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Chapter 14: Pigs, Mousetraps & Revolution

By: Investor Solutions

CONGRATULATIONS! Based on the knowledge you’ve accumulated from the previous chapters, you now possess the broad outlines necessary to achieve financial success. But since implementing your strategy is just as critical as designing it, there are still lots of ways you can screw up. The devil, unfortunately, is in the details! Luckily for us, there are resources available today that our parents couldn’t have even imagined years ago. Obstacles may appear in our way, but as long as we know what to expect, they are easily avoided.

 


In many ways, 20 years after May Day, the process of change is still just beginning. As more and more investors vote with their feet, they are further transforming the industry in their favor.


But before we turn to the nuts and bolts of implementation, let’s shift gears a bit. We first need to examine the landscape of the financial services industry — an industry undergoing radical change. In the past, we have talked about many of the advances in financial economics over the last 40 years. But there is one cataclysmic event I’ve yet to elucidate that is behind the sweeping transformation now taking place.

Viva La Revolution!

You’re forgiven if you missed the revolution that began on May Day 1975. No, it’s not an event celebrated each year with a giant march through Red Square. No epic poems chronicle the events of this glorious revolution, and it lacks any anthems or ballads. There is no holiday, are no statues, and no fireworks. The revolution’s heroes never received a parade, and the whole thing passed almost unnoticed by an indifferent public.

Nevertheless, May Day 1975 should be celebrated vigorously by all investors. The revolution set us free, and today we have options we couldn’t have imagined previously. Clearly, a short history lesson is in order.

The Dutch Make a Purchase

A few hundred years ago, the Dutch made a small real estate deal to acquire a little island in the Northeast. The price was certainly reasonable, and the island was nicely located at the mouth of a great navigable river which opened up to a fine harbor and sound.

Given the nifty location, it wasn’t long before the Dutch began trading with their new neighbors on the southern tip of the island. At first, trading was primarily confined to commodities, which the surrounding area had in abundance. These commodities were then shipped home through the harbor facilities. Over time, trading expanded to finance a lively commerce. New companies were formed, and investors were invited to purchase “speculations” in fledgling ventures. These “speculations” were certificates of ownership or debt and would much later be called stocks and bonds. The certificates were placed on open-air tables, and investors wandered the area examining the certificates, gossiping, bargaining, and eventually buying or selling.

Enter the Pigs

With all this trading, a problem soon developed. Pigs from the adjacent common area often ran wild through the trading area, splattered the traders, knocked over the tables, and trampled the speculations. After short consultations, a wall was built to keep the pigs out. Later, the street where the trading took place was named after the wall. In time, the area grew to become the financial capital of the world. (Some might speculate that the wall was never effective, or at least that the pigs now have two legs!)

Early on, the securities traders formed an association to govern their business transactions. It was decided that the association should have a monopoly on trading, and that no traders should undercut the prices of their competitors. Traders who violated the agreement were banished from the association, which effectively ended their careers. This arrangement greatly enriched the traders, but certainly couldn’t have been considered unusual given the business climate at the time. At least there was very little recorded dissent or comment from economists on the negative implications for market efficiency. Later, the trade association was given government sanction, and commission price fixing became the law of the land.

May Day

Business continued in this manner until May 1, 1975. “May Day,” as it is called in the industry, marks the point at which the SEC began allowing negotiated commissions. The event was greeted with howls, gnashing of teeth, and predictions of doom by the brokerage houses. Somehow these symbols of capitalism believed they couldn’t survive competition! May Day was the beginning of the end of Wall Street’s guaranteed good deal. As you can guess, brokerages didn’t exactly fall over themselves advertising discounts to investors. But the genie was out of the bottle. Little by little, Wall Street found itself being dragged into the real world of competition.

Initially, the benefits of May Day were unevenly distributed. Large institutions could immediately trade blocks of stock for a tiny percentage of previous costs. But small investors’ trading costs actually increased at the “full service houses.” Soon, however, discount brokers appeared offering sharply lower trading costs to retail investors. At first, discount brokerages provided few services, but little by little the quality and quantity of their services increased. The success of early entrants such as Charles Schwab attracted additional players. Competition did what it usually does: further reduced prices, increased quality of service, and multiplied consumer choices. Stay tuned. The story is far from over, and things will keep getting better and better for the small investor.

A Monumental Change

Meanwhile, other institutions are also keeping the heat on. Banks, insurance companies, and mutual funds are cutting into Wall Street’s traditional turf. In particular, no-load mutual funds have provided attractive alternatives to traditional brokerage houses and broker-dealer operations. Independent investors have embraced them in amounts that are hard to imagine. But “no-load” means “no help,” and many investors lack the time, inclination, or confidence to choose from a variety of offerings. Last year, over 1,500 new mutual funds were launched in the United States alone. Naturally, the selection process can appear rather daunting.

This monumental change wasn’t just confined to the brokerage industry. Insurers and bankers have undergone a parallel experience. In the good old days, long before voice mail, and even before the break up of the phone companies, stock brokers sold stock, insurance agents sold insurance, and bankers took deposits and made loans. Today everybody does everything, and it is difficult to tell who the players are even with a program.

Until just a few years ago, bank and saving-and-loan interest rates on deposits were capped by federal law, while bankers were free to charge whatever they could get away with for loans. Individuals had few alternatives for savings. Most could not afford to purchase individual T-Bills. Savings bonds required long-term commitments.

Money Market Funds

The advent of money market funds changed all that. When interest rates began to rise during the 70s and 80s, banks found themselves hemorrhaging deposits. “Disintermediation” became the buzzword of the day. A succession of extraordinary policy blunders followed. To compete against the money funds, deposit interest rates were unfrozen. But the banks then found themselves in the unfortunate position of paying high rates to depositors while many of their older loans were fixed at very low rates. Banks were encouraged to make high-risk loans and enter other lines of business to increase their earnings.

Federal deposit insurance may have protected savers, but the resulting frenzy of foolishness, greed, and corruption lead to the near collapse of the banking system. (To be fair, the banks didn’t create the inflation that drove up interest rates; Lyndon Johnson’s Great Society, the Vietnam War, and the oil embargo did that.) Today, after a zillion dollar bail-out program provided by the taxpayers, banks have adjusted to a system where they pay reasonable rates to depositors. While banks have not exactly rushed to increase deposit rates, the availability of money market funds enforces a market discipline that keeps rates in the ballpark.

Price Competition

For a long time, insurance companies lived in a world protected from price competition. While no federal regulations governed their rate making, each state reviewed rates with an eye to protecting the solvency of the insurance industry. In practice, the State of New York was able to set rates for most insurance companies nationwide. As a condition for doing business in New York, insurance companies had to charge uniform rates and pay uniform commissions in every state in which they did business. Few companies wished to be locked out of New York, so they happily went along. Like the securities business, an industry ethic developed which considered price competition dirty. It simply didn’t exist. Policies were carefully designed to provide comparable but not superior value to the insured. Insurance departments rewarded any attempt by companies to lower rates, provide discounts, or offer rebates with license suspensions. Fair policy comparisons were just about impossible, and the widespread use of dividend projections rendered the entire exercise meaningless in any event. Agents were carefully trained to sell high-cost, high-commission products, and avoid the use of term insurance at all costs. Loyalty to the company was considered superior to loyalty to the client.

Eventually the insurance companies succumbed to the same market forces that affected banks. Rising interest rates in the 70s and 80s, coupled with the widespread acceptance of money market funds, provided savers with far more attractive alternatives to insurance policies. “Buy term and invest the difference” became a popular philosophy for savers. Little by little, the insurance industry was forced to increase policy values. New types of policies like universal life, variable life, and lower cost term were introduced to re-capture the market. Internal expenses were cut, and mortality charges adjusted to reflect longer life expectancy. Today, a dollar of life insurance costs about one-third of what it did 25 years ago, and cash values are greatly enhanced.

All this change comes at a price. Change brings noise and confusion. It takes us awhile to sort out the new benefits (for instance, I still don’t know who to call when I have a problem with my phone!). But the trade-offs are overwhelmingly favorable. Investors astute enough to look beyond traditional sources found themselves richly rewarded with lower costs, increased options, and fewer conflicts of interest.

Monopoly and Regulated Industries

Many regulated industries share common characteristics. A great many people get paid far too much to do far too little. Innovation is stifled and consumers pay far more than they should. Wall Street was no exception. Prior to May 1, 1975, price competition in the securities industry was illegal. Wall Street was one big gentlemen’s club raking in inflated monopoly prices while worshiping the status quo. Commissions were fixed. Competition, such as it was, revolved around peripheral services such as research or other advice. Prices for services were bundled together. You paid for the research and other services whether you wanted them or not. Even if you considered Wall Street’s advice worth far less than zero, you paid.

The discount brokerages unbundled services and slashed pricing. Investors who had the time and inclination to go it alone reaped enormous benefits. For instance, several years ago, brokerage houses offered to trade and hold no-load mutual funds in their accounts. Initially, they charged a small transaction fee to cover the cost of the service. More recently, however, they have introduced a no-transaction fee service for selected mutual funds. (As you will recall, there ain’t no such thing as a free lunch. The brokerage houses receive compensation from the mutual fund company directly for acting as a distribution channel, and for providing certain shareholder and administrative services. These payments average about .25 percent to .35 percent annually. However, no additional cost is incurred by an investor who utilizes a brokerage account over what a direct purchaser would pay. As long as a fund has a 12(b)-1 fee of .25 percent or less, they are allowed to call themselves a no-load fund.)

Even if the investor pays a transaction fee to the brokerage house, it is a small portion of the cost of purchasing a typical load fund. For instance, at $100,000 a typical front-end load commission would be $3,500, while a transaction fee at a discount brokerage would be below $300.

This seemingly simple service is a giant advance for investors. Prior to this, investors had to identify a fund, open an account with the fund through the mail, and transfer funds to purchase shares. The entire process could take weeks. Redeeming shares involved much the same process and time. Funds could be out of the investors control for extended periods while in the mail, waiting for redemption, or waiting for the checks to clear. Transferring from one fund family to another was a nightmare of paperwork and delay. Tax accounting was too dreadful to contemplate. Each fund family provided their own reports. Managing a diversified portfolio was a complex task indeed.

Easy Street

Now a single account can hold many funds or families of funds. Funds are cleared overnight, and transferring requires a single telephone call. The brokerage provides a monthly consolidated report, and managing the funds becomes a reasonable task. What’s more, a consolidated tax statement comes once each year. More recently, the discount brokerage houses have introduced software for 24-hour trading and account monitoring from the comfort and convenience of your home or office.

When discount brokerages began to offer their “back office” facilities to independent fee-only investment advisors, retail investors could obtain professional unbiased advice — and efficient execution — at a total cost far below what was previously offered. By providing a clear separation between brokerage functions and advice functions, investors who sought advice avoided the conflict of interest which poisons the commission-based brokerage business. This arrangement offers such enormous, readily apparent advantages that it threatens the way Wall Street has done business for generations.

Building a Better Mousetrap

The person who said “Build a better mousetrap, and the world will beat a path to your door,” didn’t understand much about business. The inventor of the new improved mousetrap must contend with the manufacturer of the old mousetrap. Even if his product is demonstrably better, he will face inertia and indifference from the buying public, and a well-orchestrated public relations campaign by the established company. After all, the established company is raking in a fortune selling the old mousetraps. Often it is well-capitalized and has a strong brand name. It is not likely to just roll over and give up its market share. It will fight like crazy to maintain business as usual.

Even if the new mousetrap eventually replaces the old one, the older company still has many options. Often the best option is to “harvest the business.” The old company can continue to profitably sell the old mousetraps for years to anyone who is foolish enough to buy them.

Another option is for the old company to introduce its own new mousetrap with some of the features offered by the competition. However, in the process, it risks cannibalizing its older product’s sales. Consequently, if the older product is more profitable, the company will attempt to maximize sales of the older line as long as possible. Taking this course maximizes profits and buys time to adjust to the new environment.

Welcome to the New World

Wall Street’s traditional brokerage houses and broker-dealers are both harvesting their business and attempting to improve their offerings. But they are clearly being dragged kicking and screaming to the party. Even if they wanted to, traditional brokerages have some formidable problems with joining the new world. Their overhead in terms of real estate, systems, and people is enormous. They will never be able to compete on a cost basis with discount brokers and independent advisors. Their used-stock sales force is poorly trained in basic economics and finance, and determined to preserve their antiquated commission structure. In addition, they suffer from a well-deserved image problem. In the meantime, the public is becoming increasingly disenchanted. Better mousetraps are available, and market share is flowing at an ever increasing rate in that direction.

In many ways, 20 years after May Day, the process of change is still just beginning. As more and more investors vote with their feet, they are further transforming the industry in their favor. The one and only thing that Wall Street really understands is loss of market share. Demand better, and you will get it. The choices are already there. All the tools necessary to implement a superior investment strategy are yours for the choosing. Your parents never had it so good.

Coming Up

We have all heard the sob stories about money lost, stolen, or swindled. How can you avoid becoming a victim? The answer is really quite simple. In the next chapter, we will give you a few common sense rules to avoid disaster.