Terror on Wall Street, a Financial Metafiction Novel (9 page)

CHAPTER TWENTY THREE

BE PREPARED

As the Pittsburgh skyline came into view, traffic slowed again, and Ike began to nervously check the fuel gauge.

     “If we don’t find gas soon, we’re going to be in trouble.”

     “Don’t you have an extra can of gas in the trunk?”

     “What do you mean?”

     “Well, aren’t you always prepared for any contingency?”

     “Usually not, why?”

     “Ike, we’ve been talking about what would happen in an economic collapse for the past six months, and now we’re in the middle of one.  Don’t you remember anything you learned?”

     “Not as much as you, I’m sure.  I suppose your presentation for the Committee has been expertly prepared and is ready?”

     “Yes, as a matter of fact, it is.”

     “And you have enough cash on hand to tide you through this crisis?”

     “Yes, of course.”

     “And a little gold?”

     “Don’t you?”

     “I’ve got some gold fillings in my teeth.”

     Ike smiled, but Snookie’s expression was deadpan.  She was a puzzle to Ike:  a super-human brain that could recite entire complex mathematical equations, but didn’t get the punchline of a joke.

     “I was just kidding, Snook.  Yes, I’ve got the basic financial first aid kit, and we used our extra gas back there when we stopped at the gas station.  But if we don’t get more gas soon, our stash isn’t going to do us much good.  We can’t run the car on gold.”

     Ike exited the interstate on a business loop in the outskirts of Pittsburgh.  Without gas, their whole mission would stall.

CHAPTER TWENTY FOUR

TAKING THE GAMBLE OUT

Harry stood in front of the class and panned the eyes of his students.  For the first time in his academic life he had to have his lecture outlined on index cards so he wouldn’t forget what he was saying.  He flipped through them as he spoke, and felt a deep depression from the fact that he had to use them as a crutch.

    
Screw these cards.  I’m going to go it without them.

     “Who has solved our financial crisis?”

     Snookie raised her hand.

     “That was quick.  Ms. Baxter?”

     “Well, I haven’t solved the crisis yet, but I will.  I’ve been looking into index funds as an investment for the masses.”

     Harry smiled.  “Tell us what you’ve learned.”

     “In my studies of the stock market I’ve learned that, over time, only twenty percent of the professional portfolio managers of actively managed mutual funds beat a simple total market index fund, and those that do, don’t repeat the performance in the following period.

     “Furthermore, even those who were fortunate enough to beat the market don’t make enough to pay for their services and the cost of the brokerage firm’s commission.”

     “That’s an interesting statistic, Ms. Baxter.  Does anyone know of any actively managed fund that can beat the index funds?”

     Bob Brammon raised his hand.  “Mr. Brammon?”

     “I know of a broker who’s been selling his clients one or two funds for the last ten years that have consistently out-paced the market.”

     “In the academic literature, we find studies that have tested the success of brokers such as those you’ve just mentioned. There are over 8,000 actively managed mutual funds today.  So by sheer chance alone, we would expect at least one actively managed mutual fund to beat the record. Secondly, you will probably find in this string of successes that the fund will have been swamped by investors wanting to get in on the manager's success .  Does anyone know how these actively managed funds do it?  Ms. Baxter, I see you have your hand up again.  What do you think?”

     “Most actively managed funds concentrate on an asset class called “value funds” as classified by Morning Star.”

     “That’s correct, Ms. Baxter.  Mr. Brammon, I assume that you spent some time in the trenches selling those stocks that your company promotes, and that you know what a typical customer’s portfolio looks like.”

     “Well, yes, I have.”

     “So, class, we have here the opportunity to learn just how one of the largest and most reputable brokerage firms works.  Mr. Brammon, what if I told you that investing your funds with a broker was no better than taking them to Las Vegas and putting them on the roulette wheel?”

     “Wait a minute, professor.  Our company has a team of some of the best analysts in the world.  And our fund managers are hand-picked from among the most successful in the world.”

     “Exactly my point, Mr. Brammon.  The idea of pooling money together for investment purposes started in Europe in the mid-1800s.

     “The first public U.S. mutual fund was called the
Massachusetts Investors Trust
and was established in 1924. Today there are approximately 8,000 funds, the majority of which are sold to the public by full service brokers and investment advisors. There are approximately 55,000 mutual funds worldwide.

     “Why so many funds? They are very, very profitable for those who organize and sell them. Approximately 83,000,000 individual investors own mutual funds. The funds sold by brokers carry stiff fees—usually a sales charge from 5% to 10% of the money invested, an annual operating expense charge of 1.5%, and are characterized by high portfolio turnovers that cause taxable events, thus reducing potential after tax returns.

     “Most investors buy mutual funds to save the time and effort of selecting individual securities for their portfolios and to obtain professional management. The performance of mutual funds is a matter of public record. If you ever find yourself interested in mutual funds, or in the position of advising someone who is, then remember these simple guidelines.”

     Harry went to the blackboard and wrote as he spoke.  He was feeling vigorous and in control again.

I’ll show Brian he’s wrong. 

1. Never buy a fund with a sales charge.

2. Never buy a fund solely based on prior performance.

3. Never buy a fund that has been in existence for     less than three years.

4. Never buy a fund with a 12b1 charge.

5. Never buy a fund with an annual turnover of more than 30%.

6. Use “Business Week’s” Mutual Fund Scoreboard to     select your fund and look for the highest rated funds  with the lowest operating expense ratios.

     As Harry put the last period on number 6, he threw the chalk down.  Then he picked up a stack of papers on his table.  He looked up at the class, and suddenly he felt lost.  He scratched his head and looked back at the papers.

    
What was next?

     “Now, who has solved our financial crisis?”

     Harry smiled, but students looked shocked, as though the question was some kind of a test or maybe a joke.

     Ike raised his hand.  “Uh, professor, I think we already covered that question.  You know, in the beginning of your lecture?”

     Harry paused and looked at the papers in his hands.

     “Yes, yes, I suppose we have.”

     He put the papers down, picked up the stack of index cards, and flipped through them. 

    “Well, I’ve made a list of questions that I have on the practices of a typical brokerage company, and for your assignment I would like you to answer each question as best as you know how.  Then, when we reconvene, we’ll compare our answers with Mr. Brammon’s.”

CHAPTER TWENTY FIVE

ANDY WARHOL

After Ike pulled off the Interstate, he noticed that the needle on the gas meter was dropping dangerously below “E” and was in the red.  He didn’t say anything to Snookie about it.  She seemed nervous enough, and it wouldn’t do any good anyway. 

     After about ten minutes of hoping and praying, he saw a gas station in the distance and reached the line before he could determine whether or not they actually had any gas.

     “There’s one, and just in time!”

     “Do you know what Pittsburgh is famous for, Ike?”

     “I don’t know.  The failed steel mills, the Pittsburgh Steelers?  I think you’re going to tell me, though.”

     “Andy Warhol.”

     “Andy Warhol?”

     “Andy Warhol’s artworks are some of the most expensive paintings that have ever been sold.”

     “What does that have to do with Pittsburgh?”

     “Andy Warhol was born in Pittsburgh on August 6, 1928.  The Andy Warhol Museum was established there on May 13, 1994.  It’s the largest museum in the world dedicated to just one artist.”

     Ike started the car to move up in line.

     “How do you remember all this, this – stuff?  I suppose now you’re going to tell me that this all relates to economics?”

     “Yes, Ike.  Of course it does.”  Snookie smiled.

     “You smiled!”

     Snookie looked at him strangely.  “So?”

     “That’s the first time I’ve ever seen you smile!  So, tell me what Andy Warhol has to do with economics.”

     “Fine art is a hard asset, convertible to even the strongest of currencies.  It has an intrinsic value, as well as a market.”

     “Yes, I remember Harry’s lecture.  So do you have an Andy Warhol, Snook?”

     “Yes, as a matter of fact, I do.”

     “Which one?”

     “A Marilyn Monroe lithograph.”

     Ike pulled the car closer to the pumps.

     “What do you like about it?”

     “About what?”

     “The Marilyn Monroe lithograph.”

     “It has an intrinsic value.”

     “I know, I know.  But what do you
like
about it?”

     “I don’t know what you mean, Ike.”

     “Why do you like to look at it?  What attracted your eye?  What makes it special?”

     Snookie couldn’t think of an answer.

     “I don’t know.”

CHAPTER TWENTY SIX

THE PITS

Harry put an outline on the overhead projector.  Once again he nervously shuffled his index cards, making sure they were all in place.

     “Today we’re going to talk about index funds.  Let’s look at the record.  Over the past 20 years, a simple, low-cost, no-load market index fund delivered an annual return of 12.8%.  During the same period, the average equity mutual fund delivered a return of just 10%.”

     Harry paused, with a blank expression on his face.  The class waited patiently, but he just continued to stare into space.  The silence lasted for a while until Snookie spoke to him.

     “Professor?”

     Harry seemed to come back to life. 

     “Yes, Ms. Baxter?”

     “You were talking about index versus mutual funds.”

     “Yes, yes, I was.”

     Harry shuffled his index cards.  He had stopped looking at them. 

     “Over the past 20 years, a simple, low-cost, no-load market index fund delivered an annual return of 12.8%.  During the same period, the average equity mutual fund delivered a return of just 10%.”

     “You said that already.”

     “Yes, I suppose I did.  Repetition is good for learning, you know.”

     Harry cleared his throat.

     “To evaluate this difference, let’s compound it over that 20-year period.  We find that the average mutual fund underperformed the index fund by 57%.  And that’s before taxes.  The average mutual fund loses an additional 16% to capital gains taxes due to continuous trading.  So, as you can see, the average mutual fund captures only 41% of the return the market provides.”

     Harry confidently looked up from the cards.

     “Now, let’s look at how the average investor made out during the last bull market.  Hang on to your hats!  It’s probably a lot different than you would think. 

     “Most individuals are unable to profitably invest in the market and are left with equity returns lower than inflation.  The average equity fund investor earned a paltry 2.57% annually, compared to inflation of 3.14%.  In contrast, the S&P 500 index has returned a 12.2% average over the last 19 years.  The average fixed income investor earned only 4.24% compared to the long-term government bond index of 11.7%, according to Dalbar’s
Quantitative Analysis of Investor Behavior
.”

     Harry went back to his cue cards.

   “But the Dalbar study has some flaws that understate the average investor's performance. A reasonable estimate of investor performance is 4% to 8% below the S&P performance for the period. Therefore, I estimate that the average investor returned from 4.2% to 8.2% for the period compared to the S&P index (12.2%) for the last 19 years.

   
 
“Most of this poor performance was due to the investor jumping from fund to fund, chasing performance.  During this course, we’re going to examine an index fund that captures the entire stock market return and we'll add other funds that will help to combat inflation and reduce portfolio risk, as well. More importantly, we will learn how to avoid the mistakes most investors make.  Can anyone tell us who developed the first index?  Ms. Baxter?”

     Snookie stood up.  “The first index was developed by Charles Dow in 1898. He added up the prices of 12 stocks, divided by 12, and printed the result in a tip sheet now called the
Wall Street Journal
. The Dow Jones Industrial Index is a price-weighted index.”

     “That’s correct, Ms. Baxter.  That index today is known as the
Dow Jones Industrial Average
, named after Mr. Dow, who was the founder of
The Wall Street Journal
. The early issues of the Journal were entirely handwritten and were distributed in carbon copies.  Can you tell us how the index is computed?”

     “Yes, professor.  A stock with a high price may have more influence in the index than a stock with a lower price but with a much higher capitalization. All other indexes are market value weighted. There are about 430 indexes of equities covering small–cap stocks, large-cap stocks, and value stocks, various sectors of the market such as financials, basic materials, retail, and so forth.

     “There are about 30 bond indexes covering segments of the bond market such as tax-free municipal bonds, corporate bonds, and government-issued securities. These indexes are used to evaluate the performance of money managers to see how various sectors of the market are doing and to develop index funds (a fund designed to track the market).”

     “Right again, Ms. Baxter.  Researchers have, over the last 20 years or so, examined stock prices and their returns according to the asset groups suggested by the indexes we have been talking about. By way of an example, it has been found that small-cap stocks have higher returns than large-cap stocks and that they are more volatile. Also, their prices are more erratic than larger companies.

     “The volatility of a security’s daily, monthly, and annual prices is a good measure of the stock’s risk. A statistical measure of risk called the 'standard deviation' is accepted by the financial services industry and by academics as well.

     “Can anyone tell us why the majority of investors do not gain the returns the market offers just by buying index funds?”

     Ike raised his hand.  “I think I know.”

     “Very well, Mr. Pendleton, give it your best shot.”

     “It’s because of the avalanche of propaganda circulated by Wall Street and the financial media via newspapers, magazines, and television. I can’t think of a single bit of news circulated by the media that’s of any use. It’s how your brain processes this flood of information that creates the problem.”

     “Do tell, Mr. Pendleton.”

     “Well, just behind each of your eyes sits a pair of neuron groups called the nuclei. These tiny little structures are most electrically active during the anticipation of eating good food or having sex with a beautiful woman…”

     Ike looked out of the corner of his eye at Snookie.  Carlos snorted and Ike’s face flushed red.

     “Uh…or participating in agreeable social activities.  Also in achieving large, um,  financial rewards. This area of the brain has superior pattern recognition capability. It can out-process the largest digital computer when it comes to recognizing and connecting a person’s face with someone you know and like, or someone who has the facial characteristics of someone you fear and hate. It also can process by means of its pattern recognition capabilities and can ignore the many signals your brain obtains when you are speeding down the highway.

     “These tiny little bundles of neurons function without you realizing that they are influencing your actions. They send signals to a portion of your brain called the amygdala, which is the Greek word for “walnut.” This area of the ancient brain is associated with feelings of fear.  Emotions such as fear and aggression are important for visual learning and memory. At night, when you go to sleep, your brain takes twenty percent of your body’s energy to clean up and discard memories that are no longer useful. If you are deprived of sleep, you will eventually die.”

     “I think you’re getting off on a tangent, Mr. Pendleton.  Are you trying to say that this ‘emotional brain’ is what causes investors to make mistakes with their investments?”

     “Exactly!  Think about it.  When there’s a panic in the markets, what happens?”

     “Everyone sells,” said Snookie.

     “Yes, and when everyone sells, prices go down.  That’s when they should be buying!”

         “Very good, Mr. Pendleton.  You sound like the great Warren Buffet’s protégé.  Well, that’s it for today, class.  We’ve run out of time again.  But be prepared to continue this discussion when we meet again.”