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Why I’m Wary of Stocks

Jim Wang’s recent Bargaineering post “Why Fewer People Trust the Stock Market [3]” inspired from me an “and-I’m-one-of-them” comment. Jim—a savvy guy who probably detected the prospect of one of those cranks who can really drive engagement—invited me to expand here on my reaction. I’m pleased to oblige.

We Do Own Stocks

First, disclosure: Stocks comprise about 15% of our (my wife and I) financial assets—far less than the “experts” would recommend for our situation. And nearly all the stocks we own meet two criteria:

  1. Based on the price we paid, their current dividend yields are 4-7%.
  2. The underlying businesses are mostly resource-based and operate in well-regulated industries. (In my opinion, regulation reduces risk.)

I’m not blindly or ideologically opposed to stock investing, but I stick with relatively safe, income generating stocks, and I actively manage stop loss orders as appropriate.

Why I Don’t Trust the Stock Market

Here are highlights of the foremost reasons I’m wary of stock investing:

Dangerous Games No One Understands I enjoy casinos, in particular blackjack and craps. I’ve studied the games, I know the rules, and I know the odds. I don’t play to make money, and I’m comfortable losing a little money because I have fun playing.

In contrast, I don’t understand the rules of the game on Wall Street. Moreover, I don’t believe anyone on the planet fully understands the mechanisms now in play on Wall Street. Effective regulation is non-existent. Financial instruments are invented and traded purely for sport and profit, with no underlying economic utility, no oversight, and no regard for consequences. The SEC, bless its heart, is pathetically under-resourced, outsmarted, out-lawyered, and out-classed. (It couldn’t even detect Madoff!) MIT PhDs madly work at supercomputers to institutionalize legal (evidently) larceny. And I’m supposed to entrust my retirement to this Mother of All Game Rooms? No thanks.

Algorithmic Trading Among the myriad examples of the gamesmanship that now dominates stock trading, I think algorithmic, or high-frequency, trading is particularly ominous. During the May 6, 2010 “Flash Crash,” after dropping 300 points over the course of part of the trading day, the Dow Jones Industrial Average plunged another 600 points—about 6%—in five minutes. Twenty minutes later, most of the 600-point drop had been regained. No definitive explanation of these events has been published, though algorithmic trading is generally regarded as having played a key role. This sort of thing troubles me.

According to financial services industry research and consulting firm Aite Group, in 2009 high-frequency trading firms represented 2% of the approximately 20,000 firms operating but accounted for 73% of all U.S. equity trading volume. Put on some Pink Floyd and check out this nifty video [4] to quickly get a sense of the explosion in algorithmic trading, beginning especially in 2010.

The problem I have with algorithmic trading is two-fold: 1) No one grasps or is seeking to control its, potentially chaotic, consequences (see Knight Capital for only the most recent fiasco), and 2) I see algorithmic trading as yet another way that Wall Street aims to rob the forlorn individual investor like me.

Marketing, Not Money Management By an amazing coincidence, the Wall Street mantras piously preached to individual investors—buy & hold, don’t try to time the market, only stocks beat inflation, you can’t retire comfortably if you don’t put the lion’s share of your financial assets into stocks—also serve to grow and sustain Wall Street, magnificently. Wall Street’s explosive success is due not to shrewd and lucrative investing of individual investors’ nest eggs but rather to skilled marketers who excel most at self-promoting numerology. You need only watch CNBC—the network seemingly invented to convert the nation to day trading—for a few minutes to accumulate evidence: A merry-go-round of Wall Street Kool-Aid guzzlers and charlatans take turns shouting the lingo and pretending to have the ability to forecast reliably stock prices.

Unfettered Risk-Taking I opposed the 2008-09 financial industry bailouts. I don’t care if no bailout would have meant I’d have to live in a tent and eat wild berries and road kill for a few years, we’d be better off, if not today then some day, if the bailouts hadn’t happened, in my opinion. The big talk during the crisis of breaking up “too-big-to-fail” institutions like AIG has predictably fizzled (Wall Street funnels mountains of cash to both major parties). For risk-taking to be prudently self-managed, the risk-takers must keenly fear the consequences of failure. With the precedent now set that politicians will use taxpayer money as a backstop, Wall Street rightly feels insulated from the most significant negative consequences of risk-taking. The taxpayer backstop naturally serves as a recklessness incentive. How would you behave differently in a casino if you were gambling with “found money” instead of, say, your retirement nest egg or next mortgage payment? Another, and more catastrophic, meltdown is more likely today than in 2007.

Unjustified Costs As I’ve explored [5] on Money Counselor, the impact of money management fees is to crush long-term performance. I keep asking and keep getting nothing for an answer: Is there any academic study that demonstrates professional money managers consistently outperform index funds, after fees and taxes? If the answer is no, then isn’t the entire active money management industry essentially a fraud? While this point is about active vs. passive fund investing, not whether to invest in stocks at all, in my mind it’s symptomatic of a culture of deception of which I want no part.

Nothing Beats Stocks? Bullfeathers

Those who make their livings buying and selling stocks have convinced individual investors that they’ll retire on a cat food diet unless they turn over to Wall Street a big chunk of their savings. We all know the self-serving arguments made by money managers (and commenters on this post will recite them all, so I won’t do it here). Two brief points:

For further reading on stock investing’s risks, I suggest the book “Risk Less and Prosper: Your Guide to Safer Investing”, by Drs. Zvi Bodie and Rachelle Taqqu. To get a flavor, here’s a link [6] to a Wall Street Journal Online piece written by the book’s authors. I’ll conclude with a couple of quotes from the article:

“Despite the assurances of the financial industry, stocks are always a risky investment, and the longer you hold them, the better your chances of getting blindsided by a downturn. The usual way of mitigating that risk, diversification, holds no guarantees, either—for the simple reason that investments don’t always move the way we want in relation to one another.”

“It may be hard to let go of the belief that buying and holding stocks is a sure-fire key to asset growth. But that’s because people have been lulled into thinking that long-term stock investing greatly reduces the risks. The truth is that stocks are risky no matter how long you hold them.”

This is a guest post by Kurt Fischer at Money Counselor [7].

(Photo: psycho-pics [8])