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Are Your Best Interests the Same as the Financial Services Industry?
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Personal financial decisions seem to have become very complicated. To add to the confusion, the financial services industry develops an unending array of supposedly innovative new products. However, a large part of the complexity that individuals face results from the proliferation of repetitive financial products in a myriad of flavors with different features and different financial trade-offs. What is "best" and "right" for individuals easily gets lost in the ensuing confusion.
Individual investors need to understand that their interactions with financial industry intermediaries are a “zero-sum game” before transactions and other costs and a “negative-sum game” after costs. The industry’s visible fees and hidden costs can siphon away a significant part of potential returns without providing individual investors with commensurate value.
Historical investment performance charts for investment funds might be historically accurate, but their presentation in advertising, on line, and in printed materials can amount to lies from several perspectives. Performance charts are designed to lure gullible individual investors with an implied promise that superior past performance will continue. The financial research literature tells us clearly that on average this is a promise that cannot be kept. In other words, historical performance charts are a veiled lie. They may report factual information, but their purpose is to deceive.
The securities industry and many of its brokers and investment advisors know that low cost index strategies are better for individual investors. However, the "active-management-beat-the-market" industry crowd will not make any money off of you, if they tell you that. They have to push the "we deliver superior performance" mantra, because that is the justification for their excessively high and performance killing fees. Since market realities make it virtually impossible for actively managed funds to consistently beat the market after their fees, they have to resort to promises, deceptions, and "statistical" lies. These lies include: #1 selecting only winners to promote, #2 easy index benchmarking, and #3 hard to interpret cumulative historical performance charts.
Securities industry customers have very widespread concerns about being taken advantage of and being cheated. Particularly since the Internet bubble market crash, investor surveys have shown that investor distrust of the industry is high.
The amount of profit in a transaction is far more important to a securities firm than whether it is the most beneficial alternative for a client. The financial interests of individual investors and the financial services industry firms are fundamentally at odds. Professional “advice” from commissioned securities sales personnel very often has a well-disguised and significant tilt toward the financial self-interest of the organizations that these professionals represent.
In a 2 to 1 decision this morning (March 30, 2007), the US Court of Appeals struck down the US Securities and Exchange Commission's rule on fee based broker accounts, which as become commonly known as the "Merrill Lynch Rule." This rule was first proposed in late 1999 and formally adopted in 2005. This rule allowed stockbrokers to act as "advisors" and to charge percent of assets fees. Prior to this rule, only investment advisors who registered with the SEC or with the states and who were regulated under the Investment Advisers Act of 1940 were permitted to do this. Under the Merrill Lynch Rule, brokers could call themselves advisers, yet remain exempt from regulation under the Investment Advisers Act, as amended.
The biggest personal finance story of the past 30 years has been the dramatic growth of the market capitalization of financial services firms within the U.S. equity markets!
The reason that this is so important to your personal finances is pretty straightforward. Simply put, most individuals pay far too much for financial products and services. Their continuing over payments show up in the increasing value of financial services company stocks. People have paid far too much for years, and the industry's excessive charges have been increasing for years.
The Financial sector has grown to be almost twice the value of the Energy sector in S&P500 market capitalization. Nevertheless, we have not heard a widespread media clamor about escalating financial services costs and profits. Instead, all we hear about are financial scandals related to greed, fraud, and scams.
Things will NOT be okay after a few tweaks to the regulatory system and a few perp walks. Individuals have in the past and apparently will in the future continue to pay exorbitant banking, credit card, insurance, and securities costs. The wealth transfer will continue unabated.
There is no reason to believe that industry self-regulation or governmental regulation will ever fix these problems. Only those individuals who become wise enough to be proactive and seek out lower cost financial products will stop getting fleeced. The vast majority or individuals will just keep on paying excessive costs to the financial industry, while they receive inadequate value in return.
What does it mean to individual investors that the financial services industry is now about 21% of S&P 500 market capitalization?
The answer is relatively simple. The securities markets tell you that financial stocks are highly profitable and have earnings that are expected to continue to do so in the future. The markets are telling you that it is unlikely that any business or regulatory factors will intervene to reduce financial services company revenue growth and/or to shrink their profit margins.
This article concludes our series on the greatest personal finance story of the past thirty years. In this article, we discuss whether the dramatic growth in equity value of the financial services sector indicates that securities markets are becoming less efficient.
Some might look at the financial services sector's current 21% share of S&P 500 market capitalization and assume that the securities markets are "not efficient." This is not necessarily the case. A far more compelling argument is that much of this growth results from a wealth transfer from individuals to the industry.
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