Analysts, Margin, Chat Rooms Come into Focus, But is the Focus Correct?
While many analysts and brokers ponder how much higher the market can go, and some industry professionals continue to call for the bursting of the bubble, Securities and Exchange Commission Chairman Arthur Levitt expressed his concerns over the markets.
In a speech given at the Los Angeles Times 4th Annual Investment Strategies Conference in February, the Chairman expressed his concerns and made a point of reviewing some of the basic principles of sound investing, and made suggestions for investors. Unfortunately, Chairman Levitt misses the mark again, making suggestions that are simply unworkable, and encouraging suspicion and lack of trust in the markets by the investing public.
The Chairmans concerns are warranted. Too many investors are looking for home runs and looking for returns of 50% and 100%. A recent survey found that individual investors are expecting an average return of 43%!!! They are trading more, for shorter periods of time, in less diversified portfolios, on less information, with borrowed money. It is a recipe for disaster.
Much of what Chairman Levitt said is not new, unusual or controversial. He encouraged investors to diversify their portfolio, reminding them that investing in one security or one industry, in the hopes of achieving a spectacular gain significantly increases the risk. But he then encouraged everyone to move into mutual funds but not just any mutual funds, one that have low management fees. Easier said than done.
A continuing theme was the independence of analysts, which seems to be the new area of concern. Comments regarding their independence, and calling a sell recommendation as rare as a Barbara Streisand concert were the main themes here. And the Chairman was not talking about analysts from unknown firms, he was clearing referring to some of Wall Streets best, referring to them as analysts from Wall Street firms on television talking about one company or another and concluded those comments by urging investors to be suspect, reminding them that analysts recommendations are often tied to their paychecks, and stating [t]he fact is, many of today’s business practices often lurk in those grey areas well beyond the bright line of right and wrong.
Of greater significance are the concerns over the increased use of margin. Many commentators have expressed concern over the use of margin at the online and discount firms for years. There is simply no one reminding these investors that leverage means risk and while it might be a wonderful concept to double your investment, and therefore your gains, by using margin, you are more than doubling your risk on the downside, if you do not have enough funds to cover the margin debt.
With recent reports reflecting the huge surge in margin debt during the last quarter of 1999, the Chairman addressed the issue. He correctly points out that investors are focusing on the upside without carefully considering the downside. He also points out that some investors have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin without any notification and potentially at a substantial loss to the investor.
His solution? He apparently doesnt have one, and urges investors to do the math and [c]onsider what will happen if say, the stock drops 50 percent in a short period of time, and how you would respond if your broker wanted you to put up more money to cover your losses.
How about a proposal that requires brokerage firms to specifically identify this risk to customers when they open a margin account, or when they enter their first margin trade? At a retail firm, there is a professional between the investor and the market you remember that professional he is known as a stock broker and that professional can advise the investor of the risk of margin when he attempts to enter a margin trade. Many retail firms have specific disclosure statements for investors who are considering trading on margin, which explains the benefits and the risks.
But the online firms? This simply does not occur. There is no professional between the investor and the market, no specific disclosures for margin risk, nothing. If the Chairman is correct, and online investors do not realize that borrowing money involves risk (and I do not believe for a moment that a thinking adult does not know this) then it is time for specific disclosures to be made to these customers. Stop around worry about day traders, lets address these margin concerns. Has everyone forgotten already that it was margin liquidations which fueled Black Monday? I realize that it was nearly 13 years ago, but some of us were around, and some of us were cleaning up the mess left by margin liquidations for years after the crash.
As anyone who reads my column or vists my web site knows, I am not a fan of increased regulation. The securities industry has more regulations than the banking industry, the insurance industry, and even the nuclear power industry. Regulations are not the answer.
With all of this talk about suitability determinations for day traders, increased margin requirements for day traders, and suitability requirements for push technology, the regulators are losing focus. Certainly day trading is a concern when engaged in by inexperienced investors, but how about their margin debts? There are widows out there buying Amazon on margin looking for a quick 10 points! Let’s get some information in that widows hands, and make sure that she understands the risks. If she does, fine, trade away, but if she doesnt understand the risks, then shame on the regulators.
What is the Chairmans solutions to these issues? Research, research, research. Throughout his speech, the Chairman constantly encouraged investors to be diligent, and do research. He wants them to review the prospectuses of mutual funds, to determine the reason for past performance and he wants them to scrutinize the fund’s fees and expenses. While he correctly points out that such fees, over time, can have a significant difference, are investors really going to take the time to find that information, and analyze it? These same investors who the Chairman notes do not read their margin agreements are going to pour over mutual fund prospectuses? If they do take the time, do they have the experience and ability to make an educated decision over fees? Are fees the sole determining factor in deciding which mutual fund to invest in?
The research theme carried over in the Internet discussion, with Levitt encouraging investors not only to be wary of chat room tips but to investigate the securities themselves. How does he propose to do that? By having investors visit the SECs website and by using EDGAR. According to the Chairman, at EDGAR, an investor simply has to type in a company’s name and he can retrieve every report they have filed with the SEC in the past five years.
Is this really the solution? Turning millions of people into securities analysts? Doesnt the Chairman realize that analysts are professionals, with vast experience in reviewing financial statements, industry sectors and the markets? Does the Chairman really think that the tens of millions of investors have the time or ability to do their own research? Doesnt he realize that we have jobs, and families, ever increasing time demands and little time to learn a new profession?
Does the Chairman even remember that there are hundreds of thousands of skilled, intelligent professionals working in the securities industry whose goal and job function is to provide exactly this type of service to the investing public?
Is there any good reason why he did not once suggest using the services of those professionals in order to manage risk, diversify portfolios, and research companies?