10. The Investor and His Advisers
The vast majority of investors are amateurs, who feel that they could benefit from professional guidance in choosing their securities, and as such there is considerable demand for financial advice - a notion that is inherently peculiar.
In most lines of business, a proprietor may seek assistance with peripheral matters that are outside the core business, but do not expect to be told how to make a profit from his core operations - it's his business, in the sense that he feels the need to know how to operate it, and it's also his business in the sense that it is no-one else's concern.
But when it comes to investments, a great many owners are clueless about the very activity that generates their profit and seek the advice of others whom they presume to be more knowledgeable about investing than themselves. In general, people are known to obtain advice on investments from a variety of sources, including:
- A friend or relative whom they presume to be knowledgeable
- Their local banker
- A brokerage firm of investment banker
- A financial services firm
- An independent investment counselor
The degree to which they rely upon these sources differs over time, but in the present age there is a preference for a "professional" whose training and experience are entirely in matters of finance and investment.
As in any ordinary business or professional relationship, a client must know enough about what he wants done to direct the activity of those whom he hires to do it for them, or he must trust in their ability to make choices for him that are ultimately beneficial to his own welfare.
The author's basic thesis is this: if a person hires an advisor to manage his investments, he must limit himself to those who use standard, conservative, and unimaginative forms of investment. If the advisor suggests any unusual course of investment, the investor either understand the service he is buying, or have good reason to place an inordinately high level of trust in his advisor.
Investment Counsel and Trust Services of Banks
The "truly professional" investment advisors, well-established firms that have handled personal fortunes for decades or centuries, "are quite modest in their promises and pretensions."
The long-term viability of such a business depends on their ability to preserve the wealth of the clients they serve for many years - so their investment choices have been, are likely will continue to be, highly conservative and follow a defensive strategy.
They recognize that a mistake made to generate a short-term profit will be detrimental to the trust their clients place in them and their ability to attract new clients, and can generally be counted upon to refrain from wild speculation with their clients' money.
This is generally the character of well-established investment council firms, trust and advisory series, and the financial services of large and well-established banks: businesses that have a large number of wealthy clients whom they have retained for long periods of time.
Financial Services Firms
Certain firms specialize in various "financial services" for the larger market, which chiefly includes research and advice regarding investments. Their chief product is information, which may be communicated to individuals in any number of ways: a face-to-face meeting, bulletins sent by mail or telegram, or a published periodical for subscribers. Some of them do not handle the actual investment activities of their clients at all, but merely sell advice, while others blend the two.
The financial services firm has a different market segment to investment counsel firms - investment counsel deal largely with wealthy individuals who do not wish to manage their own investments, whereas financial services are provided to individuals of more modest means who seek to make decisions, but seek advice and information on which to base those decisions.
Some of the best-known firms in the industry - such as Moody's and Standard and Poor's - are largely involved in the analysis of securities. Some of their analyses are known to the general public (such as the S&P 500 index of stocks), others are very closely guarded and made available only to paying clients.
The goal of financial services firms is accuracy in making predictions, as the value of their service relies on their ability to do so. Those who have enjoyed long-term success generally are conservative in their opinions, and are known to hedge and qualify to minimize the possibility that their conclusions will be laughably wrong. So in addition to the statistics of analysis, they are also quite adept at the practice of Delphic phrasing - making important-sounding phrases that are abstract and meaningless, but appear to have been prophetic when considered n retrospect.
While their analysis of securities is of questionable value, their interpretations and forecasts of business conditions are much more informative and authoritative they collect and analyze data pertaining to the economy - buyers and sellers of goods in various markets - which is a fairly reliable indication of the future incomes of those who manufacture and sell those goods.
As such, their general recommendations of individual securities has been fairly reliable. And while they have made mistakes, their successes outnumber their failures to a degree that they maintain the trust of those who pay for their insight. In all, it can be said that a financial services firm will render a highly informed and carefully considered decision, but not necessarily an accurate one.
Advice of Brokerage Houses
The core services of brokerage houses is buying and selling securities on behalf of their clients, for which they are paid a standard commission. Practically all such houses that deal with the public operate an analytical department to answer inquiries or make recommendations, and who are increasingly involved in dispensing financial advice to their clients, free of charge.
The problem with this practice should be self-evident: the brokerage has no stake in preserving the wealth of its clients, but turns a great deal of profit on commercial transactions. Taken together, their motive is clear: to encourage their clients to make frequent transactions of the kind that earn the highest commission for the house.
While it seems contrary to common sense to accept advice from an individual whose primary interest is in their own profit at the expense of those whom he advices, many investors seek out and rely upon exactly such sources.
While it is arguable that a brokerage can seek to make good recommendations to maintain the long-term trust of clients, the history of such firms provides ample evidence to the contrary: the most successful and profitable of brokerages are those that cater to speculators, and encourage speculation. Generating a constant stream of commissions from clients whose portfolios are in a constant turmoil of buying and selling.
The most ethical of brokerages refrain from giving financial advice - they confine themselves to executing orders given to them, and providing financial information and analysis from other sources while meanwhile tendering no opinion of heir own on the investment merits of securities.
But the common practice of most houses follows a more traditional business model: the "advisors' are salesmen who encourage customers to undertake courses of action that result in the greatest profit to their own houses.
That said, some houses have attempted to provide financial services as well as brokerage services, generally by creating a separation between departments of their organization: a pure brokerage service whose employees merely execute trades without dispensing advice, and a pure analysis department whose employees dispense advice but are not authorized to execute trades.
It remains questionable as to whether this practice is successful. In theory, the advisor and broker are separate persons reporting to separate branches of the organization - but in that they are branches of the same plant, the whole of the organism is geared to seek its own sustenance, and the advice of a "separate" financial advisor working at a brokerage house may be tainted by he business's desire for profit - that is, the advisors are encouraged to give advice that ultimately profits the business when the customers accept and follow it.
Certified Financial Analysts (CFA)
It is notable that there are no formal requirements for a professional who means to charge clients for dispensing financial advice. Anyone may set up shop and dispense council without having any experience or special knowledge and without undergoing any training or licensing whatsoever, and a great many have done so.
To salvage the reputation of the profession, the financial services industry established a chartered financial analyst designation, the "CFA," whose similarity to the title of a certified public accountant (CPA) is an evident and entirely intentional ploy to borrow upon public regard to a financial profession with a much more long-standing reputation for professional competence and ethics.
(EN: There's a footnote indicating that the author of this book was a strong advocate of professional designation, as much as twenty years before it became a reality - and the way in which he describes the profession seems to convey a sense of hope that such a program could be used to establish a professional code of ethics and, at the same time, a sense of disappointment at what has actually become of it. In the present day, a CFA designation is obtained by passing a series of three-exams, having a degree or four years experience, and agreeing to a code of ethics. It is fairly simple to obtain the designation, no other action is necessary to maintain the designation once earned, and the organization is not proactive in informing or monitoring the conduct of its membership.)
Dealing with Brokerage Houses
The reputation of brokerage houses has justly suffered over several decades. The bankruptcy of a financial services firm is an extreme level of embarrassment, yet quite a few brokerages on the NYSE, including a few of considerable size and long-standing reputation, have entered bankruptcy. The unethical and ill-advised behavior has been so widespread in the industry that a government agency has been appointed to police the industry, even as the level of interest in investing by the public has been favorable to the industry, with a growing number of customers, a growing amount of assets under management, and a shirking number of firms to compete with their business.
Naturally, there was a great shake-out in the industry, and a loss of public trust, in the wake of the 1929 debacle in the market. But even in recent years, there have been financial troubles at brokerage houses as well as widely publicized failures of competence and ethics in the investment profession.
In one ironic incident in 1970, a rash of bankruptcies was blamed on "the falling off of volume" in trading activity - and in the same year, the NYSE trading volume was the largest in history, twice the volume of any year before 1965. If it is true that firms as a whole allowed their own expenses to increase at such a rate that they could not sustain themselves in a period of high customer demand, it does not speak well for their business acumen or financial management skills.
Another explanation is that firms invested their own capital in the markets, and when the market declined in 1969, the capital resources of the firms fell drastically and the companies became unsustainable. It is plainly inexcusable for a firm that claims competence in managing the investments of its customers to show such gross incompetence in managing its own investments.
Ultimately, this has discredited the brokerage house as a provider of financial services and advice. Membership in the NYSE is not sufficient credential to merit trust. A conservative investor who purchases investments for the long term would further be advised to seek a more stable firm with which to transact business - i.e., but stocks and bonds on the market if you must, but have the securities delivered to a bank for safekeeping. This will cost a little extra for these services, but the expense is well worth the peace of mind.
An investment banker is a firm that manages the issue and sale of new stocks and bonds. The term "underwriting" is often used, but in this sense it pertains to the guarantee made to the seller that the security will be fully sold. A number of brokerages participate in underwriting activities, but there are firms that are purely investment banks.
Insurance banking is "perhaps the most respectable department of the Wall Street community" in that it provides financing for companies and securities for investors. In the best of instances, it does so in a manner in which the securities sold are a fair value in exchange for the cash provided to the business - though some speculation occurs in setting the price of an offering, it is ultimately governed by an estimation of what the buyers will be willing to pay.
Certain customers deal directly with investment bankers for the purchase of new securities, particularly those who sense that a security will rise to a higher price in the market shortly after its issue. Those considering this activity would do well to keep in mind that the investment bank's service is in to maximize the profits of sale for the firm selling the securities, not in the return investors who are buying them, so their recommendations to investors should be taken with the utmost scrutiny.
The author feels that investment bankers as a whole have been honest and competent in the issue of new shares - but there have been numerous incidents over time in which they have participated in "less than credible activities" to create an inflated perception of value for the buyer of new issues in order to better serve the seller and maximize their own commission.
In previous chapters, the author has discouraged investors from latching onto new issues, as the information about a new firm is scant and unreliable, but if one gives in to temptation, be mindful of the reputation of the firm and diligent in confirming their suggestions trough independent research.
It is customary, especially in smaller towns far removed from the financial markets, for individuals to consult a local banker about investments. While bankers tend to lack experience and expertise in securities, they tend to be experienced and conservative in the management of money, and his cautious temperament does much to cool the aggression of the unskilled investor who is seeking to make fast money in the market.
The author takes a more critical attitude toward the widespread custom of asking advice of relatives or friends. Given the variety of knowledge and experience in the general public, no categorical statement can be made that applies to all. While they can be counted upon to consider the best interests of those who rely on their advice, having no potential to profit by misleading them, they may not have much knowledge or experience in the area of financial management - and good intentions do not guarantee good advice.
Most security buyers are constantly assaulted with unsolicited advice, for no fee at all - and it is entirely worth the price demanded. In the best of cases, this advice comes from those who have invested little effort and have little expertise; in the worst of cases, it comes from experts who have their own welfare in mind, often at the cost of those who accept their advice.
Investors who are prepared to pay a fee for financial advice and rely upon the counsel they receive are encouraged to consider the reputation of the firm from which they seek this advice - it should be well respected, well managed, and have a history of sound operations. Such firms will not make grandiose claims or promises of stellar performance, which is a good sign that they consider the long-term welfare of their clients.
Ideally, the investor will work in active cooperation with such an advisor. He will want their recommendations explained in detail and will insist on using his own judgment in deciding whether to take action upon them. Only in the exceptional case, where the investor has complete trust in advisors whose competence has been thoroughly demonstrated, should he even consider acting upon advice without understanding it thoroughly.
However, the conservative investor has little need for advice. He will not frequently trade in securities, does not seek to make an inordinate profit, and the analysis necessary to identify a stock or bond as fundamentally sound require no great skill at mathematics or deep knowledge of the investment field.