Tag Archives: Wall Street

How Wealth Is Created

As investors we all expect a return on our investment but first we need to understand how wealth, the source of that return, is created. If no wealth is being created, there will be no return on our investments. (Paul may get rich by robbing Peter but that is a zero-sum game that does not create any new wealth.)

To create wealth you need a growing economy and for an economy to grow, you need the following:

1. Skilled Labor

2. Natural Resources

3. Intellectual Capital (people with creative ideas, leadership abilities etc.)

4. Financial Capital

You bring these four inputs into a “market” economy and wealth is created. As investors, providing the financial capital, you are entitled to your share of that increase in wealth. It’s what we call the “capital market rate of return.”

When the economy is strong and growing, the return for all four of these inputs will be greater, than when the economy is weak. In the U.S., the return on “financial capital” for the past 100 years has averaged around 10% per annum, but as we all know too well, we have periods when the capital market rate of return is much less, or even negative. Since 2000, the capital market rate of return has been close to zero.

I could interpret these recent numbers as a good sign for higher returns in the future, but I am not here to make a forecast. What I am telling you is that, as investors, we need to pay closer attention to the costs of investing. Wall Street cannot survive for very long in a world where the capital market rate of return is close to zero. They expect more and the only way to get it is to take a chunk of everyone else’s share of the increase in wealth. When the capital market rate of return drops significantly, you never see an equivalent drop in fees.

What you do see, is pressure on the Wall Street sales force to sell high cost products, and the fees end up consuming a much larger share of your return. Losing 2 or 3 percent of your capital each year in fees, has an enormous negative impact on your long-term investment gains. Fortunately lower cost alternatives do exist. Using ETFs, index funds, discount brokers etc. will, in my opinion, always be the better option.

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“Where Are the Customers’ Yachts?”

This is the title of an investment classic written by Fred Schwed in 1940 (more than 70 yeas ago) about the “sales culture” of Wall Street Banks, a culture that always puts profits ahead of client interest.   Last month when Greg Smith resigned from Goldman Sachs and wrote his opinion piece for the New York Times, my first thought was, why did it take him 12 years to figure this out?  I am happy for him but his disclosures are not going to change anything at Goldman Sachs or anywhere else on Wall Street.  The money is simply too good to pass up.  Personal ethics will almost always be trumped by the desire for big money.  I can speak from my own personal experience with Merrill Lynch back in the mid 80’s and over the next few days I will write about some of the most egregious examples of client abuse I witnessed.  Of course, I was working in the trenches with retail clients where the abuses occur daily whereas Greg was working with large institutional clients who were more sophisticated.  A more difficult target, but a target for exploitation, nonetheless.

Last summer I spoke to a group of high school seniors interested in a career in financial services at a “career day” function and I began by asking, “how many of you want to be sales people?”   Not one student raised their hand so I asked them why they were attending this session.   We then discussed what they thought a career in financial services entailed.  All of them wanted to help people with their investments, and had no interest in being a commissioned sales person.  I shared with them my experience and told them it was not all bad news.

They could have a career in financial services and put the clients’ interest first if they were to join a small but rapidly growing profession called “fee-only financial advisors.”  These professionals are compensated with fees paid to them by the client, not commissions paid to them by their employer.  This means the client is getting objective advice and not a sales pitch.  By the end, I do not think I have ever had a more appreciative audience.  They were gratified to hear the truth.

As I said before, the culture on Wall Street will never change.  The money is too good.  But unlike 30 years ago investors do have a choice, and do not have to work with the Wall Street Banks.  There are fee only advisors all over the country now offering a more successful investment experience.

The Wall Street Banks spend a fortune in advertising and PR to convince investors they are skilled and ethical.  And they have been successful.  But since 2008, it has been more difficult because what investor would want to have their money with a firm that could not manage their own money successfully.  Now they want you to trust the “New Merrill Lynch” which is now part of Bank of America.  But rest assured, as Greg Smith documented in his letter to the New York Times, nothing has changed.

Note:  It’s not just Merrill Lynch and Goldman Sachs, the Wall Street Banks are all the same.  But my own experience was with Merrill and where I came to know the truth about Wall Street.


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