The crack team at Rock Your Stock put our heads together and came up with a list, in no particular order, of some of the little known truths about Wall Street. We hope you enjoy it. Please feel free to add to the list in the comments section. Thanks.
Only your broker makes moneyThe 1940 book Where Are the Customers' Yachts? or A Good Hard Look at Wall Street points out that the only one making money in the traditional broker-client relationship is the person getting all the commissions. The truth is, your broker makes money whether you’re buying or selling. It doesn’t matter that the $10 stock you bought is now worth half that amount. Your adviser will convince you to sell your holdings, preserving your capital to invest another day. Once you’ve licked your wounds, your broker will return insisting the time is right to jump back into the markets to recoup your losses, which they remind you are deductible against future gains, diminishing their negative impact on your portfolio. It’s a nice story but so was Alice in Wonderland.
Diversification protects you against above-average returns Financial commentators will tell you to avoid putting all your eggs (assets) in one basket. They reason that properly matched, non-correlating assets are the best way to protect against market corrections of any kind. The average investor, in order to achieve such a level of diversification, goes out and purchases eight mutual funds from their complicit financial adviser. The only problem with this scenario is you’ve removed any potential rewards by eliminating all possible market risk. In this case, once again, only your broker makes money.
Analysts are just as confused as the rest of us Have you ever wondered why analyst estimates can be wrong so often yet investors hang on their every upgrade or downgrade, moving the price of a stock each time they revise their opinion. Investment professionals use fancy mathematical models to come with these estimates and generally, only after much schooling. It’s a given that most if not all of them are extremely bright. However, bright doesn’t necessarily make you right. When it comes to being correct about a stock, more often than not the intangibles win out. Investing is about understanding how a business makes money, not the numbers themselves.
IPOs are a chance to make anyone but you richer Initial public offerings are one of the primary vehicles venture capitalists and other early stage financiers use to exit their investments. Every pitch for venture capital comes with an exit strategy. Without it, you have no hope of receiving funding. Private equity investors’ want to know where the end zone is; it’s human nature. In addition, investment houses make substantial fees from these deals so it’s natural for their brokers to peddle these offerings. Always remember one thing: you’re not being given a piece of the pie because of your good looks. Pass on the IPO and buy the stock after a year of trading. You’ll make a lot more money this way.
Buying on margin can bury youEvery large brokerage house advertises the availability of margin accounts on their home page. Their rates for borrowed funds seem reasonable and generally, they are. Here’s what they don’t tell you: if you buy 100 shares at $10 for $1,000 in stock and it goes to $5, you’ve lost $500. If you use margin to buy an additional $1,000 worth of stock and the price drops by 50 percent to $5, you’ve lost your original $1,000 plus the outstanding interest. Sure, it can work the other way but rarely does it happen. Once again, the only one who gets rich is your broker. Avoid margin accounts like the plague.
Your broker recommends what makes them the most moneyI can hear honest, hard-working stockbrokers screaming and tearing their hair out as they read this. How could any law abiding, honest individual forego every shred of decency in the name of larger commissions? Easy, just like you and I, they need to put food on the table. A bang on explanation comes courtesy a scene in the movie Wall Street where Charlie Sheen explains to his dad why he’s always broke. The overhead just overwhelms. Suits, cars, dinners, expensive cigars, golf games, etc.; somebody has to pay and it isn’t going to be your friendly broker. Always ask two questions: why are you recommending this investment and how much do you make for doing so?
Investing in stocks whose products you actually use makes senseIf you were to buy the stocks of 8-12 companies, one’s you loyally support through frequent purchases (think Nike, Starbucks, and McDonalds) and whose financial statements were reasonably healthy, over a 10-year period you’d easily beat the markets as a whole and most active money managers. Why: because you wouldn’t be trading like a lunatic racking up the commissions and paying taxes left, right and center. Besides, how can a broker provide any advice if you fully understand the stocks he’s recommending. It’s much better to put you in stocks you can barely spell, let alone figure out what they do. Remember, BS and bafflegab always beats common sense on Wall Street.
Stockbrokers are really well dressed salespeopleThe Charlie Sheen’s of the world loved being stockbrokers. The name was a badge of honor. Now, Wall Street gives them all sorts of fancy titles in hopes that you’ll spend excessively for over-priced commissions on stocks selected solely by the complexity of their business model. I’m being a tad facetious here but why not call a duck a duck. If it looks like a duck and quacks like a duck, it’s probably a duck. Brokers are nothing more than very good salespersons; you’d have to be to bring in $5-10 million in new business your very first year just to keep your job.
You’re really not that important a clientUnless you bring a six-digit investment portfolio to the table, many brokers won’t even take your business, let alone give you the time of day. Don’t expect to get full-service from a full-service investment firm if you bring a measly $25,000 to the party. The investment business is all about asset gathering, not advice. Why else would Separately Managed Accounts be the fastest growing segment of the wealth management industry.
Independent investment research isn’t really independentIn the late 90s, conflicts of interest in investment research were the norm. The tech craze was out of control and brokerage firms and their analysts were more than amenable to giving a suspect investment its seal of approval all in hopes of keeping the gravy train rolling. As we know by now, it all came to a grinding halt. In order to placate securities regulators, firms moved to provide their clients with independent research; research free of any perceived conflicts. The problem with this solution was it simply pushed the conflicts farther down the line. If you own a research firm and look to cover two firms in a specific industry but you know the big boys are only interested in one of them, why would you cover both? You wouldn’t and there lies the problem. The conflicts may be different but the result is the same.
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