It can be hard out there for individual investors trying to compete with Wall Street, and there's certainly no shortage of news to make you cynical about investing. Earlier this year, famed author Michael Lewis claimed that high-frequency traders are beating regular investors to trades, and essentially taking advantage of arbitrages in a matter of milliseconds.
Wall Street banks have been fined many times for defrauding clients, and much of the financial crisis can be blamed on the big banks betting against clients, and repackaging faulty mortgage bonds as "AAA"-rated debt. With that in mind, let's take a look at three things that Wall Street won't tell you about investing.
1. "Hold" often means "sell"
Citigroup (C -0.78%) was recently fined $15 million, essentially the equivalent of a $50 parking ticket for the banking giant, for labeling some stocks as hold, yet telling a separate group of clients they were a "short." The analyst in question had identified at least six stocks as shorts for well-heeled clients at Citibank "idea dinners" despite publishing research that called them holds.
According to the SEC, research analysts often have to certify that their stock recommendations are their own honest and personal beliefs. This can create problems for banks, however, which often need to "make markets" -- that is, find buyers and sellers for certain securities. Moreover, the need to please important clients with access to different information also creates this discrepancy.
Part of the problem is that the big banks don't want to offend the same companies that are often their clients or potential clients in the investment banking division. Hold doesn't always mean sell, but examining whether a bank has done any underwriting for a company could indicate that a hold rating is really closer to a sell.
2. A lot of what we're saying is just noise
Like the disguised meaning of "hold," Wall Street also likes to throw in jargon and other concepts that make investing seem more difficult than it needs to be. Much of this esoteric terminology relates to technical analysis, a tool used for investing that divorces a stock's value from any facts about the company, looking strictly at the stock's chart instead.
A recent article in Investor's Business Daily, for instance, describes Chipotle as having a double-bottom base, and Dunkin' Brands as etching a handle, explaining that a handle involves a "modest decline in a base. It needs to run at least five sessions, and ideally it should have a soft volume." Moving averages are also a popular subject of technical analysts.
The problem with technical analysis, apart from the language sounding ridiculous, is that there's no real definition of it, and there's little proof that it actually works on a consistent basis. Finally, it clouds out judgments from fundamental analysis, which is based on actual financial results and more rational analysis.
Similarly, concepts like diversification also appear overrated upon closer examination. The tactic of spreading investments across different asset classes has been proven to reduce risk; but it also limits rewards. Warren Buffett, for example, the world's most successful investor, rejects the strategy, and invests most of Berkshire Hathaway's money in financial and consumer goods stocks.
Billionaire entrepreneur Mark Cuban also said diversification is "for idiots," advising investors to "do your homework and play your best bets." The statement underscores a major problem with diversification for individual investors, which is that it takes them away from their knowledge base.
3. Half of us (and you) need to be wrong
Every trade has a winner and loser. While retirement windows, risk profiles, and other differences might make some trades beneficial to both sides of the transaction, generally speaking, a stock will either outperform or underperform the market. That is the nature of markets, after all. They adjust to perception. If every investor thinks a given stock is a buy, then the price should rise to the point where it hits equilibrium, and there is an even debate about its future direction.
The Volcker rule, set to take effect next year, is designed to restrict banks' proprietary trading and, therefore, betting against clients; but the simple investing advice remains the strongest for those who wish to escape the fees of Wall Street. Adopting a buy-and-hold investing strategy using index funds and reinvesting dividends is one of the best ways to ensure long-term wealth accumulation. Buffett himself even asked his inheritors to put 90% of his cash into a low-cost S&P 500 index fund. Going on, he explained:
I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions or individuals -- who employ high-fee managers. Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.
I couldn't agree more.