Terror on Wall Street, a Financial Metafiction Novel (16 page)

     Early on, my buddies, with our new PCs (when they first came out from IBM), were trading on the NYSE using our computers to send orders directly to the floor of the exchange. In the early days no one was watching us and, at times, we were not too accurate in meeting the five-day settlement rule to settle our accounts.

     Sometime in the 1970s, I jumped into the bond market after reading Fabozzi’s handbook on fixed income securities. At the time, long term treasury bonds were yielding 14%, zero coupon municipal bonds  12%, and listed telephone bonds were yielding 18%. I leveraged the portfolio to the extent possible so that the interest income just paid for the margin costs.

     At the peak of this foolish, risky venture, my debit balance was way over $580,000. This was a  non-deductible expense because of the municipal tax-free bonds. I did, however, have an exit strategy. Over time, the interest income paid off the margin debt.  As interest rates declined, the value of the bonds skyrocketed to unreal values.  Foolishly, I liquidated the bond portfolio prematurely and took the profits.

     The lesson I want to impart through this book is one about how to invest in the stock market and,  ideally, I want to leave you with some things that you should consider before making a decision about selecting any investment.  The more you know about the stock market and about the history of investing in capital markets going back for the last 5,000 years, the better prepared you will be to make correct investing decisions.

     As a rule of thumb, it is extremely unlikely that there is, at any moment in time, any bargains in the market. The market is extremely efficient and temporary bargains last only a few seconds in today’s markets. Highly paid experts (with resources we can only dream about) are watching the market closely, seeking opportunities to buy at favorable prices - which is not to say that the market does not go crazy at times, but that you can know this is occurring by watching the VIX, which warns you in advance by soaring well before euphoria hits the market.

     The more you know about the people you will encounter in the financial services industry (and, I might add, about yourself and about  those three pounds of grey matter encased in your skull that can cause you to subconsciously make damaging mistakes), the better off you will be.  It boils down to understanding the limbic system; that portion of your ancient brain that protected you from being eaten for dinner by a hungry saber tooth tiger.

     Early on, as a child, I
’
m
sure you watched your mother make a batch of tollhouse cookies. She mixed some flour with butter, sugar, and baking soda (in the right proportions), added some chocolate chips, put the mixture in the oven, and a new product came out of the oven: a product that tastes entirely different from any of its individual ingredients.

     Well, believe me, portfolios of securities work in exactly the same way. If I take a selection of individual stocks and bonds organized into groups called asset classes, I can create a portfolio of securities that will have an expected return higher than the weighted average of its component parts with significantly less risk. If you had told a Wall Street executive that you could buy a sample of the entire domestic market in a single transaction without paying a commission, he would have jumped out the window.

     Be sure to open up a Roth account and place the maximum amount into the account each year. Those under 50 can contribute up to $5,500 per year, and at the age of 60, the maximum goes up to $6,500 per year.

Modern portfolio theory

     A young graduate student named Harry Markowitz wrote his PhD thesis, which consisted of just a number of equations, in one afternoon in the library of the University of Chicago, or so the story goes. His doctoral thesis was all of 14 pages long. His two professors immediately recognized the importance of his discovery, but took a few minutes to figure out whether the degree was to be in the field of mathematics or economics.

     Unfortunately, in order to populate the equation with the appropriate values, we need to know the expected return of each and every security in the market, an expression of their risks, and the relationship of each security to one another. This task cannot be accomplished within the life expectancy of a human being on the planet in which we live, nor computed with the fastest computer we know of today.

     The solution is to assign each security to one of several asset classes based on the size of the company measured by its market capitalization and its risk, as measured by the volatility of its prices, and by its correlation with all other asset classes. Later (in 1990) we added another asset class called “value stocks,” identified by the ratio of stock price to book value per share.

    As the story continues, years later Harry Markowitz (along with William Sharpe) was awarded the Nobel Prize in economics. For the first time someone had linked risk to return. Simply stated – a   
Markowitz efficient portfolio
is one where no added diversification can lower the portfolio's risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio). The Markowitz efficient portfolio is the set of all portfolios that will give the highest expected return for each given level of risk.

     We all know that the more risk we take, the higher the expected return. Index investors use index mutual funds to construct portfolios that meet certain levels of risk. For example, a retired person living off of his portfolio must lower his risk so that he does not run out of money. He does this by reducing his exposure to equities and the value asset classes. Keeping your fixed income allocation to your age is a good rule of thumb. My portfolio is currently 83% fixed income assets and immediate annuities and 17% equities. The equities do not contain any value stocks because this asset class runs in spurts: for a period of time they do well, followed by a lean period. I have a rather large amount of money invested in foreign equities because I believe that the dollar will continue to depreciate over time.

     It can be shown that slice and dice portfolios have in the past produced fantastic returns. Experts who have written good books on indexing have model portfolios that have done very well in good and bad times. Any book by Rick Ferri, Larry Sedro, and William Bernstein are recommended. It is a good idea to purchase and read all of the books by the above authors and the books by Jason Zweig which cover your brain and how it influences portfolio decisions.

     Slice and dice model portfolios can (and do, at times) produce expected returns as high as 20% nominal above the market with 50% less risk than the market over 30- and 40-year periods. Achieving these fantastic returns depends on how the dice are rolled: random events that cannot be forecasted but are likely to occur several times over long time spans.

Neuroeconomics

Neuroeconomics is a new discipline, the discussion of which warrants the following observations:

1. Cats can hear ultra-sounds which humans cannot.

2. When a tabby jumps off your lap and heads for the kitchen, she has heard, with ultra sounds, some mice conversing in the kitchen.

3.  Humans see colors. Your dog cannot.

4.  Dogs can smell things at concentrations 1,000 times weaker than humans.

5.  Bees can see infrared radiations.  Humans cannot.

6.  Blind people can identify their family and friends by their smells.

7.  Young children’s' taste buds are 5 times more sensitive than their grandparents, and that is why your grandchildren do not like their the food that adults want them to eat.  (Don’t worry: their selections will provide all the things they need to mature properly.)

8.  A small child needs loving handling from birth in order to develop properly.

9. Talk to your baby. They need to hear your voice from birth on so their minds become wired to understand what you are saying and learn the language you speak.

10. If you are bilingual, use both languages at home. Your children will have no problem learning both languages simultaneously.

11. Every language has different speech sounds that must be learned at an early age to become familiar with and fluent in the language. English has 41 different speech sounds while Hawaiian has only 12.

12. During the first few years of life, your children are establishing dedicated connections between their auditory receptors in the auditory cortex. There are two speech centers in the brain: one for speaking and the other for understanding what you hear.

     Why do I make these observations?  Because, in order to become a successful investor, you need to understand how the brain works.  Each and every day, as an investor, your sensory system is bombarded with signals that may or may not be beneficial to your success as an investor if they are not properly evaluated by your limbic system (an ancient part of your brain).

     The anticipation of receiving a reward (such as your portfolio going up three days in a row) will trigger the same portion of your brain as a good shot of heroin satisfies a heroin addict. By way of example, most IPOs go up in value the first day and lose value after the 30-day period expires when the underwriter is permitted to manipulate the market for a successful underwriting. Do those rascals know this?  You bet they do.  Then they go down in price because of the difficulty of getting all that money to immediately work properly.

     As the CFO of a small OTC company, I took the opportunity to arrange a secondary offering of the company’s stock.  We needed some additional capital for new product development and our principal shareholder wanted to sell some of his unregistered stock, as well.  After going through all the traditional steps such as lunch at the Harvard Club, listening to a shoeshine boy in the underwriter’s office tout some stocks, we settled on a price at $8.50 per share, right where the market was selling our shares in the over-counter market.

     As was customary, we flew to New York on a Monday several weeks later for the pricing meeting the following Tuesday.  On the previous week, our stock had taken a bath on late Friday afternoon about 30 minutes before closing. I rushed down to the market maker in Los Angeles for our stock (we were in the pink sheets at the time) to find out what was going on and I learned that there was a lot of shorting going on by customers of Wall Street firms.

     This often happens to small OTC companies. Insiders were shorting our stock, knowing they would be covered by the offering if the price was busted or later, after the 30-day distribution period was over.  I had a little talk with the boss and told him what was happening. Should we fight or run? I said, “Harold, lets fight, but let’s make sure we win.”

     At the Tuesday pricing meeting we had our 'fish or cut bait' meeting.  The lead underwriter wanted to price the offering at $7 a share.   I wanted the $8.50 we had agreed to several weeks earlier.  I suggested we review who stood the most to lose if the offering did not go through and we decided to cancel it.

     I then told them our situation. I had written the S-1 registration statement and our lawyer was to be paid with a 5,000 share option on the stock, to sign off as the lawyer.  Our auditor had made a mistake, failing to verify the post-closing entries in our books several years earlier, and owed me an audited stub period. Harold wanted an excuse to visit his daughter, who lived in New York.  And I told them that we would go right home right now without suffering any losses unless we got our $8.50 a share. We won, we got our price, and the story made the rounds on the Street, as good rumors have a way of doing.  What happened was that the underwriter caved in because he had far more to lose than we did.

     Later, as punishment, I refused to pay their attorney’s fees for filing the blue sky laws on the basis that my secretary had filled out all the forms in Los Angeles. I paid him $1000 for the phone call to satisfy Texas’s questions. 

     I returned to Wall Street a month or so later to give a pep talk to the brokers and a little speech on the company’s future, to help with distribution of the shares.  It was then that I met Charles Ellis. Charley asked me if I believed all that I was telling the brokers. I told him that this offering was as good as any other one. He asked for my card, and several years later I received a complimentary   copy of his book titled
The Loser’s Game;
and after I read it, I immediately became an indexer.

Vanguard, the investor’s friend

I would like to tell you about a friend of every investor whom you should know because this would mean money in your pocket.  John Bogle graduated from Princeton in 1951, the same year I graduated from Claremont Men’s College.  His senior thesis was titled
Mutual Funds Can Make No Claims Over Market Averages. 
Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelsson’s paper
Challenge to Judgment
, Charles Ellis’ 1975 study
The Loser’s Game,
and al Ehrbar’s Fortune Magazine 1975 article on indexing.

     Today, no Wall Street firm tries to make money indexing because they can’t figure out how to make money selling index funds.  Vanguard is a non-profit company owned by the shareholders of Vanguard Funds. Based on 2009 industry average expense ratios, actively managed mutual funds are 1.19% and Vanguard’s expense ratio is only 0.23 percent – five times lower.