Wall Street was never on your side
- February 28th, 2012
We have received a great deal of positive feedback on our recent post entitled “There has never been a better time to be an individual investor.” Most of the negative feedback thinking that we had made some sort of market call. All we are saying in this post was that individual investors now have the greatest array of tools and services to manage their own portfolios.
The most substantive feedback we got was in a post by Tim Richards at the Psy-Fi Blog entitled: “There has never been a more dangerous time to invest.” The point being that the outpouring of research into behavioral finance has given Wall Street ever more precise tools to (legally) exploit the behavioral biases of individual investors. He writes:
Prior to the general appreciation of the behavioral biases that accompany our every living breath the ability of financial firms to exploit our behavioral weaknesses was limited to the relatively simple ways they could find through evolutionary happenstance. Sometimes they figured out how to make money out of peoples’ cognitive biases, but mainly they just threw money around in the hope that it would stick. However, what do you think they’re going to do when they realise that there’s science behind these traits and you give them the best minds and vast quantities of investment dollars to start looking at them?
This is indeed a danger investors face. However it only reflects the degree to which the financial industry can attempt to exploit investor weaknesses. The fact of the matter is that Wall Street has always been in the business of taking advantage of the little guy. It is only recently, largely through advances in technology, has the playing field tilted in favor of the individual investor. Richards notes the ways in which individual investors can take on Wall Street, largely by refusing the play the game as it is currently played. He writes:
Despite our manifest deficiencies we aren’t without our own weapons – the behavioral weaknesses of the financial industry itself. We can fight a successful guerrilla war by refusing to engage in a pitched battle on their terms: trade rarely, go where they don’t go and never, ever believe you have to react in seconds or even minutes and hours. When High Frequency Trading algorithms can execute faster than you can blink you’re wasting your time, your money and throwing away your intellectual advantage: faster is not better.
There is a broader public policy question implied by this discussion. Regulators have a role in what products get approved. One could argue that by approving ever more specialized and leveraged ETFs regulators are making life harder on individual investors. David Merkel at the Aleph Blog in a recent note that when it comes to ETFs investors are being led astray. He writes:
4) ETFs affect the market as a whole. They allow average people to speculate on broad trends, without telling most of them that they are noise traders, and are getting taken for a ride. Dollar-weighted returns are far less than that for buy-and-holders in ETFs. The traders are getting creamed…
6) ETFs allow investors to play well outside their circle of competence. Beyond that, some ETFs don’t always do what they promise because of the derivatives that they use, roll, etc.
These are important points. Because as important as ETFs have been in leveling the playing field for individual investors, they have also generated a whole host of other problems. We note in our forthcoming book how the fund industry has taken what had been a largely unalloyed good and has made the world of ETFs more costly and complicated than need be.
So while today may be the most dangerous time to invest, it ranks alongside all those other times that it has been dangerous to invest. In short, all times. The aftermath of the financial crisis has seen individual investors take charge of their portfolios in increasing numbers. This reflects not only a dissatisfaction with the traditional brokerage model, but it also reflects the enhanced tool set investors have. And that tool set is only getting richer.
Mick Weinstein at Covestor has a handy graphic which shows the three main options investors have in managing their investments today. The point is that investors are drifting from the far right hand side of the graph with their money managed with traditional brokers into models that more effectively take advantage of technological innovations, including ETFs.
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- To bond ETF or not: an excerpt from Rational Expectations by William Bernstein
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