Wall Street is “rigged.” That’s the word Michael Lewis, author of the bestseller Flash Boys, is spreading among the news networks, and it’s produced a vast outcry in the financial community.
Really? As Gordon Gekko, the unscrupulous corporate raider in the ‘87 classic Wall Street, says, “Come on, pal. Tell me something I don’t know.”
There’s a lot to learn from Gekko, who spends the bulk of the film demanding a young stockbroker named Bud Fox bring him information—information no one else can or will deliver. A few Gekko-isms should jolt your memory of the movie:
- “The public’s out there throwing darts at a board, sport. I don't throw darts at a board—I bet on sure things.”
- “You ever wonder why fund managers can’t beat the S&P 500? Because they’re sheep, and sheep get slaughtered.”
- “The most valuable commodity I know of is information.”
Now, of course Gekko’s criminal endeavors were bad news, but his message of “greed is good” was not. Had he been a soft-spoken, cardigan-wearing mentor like Mr. Rogers, he would have said, “Greed is good. Working hard and accumulating wealth is virtuous. The wealthy not only invest and create jobs for our community, but they are also the most philanthropic. And, the real secret to investing success is to gather information ahead of the crowd.”
Either way, Gekko was right about one thing: The most valuable commodity is information. For retail investors, this presents a problem: we’re competing with brokers for that commodity, and winning that game is the only way to invest before the herd. Your broker might be a perfectly nice, morally upright person. Heck, he might even be a friend. But put your best interest first? That’s not what his employer pays him to do.
The Advent of Fee-Based Products
Three major changes affected how brokerage firms interact with ordinary investors today:
- The emergence of 401(k)s and IRAs;
- Discount brokers offering reduced trading fees; and
- The passage of the Gramm-Leach-Bliley Act allowing banks and securities companies to combine in ways that had been long prohibited.
For discount houses and full-service brokerages alike, the income from client trading was insufficient to support million-dollar bonuses. So, with dollar signs twinkling in their eyes, brokerages looked elsewhere. They saw the huge fees mutual funds were charging, particularly with all that 401(k) and IRA money up for grabs, and decided sponsoring their own funds was a great idea. Today, the primary goal of retail brokers is moving client money into those fee-based products.
In other words, retail investors are on the bottom on the totem pole.
For High-Net-Worth Individuals Only
Private money management is another fee-based profit opportunity for brokers, but as a client you have to be a high-net-worth investor to get any benefit from it.
When a doctor friend of mine sold a piece of property and had $3 million to invest, he chose a major firm with a terrific track record to help. Their glossy brochures were impressive, and they did an OK job, but when his annual contract expired, he terminated the relationship with the brokerage. It wasn’t because they had done poorly, but because they treated him like the proverbial red-headed stepchild. It took on average two to three days to even get a return phone call.
Another friend, whose account is likely 100 times greater than the doctor’s, does business with the same firm and has been quite pleased. No surprise there. As he said, “I get the first team and have the cellphone number of the vice president, who handles my account. If he does not answer right away, I get a call back within an hour.”
Where Do Brokerage Firms Get Their Knowledge, and What Do They Do with It?
Brokerages have armies of highly qualified research analysts. The best and brightest work for their in-house trading operations, manage mutual funds, work with programmers on algorithms for high-frequency trading (HFT), or manage money for their platinum clients—folks able to meet those $100 million account minimums.
Real research goes deeper than just analytics. A top-notch analyst understands a company in its entirety, including its management, business, products, competition, cash flow, and dozens of other variables, and applies his own judgment. The information he’s looking for is unlikely to be found in an annual report.
Acquiring knowledge ahead of everyone else is the golden nugget. If we knew a week ahead of everyone else that the FDA was going to approve or deny an application for a new drug, we could make a lot of money, except that would be insider trading and against the law.
Legally finding those golden nuggets ahead of everyone else is expensive and time consuming. When brokers find an opportunity, they act quickly and use that information where it does them the most good. By “them,” I mean their own in-house trading, their big clients, and probably the personal account of their brother’s cousin twice removed.
By the time the investment is written up as a Buy and widely disseminated, the carcass has already been picked over and the retail clients get the scraps, if anything.
Before my longtime stockbroker retired, she and I asked her firm’s research department for research on particular stock. We received a one-page form letter rating the stock a BUY because “8 out of 10 firms have it on their Buy list.” When she retired, I closed all of our accounts and never looked back.
So Where Does That Leave the Individual Investor?
We don’t all have to go back college and become financial analysts; we just need inexpensive access to the best of them. Thankfully, investment newsletters have jumped in to fill the need for true independent research.
Here’s a tip: Separate the newsletters you receive into trading publications and investment newsletters. The former use daily charts and movements to trade in and out of stocks quickly—not exactly what you want to do with your retirement nest egg. That doesn’t mean you have to ignore trading publications; if a chart shows a company is currently out of favor on Wall Street, it could be a candidate worth investigating.
The latter type of newsletter is for investors, “investing” being defined as putting money into a stock because one believes in its growth potential. Write-ups in these investment newsletters go into great detail about a company, its management, products, competition—they look past the numbers and convey a clear sense of what the company’s future will be.
Even if you have a broker and financial advisor, looking after your own nest egg is not a job you should hand over to someone else. Most stockbrokers, financial planners, insurance salesmen, and bankers are all good resources, but will only recommend investments that make them money. They’re just doing their jobs, and that’s fine.
On the other hand, when you’re looking for those golden nuggets, quality newsletters that provide true independent research for independent thinkers are like a personal team of gold miners. This is where the money is made.
Good analysts will tell you what they’ve uncovered to let you comfortably buy in to a company and why you should expect to profit. A little over a year ago our analyst team and I looked at Hess Oil, which was out of favor among most analysts at the time. The company was in transition: one group of stockholders was pitted against the old line management, their business was fragmented, and they were going to have to take a step back in order to move two steps forward. But we liked the business plan management put forth to turn things around and thought they were headed in the right direction. We beat the crowd and recently closed our position with a 70% gain.
There are other profit opportunities like Hess out there. Your desktop computer today has more power than most Wall Street brokers had 20 years ago. Research today is more than just running the numbers and trying to spot trends. Legendary investor Benjamin Graham was a value investor. When the price-to-Earnings (P/E) ratio got low, he would buy; when it got too high, he would sell. Today he would find himself losing to those with bigger, faster computers. To find those nuggets of information that will make us money, we must do much more. The computer alone won’t do the trick for the retail investor.
Should You Fire Your Broker?
Brokers and other financial advisors can be valuable resources. That said, choosing the right one is paramount. That’s why my colleagues and I wrote The Financial Advisor Guide, a straightforward educational tool that can help you make the right choices for your unique financial situation. Learn how to access your copy of The Financial Advisor Guide here.