Brokers are Butchers
Quote by Kieth Cunningham
Why are the investment recommendations from your broker the most expensive advice you can get?
Just imagine asking your butcher: Can you give me a recommendation for healthy food? What kind of answer do you expect? The butcher would recommend you for example some organic filet steaks from grass-fed Angus beef, imported from Argentina, with marmorized fat structure, slowly dried, and aged over 3 months.
Is that healthy food, which serves your body as well as fresh fruits and vegetables with a high content of living water content? And how about the price per portion? A portion of locally fast-produced beef costs easily 5 times more than vegetables. And the imported Argentinian Angus beef can be another 4 times more expensive. So, in total a factor of 20 times more expensive!
Even if this recommendation is for sure better for you than meat from livestock reared in barns, which got raised with hormone and antibiotics enriched artificial food, and never got to see, nor ever walked on a grass paddy during its entire life, it will rather serve your butchers wealth, than your physical health.
Now looking into your depot: What are the steaks, and what are the vegetables and fruits?
Firstly, let's have a look at the expensive steaks:
- Cryptocurrencies and forex
- CFDs and other hedged or leveraged products, certificates, options, and other gambling products
- Short-term speculation, day trading
- Distributing funds
Noways, the noisiest butchers (brokers) are the cryptocurrency exchange platforms. Whereas trading with cryptocurrencies is in principle nothing else than foreign exchange. Only with the little difference, that there is no regional or national economy behind it.
The value of a currency represents the trust in a country's or region's economy. For example the Yuan for China, the Euro for Europe, or the Dollars for the United States. The expected economical development of a country or a region makes the exchange rate development a bit predictable.
The expectation, that China's economy will grow faster than Japan's, will cause the Chinese Yuan will rise against the Japanese Yen. But having no economy behind a currency means, that its future development is completely unforeseeable. This turns crypto trading into pure gambling. Due to that, its volatility is so high. Because it is just a phantasy product, which price rises and drops with the greed and fear of the investors. Can you predict that? I don't know, how to do it. Yet ...
One can never win a game in the long term
without understanding its rules.
Many brokers offer commission-free crypto trading. But generally, the spread between buying and selling price is so high that the butcher has a lot of fun with it, especially if you trade frequently. The more often you buy and sell, the better for the broker because he earns the spread. That explains why crypto brokers have such a huge marketing budget. So, one gets to see that much advertising for crypto trading everywhere.
With Foreign Exchange Trading (which is commonly called FOREX), the situation is a little different. The spread is small and the volatility is also comparably small. To make, or lose money, with Forex one needs to trade high amounts.
If you buy Chinese Yuan for 1.000 US$ and the Yuan rises 1 % you gain 10 US$, and you might pay 2$ in fees per trade, commission, and 1$ for the spread. That equals gaining 10$, minus 5$ costs. In total, you are earning 5$ with this trade. Not very exciting. You paid 50% of the raw earnings for your broker service. Not very exciting, neither for you nor for your broker.
Your broker is more than happy to help you make your trades more lucrative. They simply leverage the amount you exchanged in a different currency with a credit. For example, to tenfold the traded amount. With such a leveraged trade, you buy again for 1,000 US$ Chinese Yuan. But the broker gives you 9,000 US$ credit and exchanges 10,000 US$ for Yuan.
Let's assume, the Yuan rises by 1% again. Now, the trade makes 100$ in raw earnings. This time you might pay 10$ in fees per trade, 10$ for the spread, and a few $ interest for the credit per day. So, you gained 100$, minus 30$ costs, and earned 70$ with this trade. That looks better now, you have 14 times higher earnings now, while the broker made only 6 times more earnings. That looks like a healthy steak, thank you, my dear butcher!
On the other hand, you also have a much higher risk, if the exchange rate drops. If you close the position, you lose 100 US$ and still have to pay the commission, fees, interest, and spread, for a total of 134.50 US$. While the broker still earns 34.50 $ for the transaction.
In this case, you most likely don't want to exchange back on the same day, and rather wait for a better exchange rate. But while doing so, the interest you have to pay for the credit becomes an issue. Let's say you have to wait for 30 days until the Yuan rises 2% above the price for which you bought it. Your raw earnings are 200 $, minus 30$ for fees and spread, and 30 times 4.5 $ = 135 $ interest. In total, the cost is 164.50 $. And your net earnings are only 35.50 $ for 1,000 $ invested for one month. This equals a yearly interest of only 4.25%. And compared to the initial unleveraged example you played 7 times better. But, your broker earned 17 times more, which makes the butcher 2.4 times happier or healthier than his customer!
If you hold leveraged trades for a long time,
the butcher eats the steaks you bought himself!
I traded forex CFDs consequently for one year using chart analysis. CFD stands for Contract For Differences: A financial contract that pays the differences in the settlement price between the open and closing trades. CFDs essentially allow investors to trade the direction of securities over the very short term and are especially popular in FX and commodities products.
At times I was among the most successful traders on their platform. But by the end of the year, my net earnings were about 7% (of my liquid money in the broker account) after the costs. Then I got the receipt from my broker for my tax declaration, which did show the fees and interest were twice my earnings. It did not declare, how much I paid for the spread between the buy and sell price. And that is almost impossible to calculate manually, but it probably was in the same range as my net earnings. My raw earnings were above 20%. But the broker's raw earnings have been at least twice as high as my net earnings. And the trader has the full risk.
The broker limits his risk and costs like that: They let you trade only with a fraction of your money. As soon as you have a negative balance in one of your trades, that comes near to the amount of your remaining cash, the trading system automatically closes your trade. Due to that, they recommend you to trade only with a little fraction (maximal 10 to 20%) of the money that you have in your broker account. And then the broker leverages your trades by a factor of 5 or 10 by giving you a credit.
Where does the broker get all of the money from, to leverage each trade by 5 or 10? They use the not invested amount of their customers. Your's as well! And in their terms and conditions, they agreed with you, that they are allowed to do so. Did you read them? Well, I did not do it either, and the brokers know that hardly anyone does it. Further, it will be described in fine lawyer language, so that you wouldn't put much attention to it anyway.
Zero risk for the broker,
all the risk for the trader!
Brokers have investors who invest in different currencies, and because they let everyone invest only a fraction of the paid-in money in the account, they accumulate a big amount of liquid cash in every currency. They use this money to give you credit. This money does not cost them anything. It is like a free credit from the investors for the broker.
And if you exchange it into another currency, they just book that internally, securing it with the not invested capital of foreign investors who hold their depot in the currency you are buying. That means zero cost for the exchange on the international FOREX market for the brokers.
Further, if they leverage your trade, they charge you for example 0.05% per day = 18% per year. And if you do intraday trading and you do 4 trades a day, you borrow 4 times the same money and the broker charges you each time 0.05%! This is like your butcher, who puts for hygienical reasons, that oily, thick, heavy paper on the scale before he puts the meat on it. Preferably, or should I say accidentally, 2nd, 3rd, or 4th sheets, there is no hygienical reason for the 2nd, 3rd, and 4th sheets anymore. Do you get the point?
As an example: You put 10,000 $ in your CFD broker account and buy a foreign currency for 1,000 $. This is leveraged with a credit of 9,000 $, for which you pay interest. Guess, where the broker got the money from, to give you the credit? It is your not invested capital! And now you are paying interest for your own not invested money. And the broker hasn't any financing cost for that money. That turns the trader from the role of the customer into the cattle, which is about to be slaughtered.
Hilarious, isn't it?
And people still buying the shit!
If you are gambling roulette at the casino, your money most likely will last longer. Because the average earning of roulette is 1/65. There are 64 fields plus the number zero. If you put a chip on the number x, and x falls, you receive 64 chips of the same value on top of your invested one. But if the zero falls, all money on the table goes to the bank. And the likelihood that 0 falls, is 1 out of 65.
Managed funds are promising a better return on investment than the related market index, for example, the P&P500 or the NASDAQ. And they advertise it with proven records for the last few years. But those fund companies start every year with hundreds of different funds. And their managers do the best they can with it to prove the strategy. After some years they select the best-performing ones. They put their marketing budget on those and close those who didn't perform well, and you will never hear about them again. That means the impression you get is not representative. Studies have shown that 95% of the managed funds are not beating the related market index. Not even before costs!
The cost of managed funds is the most critical factor. Because managed funds have a buying fee of up to 5%, typically a management fee of 1%, and sometimes a selling fee of up to 5%. And the fees are not calculated on earnings, but on the invested amount. Subsequently, the buying and selling fees make them not suitable for short-term trading. Because if you lose 10% for the roundtrip, there is no way in making money from today till tomorrow. Apart from being able to predict an event like a "Black Friday", and investing in a short position! And even then, there would be better options than managed funds.
So let's use them as intended, and hold them for a long time, for 40 years. You buy a managed S&P500-related managed fund and pay a fee of 5% for buying it. You keep it and they subtract a 1% management fee each year, and you sell and pay another 5% for that transaction. 5% + (40 * 1%) + 5% = 50%. Once again, the calculation is based on the invested amount, not on the earnings. That the value of the fund is changing and hopefully increasing over time, makes the exact math complex. But in a simplification of it, we may assume that you pay about 50% of its leverage value over that 40-year period for the fund management. And that has only a chance of 5% to beat the S&P500 index (before its costs). So after costs, you end up with only half of the increase in value compared to the S&P500 index development. Since you paid an equivalent of 50% of your assets for the management.
Secondly, what are the fruits and vegetables?
- Individual stocks of brokers, stock exchanges, or investment firms
- Unmanaged index fonts
- Long-term investing: Buy and hold strategy
- Avoid taxes by accumulating ETFs
How to become the butcher - or at least a part of it?
If you don't have the pocket money to find a brokerage firm or it that is not your passion, you still can earn money on day trading: One needs to be a part of the butcher! And how can you do so? Just buy and hold stocks of the broker, a stock exchange, or investment firms. Especially during volatile times, they make a lot of money, due to the frequent trading of nervous investors. I decided to invest about 10% of my assets in Berkshire Hadaway stocks. This is like a well-managed fund, with a long and successful track record. Investing directly in stocks involves low trading and no management costs. Its long-term development is far better than the S&P500 index. But still, not as good as the NASDAQ.
We need to ask: Is there a possibility to invest directly in an index like the NASDAQ, and still, avoid the management fees?
Yes, this is possible, at least with comparably small costs. There are unmanaged index funds, commonly called Exchange-Traded Fund (ETF). Those are a basket of securities, you may buy or sell through a brokerage firm on a stock exchange, which consists of exactly the composition of its related index, e.g. the NASDAQ.
Some of the ETFs are physically replicating the invested money. That means they are actually invested in all of the stocks represented by the referenced index. That happens automatically by a computer program. So there is no fund management team to pay for. But it still creates costs for the trades they need to do for the permanent change of index composition and match it. This is represented in a slightly higher annual fee. But due to that they typically underperform the index slightly.
There are other synthetic replication ETFs, that are not invested physically. Consequently, the fees are even lower. They match the index precisely (before costs). And others ETFs, even allow investors to go short. That means, the ETF management software lends the ETFs to other traders, who speculate that the related index will fall in the near future. The charges for the interest are getting shared with you. With this additional income stream, they can slightly outperform the index. But that is only a very small amount. And the butcher will make sure, that he keeps the best part of the steak!
Apart from the broker's trading fees, you pay usually only a yearly fee of 0.1 to 0.5%. In the best case, you pay over 40 years only 4% of its average value.
That is really great news, paying only 4% of its average value in fees for holding the ETF for 40 years, instead of 50% for the managed fund. You end up with about twice the money. This is without considering the compounding effect. But the ETF's average value will be higher. Now, compounding can play out its power.
Compounding, the strongest force in the universe
The low trading costs provide you the flexibility to rebalance your investments. Rebalancing means, if your asset allocation strategy is for example:
- 20 % NASDAQ ETF
- 20 % MSCI World ETF
- 20 % MSCI China ETF
- 20 % Gold Producers ETF
- 20 % diversified in individual Butcher stocks
And after a year your depot composition looks like that:
- 22 % NASDAQ ETF
- 14 % MSCI World ETF
- 26 % MSCI China ETF
- 18 % Gold Producers ETF
- 30 % diversified in individual Butcher stocks
- 2 % NASDAQ ETF
- 6 % MSCI China ETF
- 10 % diversified in individual Butcher stocks
- 6 % MSCI World ETF
- 2 % Gold Producers ETF
But do it wisely with a slow hand. Because as soon as you realize earnings, the taxman got his foot in the door. And that violates the compounding. Every country has different tax rules.
- In Germany, we have to pay 25% on capital gains each time we sell and take profits or receive a dividend payment. If you do 12 trades a year taking 4% of earnings on average, the tax reduces the amount you got to reinvest by 1%. That equals (without compounding) that you have to pay 12% of the average treated amount in taxes. If you sell without earnings, you pay nothing.
- In Indonesia, one has to pay 0.1% of the trade amount. Indonesians have to pay an income tax of 10% on dividends. Which sounds nicer, and is better for long-term investing. For 12 trades a year, you have to pay 12 times 0.1% which is only 1.2% of the average treated amount in taxes. But you have to pay this independently of your earnings. So you pay it also if you sold with a loss.
Because the tax each time reduces the amount you got available to invest. And each time means, that its negative effect compounds. Not on a yearly basis, but with each trade you do.
The taxman becomes the new butcher,
who's violating the compounding
The trick to getting him out of the door is to delay the taxable event as much as possible. And that is possible with accumulating ETFs. Dividends are internally reinvested and do not get visible to the taxman. Other than distributing ETFs and individual stocks, that payout the dividends which increase your available money in your broker account and get taxed immediately. 25% in Germany and 10% for locals in Indonesia, as mentioned before. For individual stocks, you cannot avoid this tax, apart from holding only those, that are not paying any dividends, and only speculating on the price development. Examples are Alphabet (Google), Apple, and Tesla, ... but by choosing ETFs that are accumulating dividends, it is possible to postpone the tax payment as long as you want by staying invested. Whenever possible invest in accumulating ETFs for their tax efficiency.
By the way, the only country indexes that are accumulating, are the German ones. So if investing in an ETF representing the DAX (the German S&P40) or TechDAX (the Geman NASDAQ) you already have an accumulating ETF. But if you compare the DAX with a national stock index from another country, be aware that the other ones are showing their value development without the compounding of the dividends. The DAX should do much better over a date or longer. But it actually doesn't. That does not make it an attractive investment anyway.
When, how much, and in what should I invest at the moment?
- When? As soon as possible!
- How much? Any money you do not need. Cash, which you can effort to lose. And only the money, which is above your financial security. If you don't have reached your financial security, or still don't even know what that means: You shouldn't even think about investing in the stoke market. Do your homework first!
- In what?
Giving advice for that is a tricky business. Doing so shows overconfidence, to know better what will happen in the future than the highly paid fund managers, who fail in beating the index by 95% of their attempts! But I am happy to share what I believe in, and what I am invested in at the moment: Preferably accumulating ETFs of undervalued markets with a good perspective, those are:
- China's market Index is at 3 year low, due to the current lockdowns. The fear of the US government is big, and that's why Trump started the trading war with china. But the perspective is that China's economy will outperform the US. China already won the economic competition against the rest of the world.
Other currently undervalued markets are:
- MSCI world
- Artificial Intelligence
- At the moment Russia is at war against Ukraine. While writing this, the Russian stock index is about 45% down compared to its historical high in 2020. However bad the news is currently, there will be someday, when this conflict will be over. Due to international sanctions, it is not possible to buy Russian stock internationally. And the current strength of the Rubel makes it a little less attractive. Also, it is an ethical question, that everybody needs to answer for himself if that helps to finance the war.
- Ukraine is still open. But I am not aware, that there are any Ukrain ETFs available. The only option is individual stocks, which are only suitable for a very small fraction of your portfolio. Since Ukraine might end up as a part of Russia, even if investing there one might end up with Russian stocks. Or, in case the company gets destroyed with nothing.
Other, but currently over-evaluated assets are: This is in general a good recommendation as a part of your asset location strategy. But at the moment both, Gold and Energy, are rather overpriced:
- Gold Mines or Gold Produces ETFs: Those have about 2 to 3 times the volatility than gold itself, without creating the additional cost of a leveraged product. The value development is anti-cyclic to the common market, so it is good to compensate for losses during times of fear when nervous investors search for a safe haven. Even if it makes you earn less during greedy times when overconfident investors forget about it. It is the perfect counterpart to world economy-driven assets like energy or the MSCI world index. And it makes a great rebalancing partner for those. And if the news is so bad, that it can't get worse, it is time to rebalance. Then sell a portion of the gold to reinvest it in undervalued market ETFs. And if the news is too good to be true, sell a portion of your best-performing assets and buy gold, while it is cheap.
- Energy, Oil, and Gas are good counterparts for rebalancing with gold. But due to the special situation with import stops or Russian energy, and the global fear, because both the Ukraine conflict, energy is completely overpriced. So it is not a good time to invest in it at the moment.
Abundance is our birthright.
- Watch the investment advice from Warren Buffet.
- What may did you learn from that?
- Stop paying the dumb tax. Learn more from Kieth Cunningham in his podcast.
For better understanding, you may simultaneously read the translated transcript of the interview about the dumb tax in your language.