Book Summary – Investment
The process of democratization began in the 1600s with the establishment of “joint-stock companies” like the Dutch East India Company. These firms marked a watershed development in the modern corporate model, in that managers ran them, directors oversaw them, and many limited-liability, passive shareholders owned them. The fact that shares of a company could change hands without altering the business’s internal capital allocation was pivotal. These stock companies were viable because of the concurrent evolution of public stock exchanges. The Amsterdam Wisselbank was the first such clearinghouse, founded in 1609.
“Investment…is truly among the central themes in the story of humankind.”
The next major step in investment democratization unfolded in Britain, where the Bank of England, created in 1694, financed the British navy. Over the next century, the bank played a part in funding commerce and trade. It also intermediated the capitalization of private country banks. The bank allowed the English government to control the capital markets to pay for its wars with Napoleon. After the defeat of the French in 1815, the Bank of England became the hub of a financial system flush with capital and positioned to fund the Industrial Revolution. Private banks, benefiting from the stability of the Bank of England, backed new industrialists with money for factories, machinery and finished goods in the manner of “modern venture capitalists.”
“Publicly traded companies…aided the pace and scale of growth in the era of the 19th-century railroads and the 20th century’s automobiles, computers, airplanes and industry.”
The Industrial Revolution broadened the market to include stock ownership by manufacturers, merchants and entrepreneurs. Securities based on prospering public corporations grew in importance during the 1800s. Over the same period, the investing’s purposes expanded beyond financing trade, commodities and industrial production.
“Rather than watching horses race around a track, bucket shop patrons got their thrills watching ticker tapes.”
In 1790, the United States offered shares in its public debt to pay for the American Revolution. A century later, Germany crafted a publicly funded retirement system, the idea of which quickly spread throughout Europe. The growing volume and complexity of investments – along with inventions like the telegraph in 1844 and other advances in communications – fed the structural transformations of the markets themselves. Transoceanic cable laid in 1866 created the first worldwide financial market around 1870, centered in London with New York as an offshoot.
“The concept of retirement…[has] been the most striking single manifestation of the democratization of investment over the centuries.”
In America in the 1880s, ordinary citizens gambled on the movement of ticker-tape stock prices. The public began to take part in market investments around 1920, but many people pulled out during the Great Depression. The 1930s New Deal regulations, in tandem with better-designed products like mutual funds, brought individuals back into the market. Adult participation grew to one in 16 people in 1952, “to one in five in 1980” and to roughly one in two by the early 21st century. Today’s stock market, with its transparency and inclusion, connects savers with financial opportunities globally. It supplies “liquidity, publicized value,” diversification and low fees.
“Investment has been professionalized, though the jury is still out on how much this professionalization has resulted in greater effectiveness.”
The biggest boost to investment democratization came from the institution of public pensions, which entrenched the idea of retirement – the expectation that older people could stop working and still maintain a dignified standard of living. Retirement requires people to invest money during their working years to draw on when they leave the labor force. Governments designed public plans, like Social Security in the United States, to replace only about 30% of a person’s lifetime average annual wages. Private pensions provided individuals with income to maintain a higher standard of living in retirement, especially high-income earners. The end of World War II ushered in an era of corporate-funded pensions as employee benefits. The 1960s saw the emergence of greater regulation and independent pension managers under contract to corporations. Strong solvency requirements in the US in the 1970s led corporations away from funding defined-benefit pensions. Instead, they contributed to plans such as 401k accounts and Individual Retirement Accounts (IRAs) that employees maintained.
“It is probably not possible to devise a single superior investment technique that works era after era.”
These successively huge waves of retirement funds have made investors out of ever-wider swaths of the general population. Pension money has also generated an industry of advisers, managers and organizations handling a world-beating $24 trillion of US pension assets in 2014. Retirement asset growth outpaced income growth by a multiple of five between 1975 and 1999. The pension boom has also contributed to a decline in the number of individuals who directly manage their own assets and to an increase in the number of institutions managing investments for them through public funds. In 1950, institutions held 6.1% of equities outstanding; by 2009, this grew to 50.6%. The rise in investment management made mutual funds big winners. These funds had $15 trillion in assets at the end of 2013, with their holdings heavily in equities.
“While the management of pension funds has long been reasonably successful, the funding of plans by the corporations who sponsored them has not always been so commendable.”
New and Alternative Securities Emerge
Individuals can invest in relatively new classes of instruments, such as index funds and exchange-traded funds. These funds – with a combined $2.6 trillion in holdings at the end of 2012 – are low cost and passive: Their values move with the overall value of specific market sectors. Investments in alternative instruments also grew in the early 2000s. Some of these alternatives – such as hedge funds, venture capital, private equity, real estate, infrastructure and commodities – are attractive to financial managers because they provide diversification and don’t follow the periodic wax and wane of mainstream markets. These are complex financial products that institutions use for their own investments. In the United States, laws restrict individuals’ participation to the wealthy.
“Performance of investments often does not scale in the same way as costs do.”
Hedge funds benefit from looser transparency and reporting regulations. Therefore, they can engage in secretive and complex investment strategies. In return for less scrutiny, they have to “refrain from solicitation of unqualified investors.” As a category, their distinguishing feature is their method of charging fees to their clients. They collect a mix of fees on a total asset base, such as 1% to 2%, plus a percentage of returns, as much as 10% to 20%. The hedge fund industry had $2.5 trillion in assets in 2014. Although media stories spotlight big hedge fund profits, high returns after fees are difficult to maintain in the long run. No single strategy remains effective for long. In reporting hedge fund results, survivorship bias a common pitfall: The stories of loss and failure disappear, leaving only the winners.
“As recently as 2012…the 10 highest-earning US hedge fund managers made over $10.1 billion in earnings from management performance fees.”
Unlike in some areas of investment, the size of hedge funds does not mean high profits. Studies show that small hedge funds perform better than large ones, perhaps because their managers find it easier to locate small pockets of inefficiencies to exploit with specific strategies. During the five years up to 2013, hedge funds as a group underperformed the S&P 500 by a two-thirds margin, although they could claim to have been more diversified and less volatile than equities, and, therefore, to have exposed investors to less downside risk.
“Throughout the [pre-2007] period, competitive regulatory agencies were allowed to develop, gaps in regulatory coverage occurred and were not corrected, clarity in regulatory responsibilities was not established, and lapses in regulatory enforcement occurred.”
Venture capital, a type of private equity, takes on a resource-allocation function in funding risky innovations in such areas as “computational power, medicine and health care delivery, data processing and analysis, and electronics.” These investments are highly concentrated in Silicon Valley in California. In 2011, US venture capital firms raised $28.7 billion. The US has 770 venture capital firms; Canada, the UK and China, combined, have far less than half that number. The nature of this investment is different from equity investing in that an investor gets a seat on the start-up company’s board and participates in its profits and losses. Some new businesses are based on intangible assets, such as ideas or branding. And some successes become household names, but in recent years this investment market is facing a saturation of web companies. A new investor elite has formed. It includes super-successful asset managers who populate the Forbes magazine list of US billionaires and whose wealth comes from alternative investing. In 2014, 128 such individuals represented some 25% of all American billionaires.
“Madoff’s ostensible legitimacy was enhanced by his time serving as chairman of the board of the NASDAQ, a fact he placed right on the fund’s website.”
The Boom-Bust Nature of Markets
Anyone investing in securities over the course of a generation knows that the values of such holdings undergo periodic booms and busts. The classic temptation of the investor, or the middleman in the financial industry, is to increase returns by using debt in easy-money, low-interest rate environments. Add the temptation of leverage to the human element of periodic overconfidence and speculation, and the result is investment volatility.
“The average hedge fund…[is] certainly not currently outperforming basic market measures of absolute return.”
In the early 2000s, the US housing market became overvalued, driven by hyperleveraging in the aggressive use of derivative financial products. Professionals viewed such innovative forms of securitization as low-risk investments. Additionally, these products spread the risk of mortgages beyond the normal providers of mortgage finance. In doing so, these instruments created a broad market risk that few fully understood and produced “the housing bubble of 2004-2006.” The bust in the housing bubble precipitated the 2008 financial crisis. In the aftermath of the housing crisis, banks’ susceptibility to swings in market confidence and liquidity led to stricter regulations. Because of the general public’s ever-expanding inclusion in investing, lawmakers want to leave riskier investing to hedge funds and private equity firms, which operate outside the credit markets that support the rest of the economy.
“The LIBOR scandal underlines once again that when the incentives for even ever-so-slight deception are so great, some people will succumb to the temptation.”
Some investment risk comes from market participants’ wrongdoing, such as insider trading, fraud and manipulation. As Adam Smith said centuries ago, the joint stock company model itself – the basis of equities – is vulnerable to issues of trust. The positive democratization of investing depends on laws and regulations – and their enforcement. Overall, by the early 21st century, society has achieved robust legal means to uncover and punish such behaviors. But these efforts are ongoing, as is the inventiveness of crooks.
Ponzi schemes are a major category of malfeasance. They crop up in many varieties. Their name comes from American Charles Ponzi who, around 1911, repeatedly “convinced many [people] that he had the means to generate shockingly high returns” in one investment offering after another. Bernie Madoff perpetrated an infamous, large-scale Ponzi scheme in the early 2000s. He collected vast amounts of money from clients and made no investments on their behalf. His management firm eventually became insolvent and he went to jail.
Trading frauds are another major category, exemplified by Nick Leeson of Barings Bank who engaged in rogue trading – unauthorized speculation, nonexistent client trades and false bookkeeping entries – in the 1990s. Many banks took part in manipulating the values that determine the London Interbank Offered Rate (LIBOR), an interest rate banks use in pricing loans. This scandal began in 2005 and went on until 2012.
The Efficient Market Theory
Investment theory aimed at understanding how the market determines asset valuation began around 1900 with a published paper, “Theory of Speculation,” by the French academic Louis Bachelier. The 100-plus years since have seen the evolution of many investment valuation models, each with merits and shortcomings. The Efficient Markets Theory, developed by Eugene Fama in the 1970s, continues to hold sway. The theory “implies that all information, both public and private, is reflected in stock prices.” Its crucial conclusion is that the “market cannot be beaten” systematically and consistently, because it immediately identifies inefficiencies and incidents of mispricing, especially in today’s hyperconnected and hyperinformed financial world. However, some outperformance of the market can occur by random chance or aberration, which explains the huge successes that some funds have achieved. The value of this theory to investors, both professionals and individuals, is in the tools it provides for identifying and understanding systemic risk, not as a method for stock picking.