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Friday, 29 October 2010

Wall Street Debunked: 4 Costly Myths Exposed

By: Lee Brodie

You know about Olympus, Zeus and the Greek myths but did you know Wall Street has a few myths of its own?

Perhaps they’re not as dramatic as Tristan and Isolde, nor as intense as Medea but they’re certainly as widespread.

In his new tell all "Smarter Than The Street” – CNBC contributor and Fast Money favorite Gary Kaminsky debunks common Wall Street myths.

Four of the costliest myths that could be destroying your wealth follow:

And yes, they are everybit as treacherous to your financial health as the Sea Sirens were to Odysseus. (Okay, we promise the bad puns stop here!)

Myth: Money Mangers Only Get Paid If You Do

It would stand to reason that if a fund loses money that it hurts your PMs wallet as much as it hurts yours. But that may not be the case.

It is true in the hedge fund world; a hedge fund manager’s compensation is closely tethered to returns but most of us don’t have enough money to enter a hedge fund.

(Most hedge funds require a minimum investment of $1 million according to Investopedia.)

Elsewhere in the financial services industry it works a little differently. “Portfolio managers get a base compensation and they get a bonus related to relative performance,” says Kaminksy.

That means the fund can lose money – your money - but the PM profits.

Case in point. You own a sector fund and that sector is down 20% for the year. Your manager returns a negative 7%. That manager beat the benchmark and is rewarded with a bonus.

You, however, aren’t so happy.

”The point here is not to assume that when your money manager makes money you make money. That’s not the way it works,” Kaminksy says.

Myth: Analyst 'Buy' Calls Mean Buy The Stock

Oh, you’ve read the headlines too many times. An analyst who’s been bearish on a sector for years has just issued a ‘Strong-Buy’ or ‘Outperform’ rating. But that doesn’t mean you should buy the stock.

”I’m amazed that just because a stock is rated a strong buy investors don’t know that doesn’t necessarily mean the analyst expects a positive return,” says Kaminsky.

Analyst who issue ‘Buy’ ratings do so to signal that the stock is best bet in its sector, but unless you must put money to work in the sector you may well do better elsewhere.

For example, Deutsche rated Citi a ‘Buy’ in August 2009. And it has outperformed its peers down about 3% while Wells is 9% lower, and JP Morgan 14% lower.

"When this analyst is evaluated at the end of the year, (the Street) thinks he's done an exceptionally good job," explains Kaminksy. However, had you put that same money to work in a myriad of other stocks you'd be a lot happier today.

What's the bottom line?

When you're reading a research report, identify whether the 'Buy' rating is a relative buy rating or an absolute buy rating.

* It’s worth noting that in this post we’re strictly talking about ‘Buy’ recommendations from a sell side analysts – so called because they typically work for brokerages that make a commission from the public’s selling (and buying) of stocks. By contrast buy side analysts typically work for mutual funds or pension funds.

You rarely hear their calls because their recommendations are proprietary.

Myth: Your Broker Has Your Best Interest At Heart.

Your broker has a dirty little secret that you probably don’t want to hear. He makes money when you buy his products. There, we said it. He’s not suggesting financial products out of the goodness of his (or her) heart. So it’s critical to know how he (or she) profits from your purchase.

”It’s amazing that people don’t ask how brokers are compensated,” Kaminsky says. “When consumers buy a house they ask a lot of questions about their broker’s commission.”

But not when they plunk down as much money or sometimes more on stocks and bonds.

”I encourage every investor to ask if their broker is being compensated because the financial product is something the firm is trying to push,” he says. “It may be a suitable product but people need to know.”

What’s the bottom line?

Do your own research, Kaminksy says, a broker should only complement your strategy. Remember, if you rely on the research of others you only know what they know.

Myth: Index Funds Are The Best Bullish Bet

You've read it in magazines, newspapers and probably in your financial history books. Over time the stock market has been the best place to invest. After all we're a nation of optimists and capitalists.

As a result you should put money into an index fund right? Whether it the S&P 500, the Dow, the Russell or some other benchmark, - if you’re bullish it’s a smart play.

Not so, says Kaminsky.

"When you’re indexed you’re fully invested and what the last decade has taught us is being fully invested 100% of the time is not the right strategy," says Kaminksy.

Instead he thinks it's much smarter to identify a handful of stocks that meet your pre-determined criteria (growth, dividend-payers, value names etc.) and make your moves accordingly.

And for those of you who argue you just want to park money in a fund and index funds are less expensive - Kaminsky doesn't buy it. "The idea of just putting money into an index fund because it has the lowest fee structure is a false strategy," he says.

Also he adds that some money managers are well worth those higher fees you pay, the trick is to do your research.

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