Investing – A Necessary Life Skill

We caught a CNBC segment yesterday that featured Steve Rattner, the former “Car Czar” and Business Insider Editor and CEO, Henry Blodget.  Their discussion revolved around the upcoming Facebook IPO, but it was their general comments about individual investors that really caught our attention.  The two were in agreement that individuals should never buy stocks.  We couldn’t disagree more.

In the segment, Mr. Rattner stated that, “individual investors shouldn’t be playing the stock market any more than you should take out your own appendix.”  He went on to add that individuals couldn’t possibly have sensible opinions with respect to overall stock valuations.

As we see it, individuals can’t afford not to “play” the stock market.  Mr. Rattner’s statement that individuals can’t possibly have sensible opinions about equity valuations is flat out ridiculous.  We’re not talking about surgery here.

Dumbing down Main Street

In our recent commentary, “Wall Street Hasn’t Trained A Real Stockbroker In Almost 20 Years” we highlight how major brokerage firms transitioned their sales forces away from their traditional business of buying and selling underlying stock and bonds on behalf of customers to asset gatherers, who sit back and collect fees by putting their clients into over diversified investment products and services.  Instead of training real stockbrokers, Wall Street has spent the past 20 plus years dumbing down Main Street.

But to understand why brokerage firms re-invented their sales forces, you need to wind the clock back to 1978.  The SEC had abolished fixed rate stock commissions and Boston-based mutual fund company Fidelity Investments opened a discount broker-dealer.  By jumping into the discount brokerage business, Fidelity gave birth to the financial supermarket.  They were the original dually registered player, offering asset management and brokerage services under one roof.

Fidelity’s brokerage strategy was to just under price the large brokerage houses.  They were only looking to attract the assets to Fidelity with the hope that the investor would eventually buy one of their high profit margin mutual funds.  It’s really no different than going to Las Vegas—they feed you and give you a cheap room with the hope that you’ll wander into the casino.

As Fidelity’s dominance in the mutual fund industry grew, they became the largest and most coveted customer for Wall Street’s institutional trading desks, but at the same time they were the single greatest competitive threat to the retail arms at these firms.  Large broker-dealers were paralysed, they had no choice but to sit idly by and watch their retail businesses get eaten alive by their largest customer.  When things got to the point that Fidelity was executing any trade for $29.99, the big brokerage houses virtually abandoned their traditional brokerage businesses.  If you can’t beat them, then join them; brokerage houses dove into the world of fee-based product and services.

The biggest investment decision that most investors make today is whether they want to take a chance with an active manager or go with a low cost index fund.  We give Mr. Rattner and Mr. Blodget credit for recommending that investors use low cost index funds, but just like the one eyed man is king in the land of the blind, index funds are only king relative to these over diversified actively managed products and services.  Indexing only wins by default.

Indexing — The “Risk Free” Equity Return

The reality is that index returns are the equity market equivalent of “risk free” return (albeit positive or negative), and the active management alternative is generally just an index fund handicapped with a hefty fee structure.  In many respects, investment returns have become commoditized.

Mr. Rattner called into question the track record of stockbrokers, but maybe he doesn’t understand that there simply aren’t many real stockbrokers today.  Investors need to fend for themselves, they need to become educated as to how to buy and sell stocks and bonds for their own account.  We’re not talking about developing a short term trading strategy aimed at beating Steve Cohen at his own game.

We can’t see why a reasonably intelligent individual with a long-term investment horizon can’t put together and monitor a diversified portfolio of a dozen or so high quality stock.  Is it risky? Indeed.  But even Mr. Rattner understands that in the world of investing you can’t expect to generate any meaningful rewards if you don’t take any risk.  His solution, buying an index fund, simply isn’t risky in the context of equity investing.

We agree with Mr. Blodget when he said, “most individuals have no idea what an incredible disadvantage they are at.”  But until investors divorce themselves from these risk adverse products and services, they will continue to be disadvantaged with lackluster returns.

In today’s pension-less world, individuals must posses the skills to put together and manage their own investment portfolios – it’s a necessary life skill. We’d bet that most individuals could form a more sensible opinion about valuation than the folks over at J.P. Morgan Chase.

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