Terror on Wall Street, a Financial Metafiction Novel (12 page)

CHAPTER THIRTY FOUR

LAW IN MOTION

Harry wasn’t feeling up to a meeting with the lawyers, so he sent the whiz kids in his place.  He briefed them all in his hotel room and gave them his final parting words. 
I feel like Vince Lombardi.

    "Mr. Rodriguez, what’s going on with the lawyers?”

     “They emailed a final draft of the legislation we’re proposing.  The business center is making copies for us.”

     “Good.  I know how hard it is to read through legalese, but we all have to do it before the meeting.  After you meet with them, we will assemble back here and have a dry run of the presentations.  Any questions?”

     For once, there were none.  Harry panned their eyes and smiled proudly.

     “You’re in charge in my place, Mr. Rodriguez, so don’t screw anything up.”

     “You can count on me, professor.”

     The group went out to the car which waited to take them to the lawyers’ offices on H Street Northwest.  It was a short drive that took an unreasonably long time, due to the location.  Finally, the driver stopped at a barricaded checkpoint.

     “This is as far as I go, guys.  You’ll have to do the rest on foot.”

     “Where is it?” Carlos asked.

     “Just down that street.”

     “Dude, isn’t that the White House over there?”

     “Yes, it is.  That’s why we can’t move any further.”

     They thanked the driver, exited the car, and headed into the mob of humanity that had gathered outside the White House.  Every conceivable space was filled with people, many of them holding signs.

     “This is not a happy group.”

     “No, Ike, it’s not.  Let’s stick together, guys.  We can’t fail Harry now.”

     The police were out in full force.  Concrete blocks had been placed on Pennsylvania Avenue in front of the White House north lawn, which forced the crowd to gather in Lafayette Square.  Carlos, Bob and Larry weaved their way through the agitated group until they finally reached the H Street entrance.  There, a contingent of police in riot gear stopped them.

     “Where are you going?”

     Carlos spoke for the group.  “We’re going to an appointment with our lawyers, right there, across the street.”

     “Have any proof of that?”

     “Dude, I didn’t know we were in Nazi Germany.  Isn’t this the United States of America?  Land of the free and home of the brave?”

     “Sir, we have strict orders to stop and detain any suspicious persons.”

     “You mean any suspicious
Mexican
persons, don’t you?  We have an appointment with the lawyers, and no, we don’t have an appointment card because we flew in for the meeting.  But, we do have the fax with the proposed bill they sent us this morning.”

     Carlos showed the fax to the police, and they let them pass. 

     “Good job, Carlos.”

     “I’m used to taking shit from the police.  It’s like a badge of courage for a Mexican American.”

     “It’s a good thing we had that fax.”

     “That, too.”

CHAPTER THIRTY FIVE

RISKY BUSINESS

Harry stood in back of the podium and flipped through his index cards as he spoke. 
So far, so good.  This system seems to be working.

    
“A broad market index fund contains about 25% less risk than the average actively managed mutual fund. The fact that a portfolio of fifty carefully selected securities will correlate 90-95% with the market’s performance does not mean that 90-95% of its diversifiable risk has been eliminated.

       “One of the axioms of Modern Portfolio Theory is that current market prices reflect the total knowledge and expectations of all investors, and no investor can consistently know more than the market does collectively. Participants in the market have discounted any known future event so as to correctly price it in today’s market.  Can anyone tell us how risk and return are related to one another?”

     “Ah, as usual, Ms. Baxter, you have the answer.”

     “Risk and return are related, and riskier assets must therefore provide higher expected returns as compensation.”

     “Mr. Brammon, I see your hand is up.  What’s your question?"

     “Well, if what you say is true, then there are no bargains in the market and it is futile looking for them. Is that correct?”

     “But those higher returns are, of course, not guaranteed; or there wouldn’t be any risk. But essentially, you are correct.  There are no bargains, and efforts to find them are futile. I believe that the evidence on the performance of professional stock portfolio managers is proof of this maxim. Portfolios can be constructed that are expected to deliver the greatest expected return for any given level of expected risk.

     “This is a very important point often overlooked by full service brokers.  Either they don’t know better or they don’t care for their clients and only want to maximize their commissions.  If you are retired, it is only prudent to reduce the risk in your portfolio unless you do not have enough money in your portfolio to live on.  Then you must take a chance and keep your portfolio at higher risk levels.  Ms. Baxter, yes?”

     “Then aren’t equity markets far riskier than believed by the average investor and, therefore, aren't a very long investment horizon and the discipline to stay the course key ingredients of the winner’s game?”

     “Yes.  That’s why the biggest danger to a successful investment program is that fellow looking back at you every time you look in the mirror.”

     The students laughed.  “Mr. Rodriguez, I see you waving your hand, furiously.  Either you have to run to the restroom - which, by all means, you don’t need my permission to do - or you disagree.  Which is it?”

     “Yes, professor.  I disagree.  There are market strategies that have been proven to produce returns greater than those of the market and these are available to average investors without any effort.”

     “Mr. Rodriguez, given that, over the long run, the  S&P has provided a 10.5% return compared to a total domestic market return of 10.4%, what examples can you cite of someone beating the market consistently over the same period of time?”

     “I can’t.  I can only point to periods of those who’ve done it with success.”

     "Exactly.  It is virtually impossible to select those stocks that will produce profits over the next 40 years.  The numbers I gave you are nominal returns from which you must deduct 3.5% for inflation.  This is proof positive that indexers can and do outperform the market.

     “They use a system that utilizes the findings of Harry Markowitz, who developed a mathematical proof that a portfolio of stocks can and will outperform the weighted average of its component parts.  I call this 2+2=5.

     “A 30-year-old should be able to save 12% to 15% of his earned income and have a period of 45 years to accumulate his portfolio and start withdrawing these funds during retirement.
13% of the total will accrue in the first trimester, 27% in the second, and 60% of the total amount will accrue during the final trimester.

     “There are no secret or magical formulas to investing in the stock market. Investing is about risk and reward and choosing the strategy that is most likely to deliver the expected (but not guaranteed) results over time.  If I had any knowledge of how to create certain outcomes with high returns, I certainly would not be writing about it, as they do.  I would be exploiting it.

     “Those who obtained extraordinary returns over a few years were just lucky. In fact, there is no known way to select those who will be lucky, is there? A Roth IRA will permit the invested funds to accumulate without income tax on dividends or capital gains taxes during the accumulation period or when the principal is withdrawn from the account during retirement. There are income limits and other restrictions when using a Roth IRA. All assets will be re-priced to current values at the death of one spouse and the surviving spouse will inherent the estate tax free under current tax legislation.

     “At the age of 75, a couple should convert sufficient funds to purchase an immediate annuity to produce enough income to cover expenses so that they do not have to sell portions of their portfolio during periods when prices are too low.”

     Harry suddenly drew a blank, and frantically shuffled through his cards. 

     “Where were we, class?”

     “Returns.”

       “Thank you, Ms. Baxter.  There are two theories about what determines the returns of a portfolio of stocks over the long run. The Wall Street establishment wants investors to believe that it is the ability to pick individual securities and timing the market that determines the vast majority of returns. Notice that Wall Street never advertises its success in its efforts to beat the market return.

     “A portfolio containing as many as 200 randomly selected stocks can deviate one percentage point on either side of the market’s expected return. Although this differential certainly is not significant in any one year, when negatively compounded over long periods of time, it can represent enormous differences in accumulated wealth.”

     Harry referred to his index cards and started scribbling on the board, excitedly.

     “Here are some of the characteristics of a good index: rebalancing and replacement rules should minimize portfolio turnover, there should be a buffer zone between asset classes, and the style indexes (growth and value) should not cover all the companies in the index. This style requirement eliminates most of the Dow Jones indexes.  A fund is inherently tax efficient if it has low turnover and there is no loss from foreign withholding tax credit.”

     “But what about value stocks, professor?”

     “Ah, therein lies the one remaining mystery – that asset class we call 'value stocks'. They provide higher returns as a category, yet when risk is measured by volatility of prices, it is lower than we would expect.  There are a ton of peer-reviewed studies available to show that active efforts to outperform the market are not profitable strategies.

     “Financial economists believe that most returns are not a result of stock selection or market timing skills. Instead, they believe that the vast majority of a portfolio’s returns results from the specific allocations to the three asset classes of equities in general and then, within the equity asset class, the asset classes of small-cap companies versus large-cap and value versus growth companies. Small-cap companies are riskier than large-cap companies, and value (or distressed) companies are riskier than growth companies.

     “A study by Wharton School of Finance at the University of Pennsylvania finds that income annuities can assure retirees of an income stream for life while costing as much as 40% less than a traditional stock and bond portfolio mix.

     “A Goldman Sachs study examined mutual funds cash holdings from 1970-1989. In their efforts to time the market, fund managers raise their cash holdings when they believe the market will decline and lower their cash holdings when they become bullish. The study found that mutual fund managers miscalled all nine major turning points.

     “What is one of the first mathematical theorems we learn that relate to this?”

     “That the sum of the parts must equal the whole?”

     “Very good, Ms. Baxter.  Fortunately, when it comes to investment portfolios, this isn’t true. The compound return for a portfolio with a fixed percentage invested on various asset classes is greater than the sum of the weighted average of the individual asset classes. This will hold true if the portfolio’s asset allocation is kept relatively constant through a program of regular rebalancing.
You can actually reduce risk without a commensurate reduction by diversifying a portfolio. Conversely, you can increase returns without a commensurate increase in risk.

     “The effectiveness of the diversification – the incremental returns – depends on the degree of the correlation of returns, which is the degree by which prices rise and fall at the same time and by the same amount between the various asset classes chosen to construct the portfolio.  Half of American blue collar workers haven’t figured out how much they will need for retirement.  Nearly one third aren’t currently saving for it, and those who did have saved less than $25,000.

     “During the 1975-1983 period, as the economy was recovering from the Great Depression, small cap stocks exploded and returned 35.3% compounded.
High returns require taking high risks, and anyone who offers you an investment that has a good return without risk is a con artist.  Over the last 40 years,  Congress has acted irresponsibly, taking bribes from the financial services industry. This must stop and we may have to pass a constitutional amendment to establish term limits, as Ms. Baxter has suggested.

     “The majority of actively managed mutual funds stuff their portfolios with value stocks and are thus closet indexers, so why are you paying someone to buy funds for you when you can buy them yourself with no commission?  There are people out there who can beat the market by their skill and knowledge, but to date, no one has figured out how to identify them before they pile up a record of successes.

     “Bill Miller, a recent market guru, turned in a record of 15 years of beating the market each and every year, followed by three years of failing to beat the market. Of course, the financial press used the S&P 500 Index to make the comparison, when his portfolio was more accurately measured by value stocks.

     “From 1984 to 2000, 90% of individual investors earned 5.23% on average while the broad market returned 16.2%, according to a peer-reviewed study. 
One study of market timing showed that for 2,000 trading days the market returned 357%; but if you missed the 10 best days, your return would have been only 7.4%, and had you missed the 50 best days, you would have had a zero return.
It is not possible to make reliable predictions on when the market will rise or fall. If it were possible, the market would respond in advance and then it could not rise and fall the way it does.”