What do the following developments of the last half-century or so have in common?
1. Mutual funds
2. Modern portfolio theory and index funds
3. Deregulation of the stock brokerage industry
4. No-load mutual funds
5. Tax sheltered accounts (e.g., IRAs)
Each of the above was hailed, at least to some extent, as giving the general public broader access to the potential riches of the stock market. Largely because of these developments, over the last 50 years the public’s participation in the stock market has increased dramatically. Unfortunately, they have also inadvertently combined to engender some profound, and somewhat disturbing, changes in the investment landscape.
Then and NowIn Business 101, my first business course in college, I learned that the stockholders own corporations; the CEO reports to the board of directors who, in turn, “report” to the stockholders. The stockholders have the ultimate authority and provide the ultimate oversight. In my early days as an investor, I owned stock in three companies. I carefully reviewed every quarterly and annual report, and attended every annual meeting. I did this partly out of a sense of responsibility, and partly because if any one of those companies performed poorly it would have a significant impact on my net worth.
In addition, in those days, it was expensive to buy and sell stocks – especially in small amounts. Selling was especially expensive because in addition to paying a commission on the sale, any gains were taxable. The high transaction costs associated with buying and selling acted as a barrier to market participation by the general public; they also encouraged those that did buy to hold their shares for long periods of time – generally years.
Now, most investors own more mutual funds than I owned stocks. Via their mutual funds, most investors own shares in scores of individual companies. The barriers to buying and selling have virtually disappeared. You can buy or sell an unlimited number of shares of stock through a discount broker for less than $10; mutual fund loads are often low or non-existent. Finally, the majority of the average investor’s sales are tax-free since they take place in tax-sheltered accounts.
Unintended Consequence: Oversight RiskOne result of these developments is decreased stockholder oversight. Via their mutual funds, many investors own (a relatively small number of) shares in literally thousands of individual companies. Investors cannot have the level of understanding of, and commitment to, their holdings that I once had. I think it is likely that this reduced attention has contributed to the escalation in “risky behavior” on the part of our corporations. It may well have contributed to the escalation in executive pay as well. Could it be that through such broad diversification we have reduced company and industry risk in our portfolios, but unwittingly contributed to the creation of a new kind of risk -- “oversight risk”?
Unintended Consequence: Increased Speculation and VolatilityAnother result of these developments is increased volatility. Because stockholders know less about and are less committed to the companies they own (directly or indirectly through mutual funds), and because transaction costs are low, the average holding period has decreased dramatically. Partly because investors know little about the companies they own, there is less emphasis on fundamentals, and more emphasis on momentum. We are replacing long-term investors with speculators. In many cases, it would be more accurate to say that individuals bet on, rather than invest in, companies. The result is “hot money” that moves rapidly into whatever asset class, or sub asset class, is in vogue. Since the influx of new money causes prices to rise, the process is self-reinforcing. The result is increased volatility, and asset “bubbles.” Finally, when valuations reach unsustainable levels, crashes inexorably follow as the self-reinforcing process reverses itself.
Theoretically, the mutual fund managers could assume much of the old oversight role; in the real world, few do. Similarly, they have probably increased rather than muted stock market volatility. According to Morningstar, the turnover ratio for the average mutual fund is close to 100%. That means the average holding period is approximately one year – hardly long-term investing.
No Good Deed Goes Unpunished??In summary, developments over the past half-century or so have dramatically increased the general public’s participation in the stock market, as was presumably intended. However, some of the side effects are disturbing. I am not suggesting that these well-intentioned developments are the cause of the current economic crisis or of the stock market crash. However, I do believe they deserve a share of the blame along with investors, fund managers, and many others. The changes have helped cause the situation by effectively reducing the oversight historically provided by the stockholders, and fostering speculation rather than investing. This in turn has resulted in increased risk-taking, increased market volatility, and an increase in the frequency of “asset bubbles” – and their aftermaths.
Public Policy Matters After All, Columbia Journalism Review
The Financial Crisis: the Role of Government, The Becker-Posner Blog
The End of the Financial World as We Know It: New York Times Op-Ed piece by Michael Lewis and David Einhorn.
What Business is Wall Street in? from Mark Cuban's blog.
Last Updated: 9/5/11