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The Ethical Investor: Wall Street Ripoff #4 -- Turning You Into a Passive Investor

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Investors can lose a lot of money, buying high and selling low, if they are very frequent and active traders. Trading costs and commissions alone can really eat into their profits as well as frequent trades that create big tax liabilities payable now rather than later. I am not sure where day trading came from, but it is home run, not to its practitioners who almost invariably end up losing their shirts, but to their Wall Street brokers who love the steady commission stream regardless of what happens to the investor's principal balance.

But, the alternative also has its problems. Completely passive investing in which investors hold a very broad diversified mutual fund or index fund, and hold it forever under a buy and hold strategy creates its own unique set of problems for the individual investor and for the market in general.

Certainly holding an index fund that holds all the stocks in the S&P 500 in proportion to their market size has its advantages. It dramatically lowers expense ratios and transaction costs as typically index funds do not trade as often as actively managed funds. Total expense and transaction costs can be reduced from as much as 2% to 2.5% per year to under .5% per year by utilizing broad index funds for investing.

The problem with everyone investing passively through index funds is that it raises the question, who is watching the store. The whole idea of owning shares is that you are a part owner in a business and that it is the owner's responsibility to hire management to run the business well. If everyone ends up owning hundreds or thousands of different company stocks through passive investing, who will have the desire or motivation or time to police these managements?

This is not a hypothetical question. A major problem today in how public companies are run is that managements are not very responsive to shareholders, that managements and their friends often control the boards of directors that are supposed to be controlled by shareholders and that managements are often granting themselves crazy levels of compensation through salaries, bonuses, stock and option grants, overly generous retirement and benefit packages and golden parachute agreements. Not to mention all the perks of employment that managements enjoy like company junkets on corporate jets to conferences that happen to be held in Mediterranean beach towns or Rocky Mountain ski resorts.

You need only see how out of control big bank managements were in the latest crisis to understand that managements may have completely different incentives than shareholders and need to be watched and policed. Bankers during the boom were more interested in rapidly adding loans to their books to juice EPS growth and justify big bonuses for themselves than they were in seeing that these loans were of a high quality. Of course, when the loans went bad, it was the shareholders who suffered because managements already had theirs in the form of hundreds of millions of dollars of annual bonuses. Even today, after the crisis cost shareholders trillions of dollars in losses, these bank managers continue to pay themselves record bonuses in the tens of millions of dollars each for stock price performance that most would describe as pedestrian or worse.

While no American citizen would ever consider selling his democratic vote to someone in a presidential election year as he understands it is his or her civic duty to participate in our democracy and vote, many American investors who passively invest in mutual and index funds do exactly this when they give up their shareholder proxy vote to financial middlemen. Just maybe, this is one thing we should never do. Maybe capitalism requires us all to stay involved as investors and read our proxy statements and vote our own shares. Passive investing through funds makes this impossible.

The counter argument is that there are professional investors out there like corporate raiders, LBO funds, private equity funds and hedge funds that will do this policing of managements for us. If a publicly traded company is being run poorly by its management team and earnings are suffering as a result, these buyout funds will swoop in and buy the company and straighten it out. Maybe so. But, you as a public company shareholder won't benefit. Any improvement in the company's operations and earnings will accrue to the buyout fund that took the company private.

In other words, these buyout funds may indeed keep managements from stealing more than they otherwise would have. But, the profits they generate go to themselves, not to public company investors. And these profits can be huge. These funds now control hundreds of billions of investment dollars and generate returns often north of 20% per year. And who are their investors? You have to be rich even to be considered. By law you have to be considered a "sophisticated investor" and most of these buyout funds won't talk to you unless you are worth at least $10 million and have at least $5 million in readily investable funds. So profits from public companies end up getting drained out of the market and end up in the hands of those that need them least, the rich and connected. Small individual investors get left holding the bag, and the bag is full of poorly managed public companies. Because small investors are so passive in their investing, they end up with two alternatives, either watch company managements enrich themselves at their expense or watch buyout fund managers and their wealthy investors buy the companies and get even richer.

Is there a better investing model out there? This is a classic collective action problem because there is nothing one investor can do on his own that will result in companies being better policed. But, if we all take more seriously our responsibilities as shareholders and become more active in our policing of managements and our fund managers, we can win this battle. This can be more easily accomplished if we reduce our holdings of individual stocks to say, 10 or 12 companies that we can effectively monitor. We will benefit from diversification, but we will not be so overly diversified as to lose control or our investments.

I also happen to believe that the benefits of broad diversification are dramatically overstated. Yes, there can be some small benefit of slightly lower volatility from holding a thousand different stocks and assets in a hundred different countries through a number of index and mutual funds, but, we end up becoming totally passive sheep waiting to be sheared by Wall Street pros. We can't possibly be expected to monitor thousands of different stocks and their management teams much less be sure that our financial advisors and middlemen have our best interests at heart. Not only does it mean that company managements are not adequately policed, it means that we are setting ourselves up as investors to be fleeced by corrupt financial advisors, bankers, brokers, fund managers and other financial intermediaries who clearly have different motivations than solely seeing that our investments do well with the minimum of risk taking. We will explore this possibility in a future installment of The Ethical Investor.

20 Ways Wall Street is Ripping Off Small Investors:

1. Providing nominal returns, not real returns.

2. Encouraging too much diversification, if that's possible.

3. Hiding fees and expenses.

4. Turning you into a passive investor.

5. Convincing you that money markets are the same as cash.

6. Telling you that bonds are safer than equities.

7. Explaining that in the long run equities outperform bonds.

8. Simply by lying about their products.

9. Convincing you that their bank is a large, stable, safe operation to deal with.

10. Recommending products that have enormous sales commissions attached to them.

11. Cheating you on bid/ask spreads.

12. Selling you what they don't want.

13. Measuring your success in dollars.

14. Lending your securities to others.

15. Ripping your eyes out if you ever try to close your account.

16. Grabbing any slight positive real return for themselves.

17. Sticking toxic waste to small investors.

18. Pretending they can pick stocks.

19. Acting like they are your best friend and they have your best interests at heart.

20. Knowing next to nothing about the value of holding real assets like gold and real estate.

John R. Talbott is a bestselling author and financial consultant to families whose books predicted the housing crash, the banking crisis and the global economic collapse. You can read more about his books, the accuracy of his predictions and his financial consulting activities at www.stopthelying.com

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