors make their own buy/hold/sell decisions.  They may use futures or options for hedging, but all decisions are made on their own.  Some devote many hours to studying markets or graphs.  Some read about and study investing and/or trading techniques. 

I'm a big fan of investors who manage their own portfolios.  But it must be recognized that not everyone has the time or skills required to do a good job.  And when your financial future depends on those abilities, it's important to hire a good manager.  Hiring yourself is best, but if you cannot do a good job, it's okay to hire others.

Financial advisors, financial planners, stockbrokers*, or anyone else who gets paid a fee or commission to provide investment advice to the general public has a fiduciary responsibility to make every effort to do a good job.  IMHO, far too many fail to do that.            *See comments

I base this opinion on the type of advice that one hears on TV or reads in the newspapers.  Financial professionals are frequently interviewed and their opinions are 'out there' for people to see and hear.

The most common advice is the same as one would offer to the 'prudent investor.'  For example: diversify your holdings; allocate your assets among different investment classes; buy and hold; don't panic when the market falls; buy mutual funds and rely on professional money managers; etc.

There's nothing inherently wrong with most of that advice, with the exception of buying traditional mutual funds.  Most of those funds cannot outperform the market averages, but that doesn't prevent them from charging fees (and sometimes sales commissions, called loads) despite their underperformance.  If mutual funds are your cup of tea, consider investing in index funds that charge very small management fees.

Don't forget hedge funds.  They had years of spectacular success, only to be followed by this year's disaster.  The managers of hedge funds charge 2% annual fee plus 20% of any profits earned.  You take the risk, they take a good portion of the reward.  Not a good deal, IMHO.

Many of you can do better

As recent events have demonstrated, traditional investment advice is not sufficient.  A necessary ingredient to long-term successful investing is risk management.  No one cares about such ideas when the markets are rising.  All investors believe they are intelligent for picking stocks that continue to increase in value.  The truth is, it's easy to make money in a bull market.

But, bear markets are inevitable.  When portfolio values fall, investors become very upset, not knowing where to turn or what to do.

To me, the solution is to constantly to be aware of risk and to hedge (reduce the risk of owning) that risk – even when markets are rising.  The amount of money that you fail to make by hedging can be dwarfed by the amount saved when the market tumbles.  Obviously this discussion is currently relevant – just after the October Massacre of 2008, and during who knows what for November.

Options are a simple hedging tool.  The basics are not complicated and can be readily understood by almost everyone.  All of my favorite, basic strategies are easy to understand, and millions of investors are capable of using options to hedge the risk of owning a stock market portfolio.  A thorough description of my six favorite strategies is available in The Rookie's Guide to Options.  You can download a free e-book sampler.

Options are not suitable for everyone, so be certain you understand the risks and rewards of using them.  But if you adopt conservative strategies and have the time and willingness to learn something new, you can easily afford the protection that hedging with options offers.  Some strategies provide minimal protection, while others can protect your entire portfolio.  Some provide limited (but significant) potential profits while others give you the opportunity for unlimited profits.

Are options for you?


5 Responses to Self-Direct or Use Professional Advisors?

  1. Charles Stanley 11/13/2008 at 11:06 AM #

    I have to take exception to one statement in this article that investors need to be aware of: stockbrokers do NOT have a fiduciary duty to their investor customers. Their fiduciary duty is owed legally to their employer, the brokerage firm. Brokerage firms avoid fiduciary status like the plague – ask anyone who has had involvement with FINRA Arbitration cases. Registered Investment Advisors are by law fiduciaries and are held to that higher standard. People who are going to delegate their investment management should consider carefully whether or not they want the person to whom they delegate authority to be a fiduciary or only be held to a “suitability” standard.

  2. Mark 11/13/2008 at 11:30 AM #

    Thank you,
    I stand corrected.

  3. Mike S. 11/13/2008 at 12:40 PM #

    Hi Mark: Thanks for a great blog. One quick question: When buying out-of-the-money Calls, do you need the underlying stock to get to (or higher than) the strike price to make a profit? In other words if you buy $10 calls for a stock currently trading at $5, for example, can you sell the call if the stock hits $8, or will you not realize a profit unless it his $10 before the expiration date? I understand how to figure out the profit potential on at-the-money and in-the-money calls, but am a bit confused about out-of-the-money calls. It looks like for stocks trading at around under $5, there are usually only out-of-the-money calls available.

  4. Mark 11/13/2008 at 12:51 PM #

    There are a lot of out of the money calls available in today’s market because stocks have dropped so much. Many of these calls used to be at- or even in the money!
    You can make a profit ANY TIME you sell an option at a price higher than you paid for it. The stock price is immaterial.
    If you buy a call with a strike price of 10 when the stock is 5, that’s a very, very optimistic play. Most traders pick a strike that expect the stock to hit, even though you don’t have to hold the option until that happens. In your example, you are looking for the stock to double.
    However, if you do buy such a call, you are likely to see a profit if the stock rises to 8 (your number) fairly quickly. The longer it takes, the less chance you have of earning a profit. And, obviously, when expiration arrives, the option becomes worthless.

  5. Mike S. 11/13/2008 at 5:50 PM #

    Another question:
    As I have learned, 1 (one) stock option contract gives me the right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock at a specific price during a specified period of time.
    Let’s say that in October I decide to purchase 1000 “far out-of-the money” Microsoft call options for 1 dollar a piece at a $25 strike price (Microsoft October 25 calls). The total premium cost’s me $1000. But, since each contract is worth 100 shares, those contracts are technically worth 100,000 shares of stock. After several weeks, it becomes fairly clear that my strike price isn’t going to get hit—the stock has been trading steadiy at $23. However, I still have the right to exercise the options at $25.
    In the above scenario, I decide to exercise all 1000 of my options regardless of the fact that they are not in-the-money. Isn’t the seller is still required to deliver me 100,000 shares? If so, that would mean that 100,000 shares would still be taken from his account and put in my account. I now have 100,000 microsoft shares in my account, at which point it’s up to me to sell them on the open market. Do I have this correct?