Within the securities market, investors have great freedom in that they are able to take risks through investments in exchange for the right to receive and keep interest, dividends, and appreciation. Yet, in the midst of this freedom, they experience various perils, such as volatility and subsequently, fear and anxiety. They may receive questionable advice. And ultimately, they often make costly and even devastating errors.
In the midst of the freedom of capital markets emerges responsibility. As advisors, we know our economic system is designed to create prosperity and that, properly guided, investors can successfully participate in its rewards. Thus, we have the responsibility to help investors engage with the world on the basis of clear, constructive thinking in search of positive outcomes. We have the responsibility of helping investors understand but not be overcome by emotional and behavioral pitfalls. In the words of Don Phillips, Managing Director of Morningstar, Inc., on April 8, 2014 at the Tiburon conference in New York City, âWe gotta manage the behavior gap.â
The Financial Markets
At some level of consciousness, all of us may comprehend that we live in a time of mass flourishing. These are the good times in human history. Today there are fewer wars, higher standards of living, better educational systems, and fewer people living in poverty than at any time in human history (Zakaria 2012). The good times are not an accident. They are the work product of the lessons of history and the evolved systems and cultural beliefs that support these systems. Compared to ages past, prosperity abounds, as does the opportunity to participate in it.
The central reason for the prosperity is a greater emphasis on human freedom. Human freedom, as defined by Professor Henry Louis âSkipâ Gates Jr. (2014), Chair of African American Studies at Harvard University, is the ability to do as one pleases. The ability to do as one pleases requires economic freedom.
Economic freedom requires assets that generate the cash flow required to sustain each person's definition of wellbeing. For more than 200 years, the market economies of the West, Europe, and North America have been supported by democratic governments that protect individual human rights (including economic freedom) through the rule of law. These governments have been guided by cultural values that encourage and promote material wellbeing and applaud innovation and entrepreneurship. This virtuous system of governance, informed by cultural values supporting the spirit of individual exploration and innovation has spawned a standard of living unimaginable prior to the 19th century (Phelps 2013). Moreover, it is this market-based system that has brought hundreds of millions out of poverty into the middle class in Asia and Latin America over the last 30 years.
It is this system that inspired the people of Western Ukraine and spurred them in the natural human desire of all people for a better life. Secretary of State John Kerry, who flew to Ukraine's capital city of Kiev when Russia seized the Crimea in March 2014, shared the story of one man he met in Kiev. The man told Kerry he had been to Australia and had seen firsthand how others live a prosperous life and that he wanted to live as they do. Rather than having his wealth stolen by a corrupt government, he wanted the rule of law, markets, elections and the proper institutions of liberty. In short, he wanted freedom.
Central to providing the freedom and prosperity the man in Kiev witnessed are the financial markets. In America, we depend on the credibility of financial markets. The source of America's greatness is its capital markets. It's not debatable (Kauffman 2014).
The Purpose of the Securities Industry
The post-World War II American economy has been largely financed by providing individual and institutional investors with access, through capital markets, to the equity and fixed income returns generated by economic growth.
However, as the American economy continued its industrialization on a large scale into the 20th century, wealthy families could no longer provide enough capital to finance the remarkable American economic growth âmachine.â Investment was now needed by large numbers of smaller investors as individuals, through vehicles like pension plans, fueled continued economic expansion and increased standards of living for the American population.
Win Smith, in Catching Lightning in a Bottle (2013), his excellent written history of Merrill Lynch, explains, âBy bringing Wall Street to Main Street and democratizing investing, Merrill Lynch helped countless middle-class individuals save and invest, and, in turn, helped thousands of companies, municipalities, and governments fund their growth.â Merrill Lynch, along with other similar institutions, executed the financial intermediation process that helped the United States to grow into an economic powerhouse.
Creating wealth on a small and large scale is the purpose of the securities industry. The Securities Industry and Financial Markets Association (2013) explains that through the medium of capital markets, the purpose of the securities industry is to match the investment capital of private investors with the opportunities offered in a dynamic, free market economy, powered forward by entrepreneurial and innovative private enterprise (SIFMA 2013).
In turn, our capitalist, market-based economic system has produced significant economic growth and wealth for many millions of Americans who may not have otherwise participated. And economic growth means a higher standard of living and attractive returns on capital. Attractive returns on capital through interest, dividends, and capital appreciation are the incentives that a market system offers to investors to support entrepreneurs and innovators as well as existing enterprises. Attractive returns are intended.
Real WinsâŠand Losses
Over the last 30 years, both the economy as measured by real gross domestic product and the stock market as measured by the S&P 500 Index grew considerably. Real gross domestic product has grown from $6.99 trillion as of December 31, 1983 to $15.94 trillion as of December 31, 2013 (U.S. Bureau of Economic Analysis 2014). During that same period, the market capitalization of the S&P 500 Index grew from $1.22 trillion as of December 31, 1983 to $16.5 trillion as of December 31, 2013 (Haver Analytics 2014). Seen as a straight line these numbers are impressive.
However, the economy does not advance in a straight line. In fact, a free market economy is characterized by change and disruption. Today's goods and services become tomorrow's rubbish, as producers innovate, entrepreneurs introduce change, and consumer demand shifts. Capital markets also innovate and some investment innovations fail. Government periodically get macroeconomic policy wrong. The result is swings, sometimes massive, in the value of securities. Volatility happens as disruption, discovery and change bring innovation and efficiency to the production of goods and services in a dynamic economy.
When economic growth lags or falls into recession as a result of capital market excesses or flawed governmental macroeconomic maneuvers, the imperative for a democratic government is to pursue policies that will produce economic growth, prosperity and a rising standard of living for its citizens. Moreover, in post-World War II America, with its rising tide of entitlement programs, the government must produce economic growth and tax revenues to finance its obligations. After economic downturns, when growth is restored, attractive capital market returns generally follow. The ebb and flow of economic growth and capital market performance act badly on the mind of investors. As mentioned earlier, over the 30-year period ending December 31, 2013, the S&P 500 Index performed at an annualized revenue of 11.11 percent, real gross domestic product has grown from $6.99 trillion to $15.94 trillion (U.S. Bureau of Economic Analysis 2014), and market capitalization of the S&P 500 Index grew from $1.22 trillion to $16.5 trillion (Haver Analytics 2014).
Disturbingly, investors did not keep pace. In fact, they lagged by a substantial margin. Despite the exciting story indicated by the amazing performance of the economy and stock market over the last 30 years the actual experience of many investors, individual and institutional, has been different, and often disappointing as participation in capital market returns has lagged. Why?
The Rot in Denmark
Anecdotally, all skilled advisors and investment managers know from personal experience that individual investors by and large are unwilling or unable to engage in the intentional study required to understand the often arcane language used in disclosure and inscrutable concepts that guide successful investing.
When this happens, inexperienced investors may rely on the media, friends, or the claims of investment firms touting investment funds with attractive recent returns and high ratings to ...