I would again like to begin by thanking all the people who have had a look at this blog since its inception about a month ago. I have received nothing but positive comments as well as constructive criticism and I would just like to thank everyone. It has been a great confidence boost to have people who have not the slightest interest in economics and finance, come up to me and tell me that they like the blog and are finally beginning to understand some of the hazy concepts found in economics. One of my aims with this blog was to make such matters understandable. This week's article is about the retail investor and how he should approach investment advice. I hope to give a rational account of the human condition and investing as learned from Ben Graham and others like Warren Buffett and Seth Klarman. I do not claim to be a successful investor, all I am doing is spreading the word from these great men and applying it in a localised manner.

During the mini-boom of the Nairobi Stock Exchange (NSE) of circa 2003-2007, share trading and speculation reached an all time high. The NSE was spoken of at dinner tables, bars, restaurants and even was used as bait for some men trying to attract members of the opposite sex. Stories went around of how people had bought homes, acquired new cars and paid for their children's school fees through their "wise investing" in the stock market. People who stayed away or were suspicious about the gains made in the stock market were ridiculed. I remember my Economics teacher in St. Mary's Mrs. Mwangi in 2006 telling me that the stock market did not reflect fundamentals and it was doomed to drop at some point. Her fellow colleagues at school thought she had gone mad. In the newspapers and on TV, we witnessed mammoth lines of individual investors queuing outside the major stock broker's offices to partake in new IPO's as well as to buy shares that are already trading. It was boom time for the NSE and many other regional exchanges. In fact Zambia's LUSE Index sustained an annualised growth rate of 53% over that same period. This is a remarkable figure for any stock exchange. What drove this growth was an increase in individual/retail investors in Kenya. Many encouraged by the new government and a general feel-good vibe around the country decided that it is time to invest.

With the IPO's some even borrowed so as to speculate and many made some gains. Especially during the Kenya-Re, Eveready and Kengen IPO's. However come 2009, many of those retail investors are questioning their participation. The NSE index has dropped from it's dizzying heights of 5234 in 2007 to 3005.41 as of September 09. I remember at it's height the chairman of the NSE proudly proclaiming that it would hit 8,000 in a year's time. It has shed approximately 40% of its value since. Many of the retailer's as they will be called in this article lost copious amounts of money and some of those who borrowed especially for the Safaricom IPO are in negative equity with their banks. Negative equity occurs when the loan repayment exceeds the value of the asset. An example can be found in the USA. With falling house prices, most people's mortgage repayments exceed the value of their houses. Borrowing to speculate is like a game of Russian Roulette, you risk something that you know and are sure of (your life/ liability) for something that you don't know and are unsure of (an empty chamber/stock price movement). The key then is for future investors and how they should approach financial advice. I will give three sources of financial advice and will analyse each in detail.

The first source of financial advice during the boom, especially for those who were "savvy" and understood some basic accounting elements, were the investment banks and technical analysts. Armed with their deep understanding of technical ratio's and mathematical nuances, many of these analysts had devised techniques of telling where future profit opportunities lay. With acronyms such as EBITDA and PE ratios, they advised the smarter retailers about their stock picks. However one folly lay in that many of these ratio's don't offer any information about the real value of the companies that were being traded. It is vital to remember that a share is a piece of a company and not just a symbol that goes up and down computer and TV screens. A lot of these accounting ratio's are very much a construct of the company that is reporting them and are thus open to legal manipulation. A company can be earning a lot of money but not generating any cash therefore the apparent prospects will be good but the company is struggling. As Warren Buffett says... "Some of these analysts can be compared to a man with a hammer, to him everything looks like a nail". The fact that they have the mathematical and intellectual aptitude to analyse things, they tend to come up with analysis that are mathematically sound but irrelevant. Furthermore, as Ben Graham wisely said "nearly everyone interested in common stocks wants to be told by someone else what the market is going to do, the demand being there, it must be supplied". These analysts are thus providing something that the market is demanding.

It should not be taken then, that these analysts are ridiculous. They are a very important element of the financial architecture, but one should make sure that they are being told relevant details not just a raft of mathematical proofs. The Long-Term Capital Management fiasco is one such example of how brilliant minds can make dumb choices by over relying on sound mathematical analyses. http://www.sjsu.edu/faculty/watkins/ltcm.htm

The second group is the stock brokers. Economics teaches us to study incentives. If one analyses the stock brokerage industry, one soon realises that stock brokers make their money out of commissions charged on trading. For them, then the focus is on volume rather than quality. With this being the case, one can quickly see how one should avoid stock brokerage advice and just use them for what they are, people who let you buy and sell. If you approach a stock broker, he/she will in most cases tell you to buy and sell a certain stock. Added to this will be tips or nudges that the stock in question will do well soon. Rarely will one tell you that you should just sit on the fence and hold your money. Reason being? they make their money out of volume rather than quality. Many of the retailers lost a lot of money by listening to some of the stock broker's tips. Stock brokers then are akin to pharmacists, whenever you go to the local pharmacy with a minor problem, rarely will you be told to just go home and rest. Sometimes, they will even sell you sugar pills because like stock brokers they make their money out of volume rather than quality. Clearly then one should avoid investment advice from a stock broker.

The last source of advice is family or friends. I think this was the biggest motivator for most retailers to enter the stock market. Stories at home, at work and at social gatherings about which hot stock to pick or which one to sell were the order of the day. One's affection for family members and friends as well as the human condition of not wanting to be left out made many follow this advice. However if your family members are not skilled investors and have not had a solid track record of success with their investments then stay away from this advice. The thing is that as human beings we are blessed with the extraordinary gift of story telling, through the years; customs, practices, beliefs and ideologies have been passed from one generation to another through story telling. Oration is then an important part of society. However, stories have no place in financial advice.

Let us take the story of commercial aviation. When Commercial aviation was setting off in the late 50's and early 60's the stories were that the industry would change the way we live and would offer an almost infinite contribution to our GDP's as well as making perpetual profits. However, nobody had analysed the business structure and realised that in the long term the industry would be weakened by increased government regulation, would face perennial uncertainty over fuel prices and even face the risk of terrorism. As I write the aviation industry is yet to turn in a profit cumulatively. Usually the sound information is too abstract for retailers to understand and thus they would rather hear stories. Maybe we should tell stories that are analogous to what the abstract relevant data is telling us. Most of the tips about the stocks to pick are based on almost spiritual beliefs and laced with human over confidence and are in their definition doomed to fail for an investor.

It seems so far that I have discredited three main sources of financial advice. There are many others such as your local bank, accountants and independent financial planners. The conclusion is not that we should all just ignore financial advice, a lot of it is useful. The conclusion is that we should be aware of the pitfalls inherent in financial advice. One should know what his aims are and should come up with the fundamental principles that will guide his investments. The conclusion then is that you should let the advisor know your stance about investments and through the ensuing mutual respect, the two of you are likely to make sound financial decisions that are specific to your characteristics and expectations. He/ she should know that you are not easily manipulated and are a focused investor. He is not likely to mislead you if you make your stance clear from the get go.