Nothing more than organized gambling…

For those who haven’t figured it out yet, our financial markets are laughable. The last collapse, that began in 2007, scared many away. But, it’s actually the recent rise over the last 4-6 months which has me more concerned. You see, there’s no rhyme or reason as to why the Dow Jones Index and others continue to climb steadily.

Sure, jobs are coming back slowly. And, there seems to be a more optimistic view that our economy will become a tad healthier in 2011. But, none of this was apparent in the third and fourth quarters of 2010 when the Dow Jones Average jumped from a miserly low of 9,500 points to over 11.500 by the end of last year. And, every day we still see plenty of negative indicators largest public companies and state and local governments that all isn’t well from a growth standpoint.

My feeling is that for the average Joe, investing in our financial markets is no different than playing craps or blackjack in a casino.  The only real distinction (and positive) with playing blackjack or craps at a casino is that a player can actually understand what his/her odds are to win (even though those chances might be ever so small). For the average investor, the belief that a level playing field existed used to provide a lot of comfort. Most felt that they would be taken care of in the long run if they invested in fairly safe and conservative bets over their working lives. We all know now that this belief is nothing more than a mirage. The reality is that huge institutional forces can (and will) coerce excess and greed into almost any investment marketplace. Because of this, no one individual investor can ever truly feel confident that his/her portfolio will be safe, or far worse, when the markets might simply crash again.

Yet, it’s pretty ironic that most of continue to operate in a mindless sheep-like fashion. We herd once again in packs to these same stocks, bonds, mutual funds and other investments. We all seem to have incredibly short memories because everyone is feeling pretty darn good now. Why not…the markets and our investment portfolio values continue to grow each and every month. So, on paper, everything looks wonderful again.

So, what’s a person supposed to do?  Most working Americans use their 529 and 401k plans as the number one vehicle to save for college and retirement. I’m no financial expert, but it is easy to see that without year to year gains in tax free (or tax deferred) investments in these types of products, it would be almost impossible to save enough money for critical long term needs. Of course, this is a double edged sword because all that money invested may not be worth much of anything in three, five or nine years when the market quite possibly crashes again.

This reality is truly an untenable enigma (at least in my mind). The only seemingly rational move I can think of is to diversify whatever wealth/money one has into a variety of different investments (like real estate and plain old savings accounts) and to become that much wiser to any situation where our markets are rising too quickly for no apparent logical reason. Apart from that, we all need to never forget that anything that looks or feel too good to be true, is just that. So, don’t get hoodwinked again into believing that our financial markets are anything more than organized gambling.

Comments

[Steve]

Good advice, Ed, though don't forget about the value of paying down debt. Paying off a mortgage at 6% (ignoring for the moment any mortgage interest tax deduction for simplicity's sake)is mathematically identical to receiving a 6% return on that same amount--except that paying the mortgage is risk free, unlike investing, which is not.

You can bigger bang for your buck by paying off car loans or credit card debt, since they are typically at higher interest rates and also offer no offsetting tax advantages.

Personally, I've never understood why people with 5 - 7% mortgages rush to invest in the market, when risk free investment returns are typically much less than 5 - 7% and as for investments with risk which pay a few points more...well, we've seen what can happen to many different, even seemingly solid(GM, anyone?), investments.

[Peter E.]

The stock market is now the ultimate sucker's bet, only now "The house" is defined as financial institutions that run up the prices, then take the fees and run.

Steve mentions GM. I just flew back from Detroit after listening to the annual Cobo Hall BS. Nothing disgusts me more than the "new GM" IPO. Here's the scheme: the Feds prematurely take a marginal company public again, claiming that when share prices hit $52, the American taxpayer is free and clear of its $50 billion. GM's at $39 after three months, way short of the $52 mark. The Carlyle Group (one of whose top guys is now GM's CEO) and the other big boys give each other high-fives, the i-bankers will quietly collect their fees, and Geithner will say "oops" in his autobio and point the fingers elsewhere.

Many in my family were communists and socialists, and I grew up around lots of angry lefties. That's probably why I've always had little patience for "eat the rich" sentiments. My belief in capitalism was based on the idea that the US -- no matter how imperfectly -- countered its wealth with at least some proportion to what the rest of our society needs. We're losing that rapidly.

[Steve]

Structurally, the game is definitely rigged in favor of Wall Street professionals. Just for one example: why should an investment adviser, mutual fund manager, etc. be compensated--as is often the case--on total dollars under management? (e.g. getting a small percentage of total funds under management as comp.) That means, for example, that even if the investment or fund consistently loses value, the manager gets paid--in other words, he's paid to lose your money. People can say that eventually, he'll lose his investors and maybe he will...but in the meantime, he's been compensated for destroying investor value.

This system also incentivizes advisors, etc. to spend more time on recruiting new clients than on actually doing well for existing ones--since they get paid just be signing people up. Consider the following: say someone has $100mm under management. If he can grow that organically by 20%--very impressive in one year!--he ups his comp by 20%. If instead he signs up an extra $50mm of investment, then even if the fund loses 10%, his comp goes up by a net of 35%.

Since it's easier to "sell" than to consistently turn in high performance--and signing up new investors pays more than beating the market anyway--where do you think a rational financial advisor or fund manager will spend his time? And more: who do you think will be hired and promoted by a bank or Wall Street firm--a good but uncharismatic manager, or a great "salesman" who can get people to invest even if he then has no clue what to do with the money?

A much more fair system would compensate advisers and managers only when they beat the market, or, at least, only when the investments under management go up (even if they don't beat the index or market generally, at least they are appreciating). Instead though, the majority of funds and advisors take their compensation even when their clients hemorrage[sp?] money.

[Ed Moed]

Steve, very astute observations. Thanks for posting.

I’m not sure we’ll ever see a compensation model like that except with a few hedge funds who really do put their money where their mouth is. But, those are few and far between.