Chapter Three

Asymmetric Information:

Rocket Science and Investor Illiteracy

The financial censorship and code of silence discussed in the last chapter is a

subset of a larger problem, namely, “asymmetric” or one sided information in the

financial marketplace. By asymmetric information we are referring to the fundamental

and undeniable fact that, compared to individual investors, the financial pros have more

and better information on the markets and the key factors that drive them. They also have

much better resources for analyzing and drawing conclusions from the information they

have. In fact, the inadequate probing and discussion in the financial press of the

importance and impact of asymmetric information is a major manifestation of the

censorship and code of silence in action.

If you think that asymmetric information is really not that important in a

competitive world of perfectly functioning markets, you may want to take note of the fact

that no less august an authority than the Nobel Economic Prize Committee disagrees with

you. It does so to the extent of awarding the 1996 Nobel Prize in Economics to two

professors (William Vickrey of Columbia University and James Mirrlees of the

University of Cambridge) for there research on this very topic of informational

asymmetries.
 The Royal Swedish Academy of Sciences in its announcement of the award on

October 7, 1996 stated the obvious that “Incomplete and asymmetrically distributed

information has fundamental consequences, particularly in the sense that an informational

advantage can often be exploited strategically”1.

(Andrew Lo’s or other research showing the value of 20/20 hindsight over

say 50 years to be presented here)

To choose one concrete illustration among very many, let us examine how a non-

level information field works as it relates to one of today’s hottest topics in the financial

markets, i.e. the initial public offering of stocks, or IPO.

In 1995 there were 576 IPOs valued at $27 billion. These numbers soared to 646

issues with a market value of $38.3 billion just in the first 9 ½ months of 1996 according

to the Securities Data Corporation.2

Stock market lore would have us believe that IPO's offer up the chance to make a

killing. Perhaps.

Doubling and tripling of IPO prices on the first day is not that unusual. (Never

mind that on average- and I stress the word average- IPOs don’t do too well in the long

run).

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 An opportunity for the public to get its fair share of the gains ? Definitely not.

Notwithstanding some crumbs thrown at them, small investors are effectively

locked-out of the IPO market (unless they go indirectly via purchases of mutual funds

that are heavy investors in IPOs). IPO shares, limited in number, are distributed by the

stock underwriters not to small investors but to the underwriters best customers and

friends, most often the big institutional investors and mutual funds managers, who can

then see them rise quickly, and who can sell them for profits before the expected

retracement in price. This happens so often there is even a word for it: spinning, as in

“spinning” (getting and selling) IPO’s for a quick buck..

The underwriters' of IPO's are in the best position of all. They can, and often, do

control how an IPO trades and who gets in and out and who can't get their order

executed. In the words of one astute veteran observer of the market: "Forget about what

you hear about the market being as unpredictable as the weather. An under writer…

knows almost exactly how his stock will perform in the after-market, at least over the

short run. After all, he's looking right at his lists of private placement clients, most-

favored clients, and the second wave of some-what-favored clients. He knows how many

shares of XXX each of these investors is in for. He knows the supply. He knows the

demand. He knows the score."3

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 There is no disputing the numbers. According to a study by Congress’ General

Accounting Office (GAO), only one out of ten IPO underwriters set aside any significant

amount of IPOs for retail investors. The other nine set aide as small as 10% of such

issues for individual investors.4

Are under writers apologetic about this practice? Not at all.

“From a business standpoint, it just pays to take care of our best customers,” said

one Merrill Lynch official who didn’t want to be identified.5 Steven Wallman, a recent

commissioner of the SEC, has a diametrically opposed view. “Its a black-and-white

corporate bribery issue”, he says...”the same as giving a sack of potatoes, a car or a

$10,000 sack of cash”.6

The practice begs several very serious questions. Are the bankers who regularly

arrange IPO deals that rocket up in price right after issuance, discharging their fiduciary

duties correctly? Is it not apparent on the face of it that these stocks are being

systematically underpriced at issuance? Doesn’t this raise a serious question about the

ethics of the participants, not to mention the legality of their actions.

Does this one little manifestation of an uneven playing field in the stock market

cost individual investors anything significant? Of course it does.

4
 According to the calculations of the National Council of Individual Investors

(NCII) of Washington, DC, the capital gains on the $27 billion IPOs issued in 1995 was

about $10.5 billion by the end of that year. Individual owned only 15% of these issues.

A modest rise of individual ownership from 15% to 25% would have meant added gains

of about $1.05 billion for small investors assuming they could get their hands on an

average mix of IPOs. But as Gerri Detweiler, the group’s director has said “As an

investor, there’s no problem getting in on lousy IPOs, but not the really good ones”.7

Multiply these numbers (which represent only one corner of the investment

world) many times over and you begin to get a feel for consequences of the non-level

playing field for Jane and Joe Q. Public’s nest egg.

Here are some examples, just from a period covering a couple of months in 1993,

of information asymmetry in the financial markets working to the detriment of individual

investors. Remember these are just a very small sample of a huge number of potential

examples, but they should give you a taste of what is going on8

- On April 14, in a private meeting, the Chief Financial Officer of Walmart told

60 analysts and institutional investors of a substantial slowdown of same-store sales. By

the close of the market on the same day the market value of the company had dropped by

4 billion dollars (6%) as 14 million shares (four times the normal daily volume) changed

hands. As the pros in the know traded in their shares, small shareholders who did not

have instant access to the information were left in the behind.

5
 - In early March, Dell Computers halted its production of notebook computers

which had been showing weak sales. Michael Dell, Chairman and CEO of the company

sold 240,000 of his shares between March 15 and March 25. Some analysts also got

word of the slacks sales and began selling the shares. It was not until May 25, i.e. three

months later, when the company made the problem known to its general shareholders in

its earnings report. By that time the shares had slide to 24 3/4 from 38 3/8 on the day

Michael Dell began selling his shares.

- In April, Primerica issued 7 million shares of common stock for sale in Europe.

By Law, it was not allowed to announce this to its U.S. shareholders because the share

were not certified for sale domestically. The stock, predictably, nose-dived when the

new shares were issued. It had fallen by 7% on the day of the issue before the SEC

allowed the company to make an announcement. (Rule 144A has a similar effect in that it

allows private sales of equity and debt to qualified domestic investors without the

notifying common stockholders who may see their holdings diluted).

- In May, Imcera Group announced publicly that its animal health care unit was

being restructured. Trading stopped on the company’s shares. But later at an analysts'

conference call, from which the press and public were excluded, more positive news on

other units and operating targets on the animal health care unit were discussed. The

analysts informed their institutional investor clients who purchased the stock before the

consequent rally. The general public was left out.

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 One can’t help but ask why such closed analysts’ meetings should be allowed by

law and why, at least, their results are not immediately and prominently disclosed (as

opposed to being buried in a hard to fathom report issued much later).

It is not surprising then that many financial pros don’t take published earnings

estimates seriously at all. In fact they often ignore them altogether, and instead trade

stocks based on whether the company is beating something called “whisper” earnings

which, as is clear from the name, is what the street talk and rumor is and not what the

public has access to. Meanwhile, the more careful and enterprising of individual

investors are sifting through the very public numbers that the pros largely ignore.

Here is one example of the importance of whisper numbers. On January 14, 1997

Intel reported fourth quarter earnings of $2.13 a share. The published First Call

consensus estimate had been $1.84. Quite straightforward isn’t it? The stock should have

rallied on better than estimated earnings, but in fact it nose dived, because the whisper

had been as high as $2.20 per share. One analyst at Cowen & Co. whose official estimate

had been $1.85 a share downgraded the stock after Intel reported the higher earnings9!

What is the individual investor to do? We’ll have some thoughts in the second part of

this book.

There are plenty of very good reasons to take, not only published analysts’

earnings estimates, but even official company earnings estimates with a grain of salt,

7
thank to complicated accounting code which make legal creative accounting possible

thanks to your friendly (to business that is) Financial Accounting Standards Board

(FASB) and United States Congress.

Just one example of how reported earnings are distorted is case company stock

options. Up until December 15, 1997, U.S. regulations stipulated that a company need

only report the impact of stock options in a footnote of its financial statements, and even

this modest disclosure began only in 1997. The actual reported earnings, i.e. the one that

you and I and everybody else looks at, did not need to take the cost of outstanding stock

options (which are very real financial items) into account. If they did have to here is what

would have happened to the 1996 reported earning of some companies: Netscape down

by 296%, Westinghouse Electric down by 129%, Reynolds Metal down by 18.3%,

Seagram down 17.4%, Armco down 14.3%, UNOCAL down 14.3 % and the list goes on

and on.10.

A new FASB rule that went into effect on December 15, 1997 removes this

distortion, but up until that time companies could abstain from reporting fully diluted

numbers. Were you and I getting distorted numbers for earnings per share over all these

years. The simple answer is yes, very likely that is the case. Was anybody telling this to

us loud enough and repeatedly enough? The answer is no as far as most individual

investors are concerned. Here we have another clear case of the code of silence and

financial censorship that we talked about before.

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 By the time published reports reach the average investor they are obsolete. The

real information is usually acted upon by those in the know before the reports are

published. The reports themselves might cause a short term market movement (no more

than a day or two), but after that they are fully priced in the market and acting on them

could, in fact, be counterproductive.

There is a saying among traders that you should “Buy the rumor and sell the

news”. Once the news is out and published and the suckers are in, then it’s time for the

pros, who are already in the position, to countertrade the amateurs and lock in their

profits. In other words the trick is to be in a position before the market has moved.

Moving with the news in the market is at best very risky, and certainly has a much less

desirable risk/reward tradeoff. We have seen this over and over in our trading

experience.

Forget about the financial press. The news there is positively stale the vast

majority of the time. One of the authors makes it a practice not to read the Wall Street

Journal until the afternoon it is published for the twin reasons that anything in it will be

available elsewhere and fully price in the market (except for an occasional spike) and

frankly because the information is available over the phone and on the various electronic

information delivery services such as Bloomberg, Reuters, Telerate, or Knight Ridder

and, therefore, Wall Street Journal news items for short term trading purposes are more

often than not a waste of time and often counterproductive.

9
 Remember the IPO's that we opened this chapter with? Several studies involving

samples of hundreds of companies show conclusively that many companies issuing stock,

whether in the form of IPO's or later stock issues, use (perfectly legal) accounting

techniques, such as accelerated recognition of earnings and delayed recognition of

expenses, to doll up their earnings just before stock issuance. When this happens, the new

stock pushes up for a while as the good news that was booked early makes its effect felt,

and then it begins to seriously lag the market as the good news fades and the delayed bad

new starts to kick in.

One study of IPO's by (Professor's Teoh, Welch, and Wong) involving 1649

companies that came public from 1985 to 1992 showed that companies, on average,

boosted their net income as a percentage of assets by 50% (from 8% to 12%) in the year

they came public. For the most aggressive companies the boost was from an average loss

of 22% to a gain of 17%; all this by using accounting creatively for discretionary items.

In the words of Professor Welch :"What is surprising to most academics isn't that

companies keep doing this. If it works, it is natural for them to do it. What is surprising is

that investors keep getting fooled by it".11

One extreme form of information asymmetry is when companies, or their direct

agents, lie to the public.

Take the case of Carnation, the famous milk company, which in August 1984

received a $3 billion buyout offer from Nestle. Wall Street somehow heard about it and

10
Carnation’s shares rocketed. Nestle was ready to walk away, so Carnation had one of its

functionaries deny to the media that it was in merger talks, which was patently untrue.

Yet this lie worked. Individual investor sold their shares at 70, while those in the know

kept on to the shares and sold them at 83 the following month12.

As a result of this episode there is now a SEC ruling that companies can’t lie, but

they don’t have to tell the truth about what they are doing either. So asymmetric

information to the extent almost of deception has in become in fact recognized by the

SEC as something legitimate.

Another example is the case of Presstek Corporation, a printing press technology

company, whose chairman and president both agreed to pay civil fines (totaling $2.9

million) to settle SEC charges, without admitting or denying the allegations, that they had

distributed false and misleading information with the objective of pushing Presstek stock

higher. And the company consented to the issuance of an SEC cease and desist order that

barred the company from violating securities laws again13 This is a company that went

from $25 a share in November 1995, to $100 in May 1996 and then nose dived to $32 by

December 1997 (adjusted for splits).

Another practice that has recently increased significantly is the announcement of

company earnings after the close of the market. This allows professionals to trade the

stocks abroad or via computerized trading. And the exchanges have little power to curb

these trades because even if domestic computerized trading during off-hours is curtailed

11
once in a while, foreign affiliates of U.S. brokerages can carry on trading with impunity.

In a business where a few minutes can give rise to major advantages the small investor

who is not linked to an after hours electronic brokerage will be at a major and undeniable

disadvantage as he will only be able to trade on after-hours reports several hours after the

fact and after the pros have had plenty of time to act on the number.

And then there is the issue of insider trading, an evolving field to say the least.

Insider trading refers to the use of non-public information by someone in a position of

trust or confidence. This clearly covers employees and individuals with fiduciary

responsibilities, but the situation is less clear in the case of outsiders who use inside

information, and a recent case of such outsiders went all the way to the Supreme Court

(See below).

What was once illegal dealings on stocks in front of corporate news

announcements, has now metamorphosed into highly leveraged option plays on all kind

of business developments and, particularly, mergers and acquisitions. The field of insider

traders now includes all kinds of other actors, from pros to lawyers, accountants, friends

and relatives of company executives or employees, their psychiatrists, drivers, tender-

offer printers, and so on.

Even Ceasar's wife is not beyond reproach where there is so much money

concerned. The holier than thou Wall Street Journal has been tainted by this odious

practice. Foster Winan, who was the author of the well known and closely followed

12
"Heard on the Street" column, provided advanced information on what was to appear in

his column to his close friends and they went on to make hundreds of thousands of

dollars on the information.

There have been several instance of fund mangers being accused directly or

indirectly of insider trading. On example is that of John Kaweske of Invesco Funds who

was accused of front running the funds he managed by buying securities in certain

companies for himself first and then for the fund. Invesco fired him for sitting on the

boards of some of those companies, which was against Invesco's code of conduct.14

The SEC has alleged that the Monetta Financial Services, the investment adviser

to the well known Monetta Fund and Monetta Trust directed hot IPO's into the personal

accounts of three of the fund's directors. The SEC alleges that this happened 12 times

between February and September of 1993 and that the directors quickly sold these stocks

for ten of thousands of dollars of profit. The lawyers for Monetta and its directors deny

any wrong doing15. Such examples abound, but this small sample should suffice for the

wise.

Since 1988 when the law was changed (making brokerage firms liable for

damages cause by their employees' insider trading) the shift of insider trading to outside

the brokerage firms had become more pronounced. This type of trading is now often done

by difficult to trace foreign banks and institutions.

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 However, even the law is written to allow insider trading in specific instances.

One example is Regulation S whereby foreigners are allowed to buy unregistered shares

of U.S. companies without these share having to be listed or reported. Reg S shares

usually are priced at a 10-50% discount compared to domestic shares. This means

American shareholders are often subjected to serious dilution of their holdings without

even knowing it. The potential for abuse of such an asymmetry of information and

unevenness of access is very easy to see.

How widespread is insider trading? “Every single merger (emphasis ours) these

days, you see insider trading” says Harrison Roth, who is senior options strategist and

first vice president at Cowen & Co. “There’s always somebody who knows something,

and they want to put money in their pocket”. Given the enormous leverage they can

generate, options are the insider traders’ new vehicle of choice and so Mr. Roth, being an

option specialist, knows what he is talking about.

Gene G. Marcial who, seemingly forever, has been writing Business Week’s

Inside Wall Street column puts it succinctly:

“Unethical and sometimes illegal insider trading abounds. It happens daily,

hourly, every minute of every day, and sometimes on Sunday too”.16 (Emphasis ours).

Exchanges and regulators do try to identify suspicious trading patterns, or to be

more precise, patterns that warrant further attention. They have computers that sift the

14
data attempting to do the detective work. An example of such a pattern meriting further

attention is when on April 4, 1997 (a Friday) trading in calls of Alex. Brown expiring in

April and May jumped from less that 500 per day to 2953, and on the very nest trading

day (Monday, April 7) Bankers Trust announced that it was buying Alex. Brown. Mere

coincidence? Another example of activity that might draw attention is that on April 8,

1997 trading in call options of Proctor and Gamble expiring in 1997 jumped to 4395

options more than four times the normal volume in that month. On the next day, April 9,

1997 Proctor and Gamble announced that it was buying Tambrands.17

How many of bad guys do the regulators catch? The numbers of cases detected

by regulators as being suspicious has been on a sharp rise, but the numbers are still

minute. There were 121 cases referred to the SEC by the NASDAQ in 1996 and 41 by

the new York stock Exchange. These 169 cases are about double the number for the

(relatively low) year of 1992, and exceed records set in the go-go insider trading ‘80s.

The number of insider trading case brought by the SEC has however remained fairly

constant at about 35 to 45 in the last decade.18

Unfortunately, when the SEC detects a case of possible insider trading the odds

are that all it will do is to announce that an investigation is underway and that will be the

end of it. In a few cases a report is also issued. Why? Limited resources? Why not put

in more resources? 35-45 insider cases brought each year simply means that uncounted

many more get away with this harmful behavior.

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 The S.E.C.’s ability to try to prevent insider trading dodged a very real bullet in

June 1997. That is when the Supreme Court upheld the insider trading conviction of an

attorney who made $4.3 million trading in stock options of the Pillsbury Company after

learning that a client of his firm ,Grand Metropolitan P.L.C., planned a take over of

Pillsbury. The lawyer had no direct connection to Pillsbury, and so he was not, strictly

speaking, an insider. The conviction had been obtained based on an approach called the

“misappropriation theory” where non-company insiders (psychiatrists, printers, lawyers,

drivers, etc.) can be prosecuted, and have been for several years, for trading based on

non-public information.

The Federal Court of appeals for the Eight Circuit in St. Louis, had overturned the

conviction, saying the SEC approach was unauthorized by Congress. The vote of the

Supreme Court was 6-3 to uphold the conviction, but it did leave one loophole. It stated

that if an outsider discloses that he or she is trading using non-public information, then

that outsider can’t be charged with insider trading.

This was the second time the Supreme Court had considered such an issue. The

last time was in 1987 when it split 4-4 on the misappropriation theory in a case involving

the Wall Street Journal reporter.19 If this second time the Court had not upheld the

conviction in the Pillsbury case, then would have been open season on outsiders’ insider

trading.

16
 There are those who actually defend insider trading on the ground that it makes

markets more efficient. The argument is that insider information is real information, and

stocks that are affected by insider information are affected by more information than

would be the case otherwise. By reflecting information more fully, the argument goes,

insider information improves the working of the markets and thus benefits market

participants as a whole including, presumably, those who are outsiders. There are several

variations of this argument. And there are a number of respected academics, refereed

journal articles and books that extol the virtues of insider trading.20

The best known academic theory used for `justifying insider trading (plus such

other financial gun-slinging as unregulated mergers and acquisitions and leveraged buy-

out) is the so call "Market for Corporate Control Theory" (hereinafter MCC).21 This

theory, which is an offshoot of the neoclassical model, basically says that the markets are

always efficient. In other words they will deal with all kinds of behavior including insider

trading efficiently. The invisible hand will take care of the excesses of insider trading,

and in any case the price of the security accurately reflects all information that is

pertinent, whether insider or not.

As mentioned, some residents of the ivory tower, and many financial

professionals, even go as far as to say insider trading even increases the allocative

efficiency of markets because it means that there is some added information flow (among

insiders) where there previously was none. Some defenders of insider trading go as far as

to quote Saint Thomas Aquinas to argue that such a practice is ethical.22

17
 If you think these arguments ring hollow you are not alone. If the market price

reflects all pertinent information, then why would anybody pay for the legion of analysts

that toil away in the bowels of the financial system? If insider information doesn't give

any long run advantages to the insiders why do so many people risk becoming felons to

utilize such information.

However, to be fair, there are studies that show that market prices adjust quickly

to what is identified as insider trading days.23 To paraphrase the old Lincolnian saying, it

seems "You can fool some of the people in the market all of the time, and all of the

people in the market some of the time, but you can't fool all of the people in the market

all of the time", to which the insider might rely "If you can fool some of the people in the

market some of the time, ..then that's plenty enough to make you rich".

We believe it fair to say that, in the overwhelming majority of cases, the gains to

the insiders have to come out of unaware investors' hide. At the risk of overdoing it, there

is another folk saying that forces itself on the mind here: "If you are playing poker, and

you can't tell who the sucker at the table is, then it's you".

If insider trading is bad on the face of it, if its real function is to limit and

misallocate information, if it leads to misallocations of resources, if it impacts the

distribution of wealth to the insiders from the rest of us, if it causes manufactured

18
volatility in the market place, then what’s even worse is than real insider information is

fake insider information.

Fake insider information is often indistinguishable from the real thing and also

moves markets and prices, all to the detriment of those who are not insiders. And faking

insider information happens more often than you may think, as stories are planted here an

day every hour of ever day for short term manipulation of the market and more. Every

trader of every instrument, and every gambler on the ponies can tell you how often these

insider tips turn out to be out and out plants.

The insider trader can be much closer to you than you think. As close as your

trusted broker. After all the nature of the relationship is that when you want to do a trade,

you place an order at a price with a broker, who then goes out and executes it for you.

Say you place an order to buy a certain share at 50. What you have done, if the

broker is not 100% scrupulous, is to give her a free put to you at 50. If within a

reasonable period of time the stock goes down a little say to 49, the broker can buy it at

that price and sell it to your at 50 as you had instructed. If your broker comes back and

says your order was executed at say 50¼ you probably wouldn’t make too much of a

fuss either (unless you order had a very clear limit order). If the share never trades below

50, your order is not executed and that is that. So by the nature of the relationship,

whereby your broker knows at what price you stand ready to trade, she may have the

opportunity to make some money off of you. Insider trading can be very close to home.

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 The rules on the various exchanges are not consistent when it comes to insider

trading. Much of what the specialists (brokers' brokers on the floor of the exchanges) can

and cannot do is not covered by the securities laws but by rules and prohibitions on the

New York and American Stock Exchanges. But the rules are much more lax on the

NASDAQ and so behavior prohibited on the other two exchanges is allowed on the

NASDAQ. Caveat Emptor.

It goes without saying that if things are bad in the U.S. with its tradition of an

active SEC, then they are much worse in the emerging markets of Asia, Europe, and

Latin America which generally lack effective rules and regulators, and even in the

developed countries of Western Europe (with the possible exception of the UK) and

Japan.

In Japan, e.g., anything goes accounting leads to misleading balance sheets and

income statements and cloaks company financial results in such secrecy that foreign

investors, particularly foolhardy individual investors, are simply throwing their money at

individual stocks in dark, whether they realize this or not.

You might think that the asymmetry of information should not extend to official

government data, especially in this age of instant communications where everyone can

know the latest numbers as soon as they come out. Think again. It’s not unknown for the

market to trade on an upcoming number on the rumor of a leak in the number, but

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evidence is very hard to come by of this. Except that there is one very hard and

undeniable piece of evidence that no one can deny.

One of the most important, perhaps the most important for traders, economic

number published by the government is the monthly employment number which usually

comes out at half past eight in the morning on the first Friday of each month. The number

is awaited with great anticipation It often causes great volatility in the markets, and helps

set the tone for the rest of the month. Knowledge of the number before its publication can

be worth millions to the wrong people, and so the people who prepare it (The Bureau of

Labor Statistics of the Department of Labor) go to extreme measures, including

sequestering staff, to ensure the number is kept confidential until official publication

time.

The same Bureau of Labor Statistics people each week publish seasonally

adjusted jobless claims numbers, which although not as important as the monthly

employment numbers are just as confidential and can impact the number. In April 1997

two days before they were published the numbers appeared on an Internet web site24. A

Labor Department spokesman couldn’t immediately explain why. A single isolated

incident? Probably. A cause of concern? Certainly. Could other numbers leak in some

way without the rest of us hearing about it? Never say never.

If we examine how government numbers are complied we will even have less

faith in their accuracy. Take for example the all important Consumer Price Index or CPI.

21
For the general public as a whole, the CPI is the most important piece of economic data

that the government publishes. Not only do bond markets and equity markets take it very

seriously and react to it, a lot peoples' wages and pensions, including Social Security

checks are directly tied to it, as are income tax exemptions and deductions, food stamps,

school lunches, and on and on and on.

How is this number is calculated and how good it is? Second part of the question

first. Several prominent economists have declared that the CPI has been exaggerating

inflation by 1.1% for several years.25 In a 2.5 - 4% inflation regime that has existed in

recent years that is an up to 40% error rate in the number. So much for accuracy of the

number and the meaningfulness of the discussions market economists among themselves

and in the electronic and print media about the significance of tenths of percentage

changes in the CPI on the general prospects for the economy and by extension stocks and

bonds. These changes are well within the margin of error of the calculation and while

they might not tell us anything very accurate and significant, they become important

because the professional economists make so much noise about them and because a

significant fraction of traders is always looking for an excuse to move the market. For

speculators volatility, for any reason, means the potential for generating profits.

There are all kinds of theoretical problems with how the number is calculated:

inadequate accounting for elasticity of demand and substitution among various products

inside and outside the basket of goods which is use to calculate the CPI, the effect the

22
venue of purchase on the price; or improvements in product quality; or changes in

consumption patterns, and so on.

And then there is the old issue of garbage in, garbage out. You feed a computer

questionable data and the computer and the statisticians do all kinds of fancy things to

this questionable data, and what you inevitably get will be of questionable validity.

Let’s see how the raw data (the garbage in) used to calculate the CPI (the garbage

out) is gathered. The data for this number that move the markets and determines raises

for workers and social security recipients and the pricing policy of firms among others is

gathered by an army of part time workers, on flex time, who make about $13 an hour and

who go from store to store to gather prices on a predetermined set of goods. And who do

they get these prices from? More often than not it is minimum wage or close to minimum

wages sales clerks. Ah, if only that 17 year old high school drop out knew what power

his answer wields! And what items do these price gatherers gather prices on? A market

basket of 207 categories. You might think that given the fast and furious development of

new products these categories would be updated once very few months. You might think

so and you would be wrong. The basket is updated once every ten years! And

improvements in quality? You don’t really expect the complex relationship between cost

and quality to be adequately addressed in such a system, do you? No? Good, because

they are not. To wit, more than a few theoretical and practical problems dog the

calculation of CPI. Garbage in, garbage out.

23
 What about something as apparently straightforward as the Dow Jones Industrial

Average. Surely this well advertised number doesn’t mislead. But it does. It tells you

only what thirty stock have done. Stocks that have been chosen, by the editors of the

Wall Street Journal, since 1928 as representing the cream of the stock market crop.

Stocks are added and dropped to the index at their whim. Usually laggards from mature

or dying industries are dropped, and up and coming industries or firms are added in.

For example in 1997, Woolworth, Westinghouse Electric, Bethlehem Steel, and

Texaco were dropped, and Wal-Mart Stores, Travelers, Johnson & Johnson, and Hewlett-

Packard took their place26. Maybe these adjustments are unavoidable, but they are

somewhat arbitrary and the decisions are unaccounted for and make the picture

somewhat more rosy than it would be. This is because strong firms are never replaced

with laggards. Maybe there should be a cause of some concern when this arbitrariness

applies to the perhaps most widely followed financial figure in the world. And then there

is also the sectoral bias of the Dow Industrial Index or any other index that one has to

take into consideration. If you want to see what the technology sector is doing, the

NASDAQ index is a lot better than the Dow. The S&P 500 will give a broader picture.

The Russell 2000 index will tell you what small cap stocks are doing as sector. The

Wilshire..... You get the drift.

And now to some more information asymmetry problems. Prospectuses written

by companies and fund mangers are often so obtuse as to be unreadable. This prompted

the S.E.C. to pass a rule in January 1998 requiring the use of simple English in the cover

24
page, summary, and risk factor sections of prospectuses. It may have taken a few decades

too long to do this, but better late than never.

However, even when the individual investor is presented with the most basic and

apparently straightforward and understandable data, all is not what it appears to be. For

example, take all those advertisements and prospectuses that talk about fund average

returns over a specific period of time. Such reporting suffers from all kinds of

shortcomings. Small funds returns can be inflated very easily by support from the parent

company, a funds returns could be very different depending how long and over what part

of the reporting period the investor has been in it, there is no guarantee that history will

repeat itself, and so on.

A hypothetical illustration of this might be a new fund with very small assets

whose uses its membership in a big fund family to achieve outsized returns and as a

result draws in say 1000 times the original funds. As a result of the larger and more “real

world’ size of the fund, the parent can no longer effectively sponsor and artificially boost

returns so the fund returns the market average, or let’s say below average, returns for the

bulk of the money. The way fund returns are currently reported, the fund would show a

high return since inception while in reality only the few shareholders who were in the

fund right from the beginning would have had good returns and the rest would have had

below average returns. In slightly more technical terms the reported average returns are

time weighted, not asset weighted. They show the returns to an average share not an

average shareholder, and so they don’t give the complete picture.

25
 Another example that makes clear how published numbers are misleading is what

happened to fund returns after the October 1987 ten year anniversary passed. Funds

suddenly found their 10 year average returns jumping by several percentage points just

because the October 1987 set back had been remove from the calculation of returns.

According to CDA/Wiesenberger, a fund research firm in Rockville, Maryland, the

overnight jump in average ten year returns for a sample of well known funds was as

follows: American Century-20th Century Vista from 10.6% to 15.4%, Brandywine

16.2% to 21.6%, CGM Capital Development 16.9% to 22.0%, Delaware Trend (A

Shares) 14.9% to 20.1%, Fidelity Select Brokerage 13.9% t0 19.7%, Invesco Strategic

Technology 18.1% to 24 %, and the list goes on27. Did these funds suddenly become so

much better overnight? Of course not. Is just a statistical fluke? Yes. Can it mislead the

unsophisticated (or sophisticated but too lazy or too busy to investigate) investor? Most

certainly yes.

We can go on and on about how published, and audited, fund figures can be

misleading. Does a funds’ long term track record tell you anything if the manger or the

strategy and style have changed? What about the legal practice of citing a managers

track record at a previous fund, or including the funds return when it was a non-fund

(such as a limited partnership), another perfectly legal but misleading practice? Or the

practice of cherry picking (out of a large set of possible periods) which period to report

so the fund looks good. Have you noticed how many funds report in their ads that they

are #1?

26
 Sometimes the cherry picking borders on the unethical if not illegal. Beginning

on April 1, 1997 (an apt choice of date as you will see) Merrill Lynch ran ads in the Wall

Street Journal and 28 other papers saying that if investors had been in Merrill’s Defined

Asset Funds Equity Income Fund Select S&P Industrial Portfolio they would have

outperformed the S&P by “over 60 percent”, emphasizing that it had a “Time Tested

Track Record”28. The fact is that the ads offer investor false comfort. They refer not to

actual fund performance but the results of a hypothetical backtesting of an index fund

that did not even exist over the period which the ads boast about. Talk about the benefits

of 20/20 hindsight and the endless possibilities and cherry picking an fiddling around

until you stumble upon and can pitch a strategy that would have done well! And its all

perfectly legal and Merrill Lynch is by no means alone in this practice.

Take as another example how funds are named. Often fund names are completely

misleading. Truth in labeling does not reach as far as fund names, and the S.E.C. would

do well to take a leaf out of the Food and Drug Administration's labeling rules on this

one. Growth, value, balanced, foreign and so on are terms that are ill defined and leave a

lot of room for interpretation, maneuver, and manipulation by fund managers. Don’t be

surprised if your global fund has a very large chunk of its holdings in the U.S. or if your

blue chip fund is riddle with risky foreign or medium-size company stock.

One study by Stephen Brown of New York University’s Stern School of Business

and Yale’s William N. Goetzmann found evidence of poorly performing mutual funds

27
changing their names and then reporting much better performance against their new

sectoral benchmark, for the very same time period and performance data! “Maybe we

have allowed funds too much flexibility” confesses Barry Barbash, director of the

investment management division of the S.E.C.29 and this is one are where the SEC will

probably tighten the rules.

The above illustrations are in and of themselves also slightly misleading. The

biggest asymmetry of information is not that individual investors don’t have timely and

accurate access to vital information, true as this statement is. The biggest asymmetry,

frankly, is that they most individual investors don't know what to do with whatever

information that is doled out to them.. You might think that this is a very arrogant

statement. But please read the following and then see if you still think it is arrogant or

just a plain statement of the truth.

The fact is that the asymmetry, or unevenness, of information utilization comes

about in two ways. On the one hand there is the vast array of information sources

available to the pros, not the least of which is the assorted forms of legal, questionable,

and illegal insider information, plus their access to resources to analyze this information

effectively and rapidly. On the other is, to put it bluntly, the financial illiteracy of

individual investors and their inability to properly analyze even the modest and stale

information that is available to them.

28
 As a transition to this topic, and just for the fun of it, let’s look at one puzzling

example of investor behavior in the face of clear and unambiguous data. The Steadman

Group of mutual funds is well known on the Street; not because of it’s consistent

outperformance of the market, but because of it's consistent underperformance. In the

five years up to April 1997, in the midst of a massive bull market three out of four funds

in the family lost money. While the S&P 500 (including dividends) had a total return of

108% during this period Steadman Technology and Growth lost 78%, Steadman

American Industry lost 53%, Steadman Investment lost 46%, and Steadman Associated

managed to gain a mere 3%.30

The first three funds rank as the worst performing funds in the country. According

to Lipper Analytical Services, at every quarter end since June 1994 one or another

Steadman fund has been the worst performing fund in the country over the last 10 year

period. Such consistency is truly unique. The best performers routinely rotate among

different fund managers. One is strongly tempted to counter trade the 82 year old Mr.

Charles Steadman. What a lot of people have sensibly done is leave the funds. As a result

in January 1997 two of the funds reported expenses of 25% of assets per year compared

to 1% to 2% for the typical stock fund.

With such negative performance and large expenses you would think all investors

would leave the Steadman family of funds in a blink of an eye, even before its Board of

Directors fires the fund adviser (which somehow it hasn’t). But the fact is that according

to Morningstar Investor as of September 30, 1997 investors had left $8 million for Mr.

29
Steadman to manage in! Maybe there’s some tax game, or client loyalty to Mr. Steadman

who has been in this business for 30 years. Maybe the clients are dead. Who knows?

Most of the readers of this book will probably think that this problem would not

apply to them. While they might concede that they could use some additional investment

expertise, they do not feel a glaring weakness in their understanding of financial markets

as it relates to their own particular investments. Maybe they are right. Maybe the very

fact that they have picked up this book means that they are a concerned and self-selected

sample of people who are striving to improve their financial knowledge. Maybe.

Be that as it may, it’s good to examine what a recent national survey has

discovered about this issue.

The Virginia based Investment Protection Trust commissioned the Princeton

Survey Research Associates to conduct a nationwide “Investor Knowledge Index

Survey”. In January 1996, 1,001 individual investors (not the uninterested general

public) were asked some very basic questions to get an idea about their investment

knowledge and habits.

This is how Barbara Roper of the Consumer Federation of America characterizes

the survey results:

30
 “The appalling lack of basic financial knowledge revealed by this survey calls

into serious question the ability of most Americans to make sound, informed financial

decisions”.31

Mark Griffin a trustee of the survey’s sponsor and director of the Securities

Division of the Utah Department of Commerce, suggests that the situation for women and

retirees is even worse as these individual fared more poorly than other groups in

answering the questions. This is what he concludes:

“This data suggests that millions of investors, particularly women and older

investors, are ‘sitting ducks’ for investment fraud and abuse”.32

Sitting ducks.

Think about it. While your at it why don’t you give a shot at answering the eight

simple questions that constituted the survey. Here they are33:

1. Over a period of time spanning the past 30 years, from 1965 to 1995, which of

the following types of investments do you think generally gave the highest

rate of return: stocks, bonds, savings accounts or certificates of deposit?

2. As far as you know, when an investors diversifies his investments, does his

risk of losing money increase or decrease?

31
3. Please tell me whether you think the following statement is true or false: A

“no-load” mutual fund involves no sales charges or other fees.

4. As far as you know, if you lose money in a mutual fund you invested in a

bank, will the F.D.I.C., that is the Federal Deposit Insurance Corporation,

cover your losses?

5. Please tell me whether you think the following statement is true or false: The

Securities Investor Protection Corporation, known as “SIPCO”, protects your

investments up to $500,000 if the stock market goes down.

6. From what you know, when interest rates go up, what usually happens to the

price of bonds? Do bond prices usually go up, go down or do they stay about

the same?

7. How do you think most full-service brokers and financial planners are paid?

Are they mainly paid: A) based on the quality of the advice they offer and

how much their clients earn?; or B) based on the amount and type of

investments they sell to their clients?

8. As far as you know, what is a “blue-chip” stock? Is it: A) a stock offered by a

high-tech company; B) the stock of an established company with a history of

paying dividends; or C) a low-priced security usually trading for less than a

dollar a share?

These are really very elementary questions. Anyone with a passing

knowledge of investments should know all the answers without any difficulty.

32
 (Question number seven is my favorite and suggests that instead of a

variety of “discount” and “full service” brokers that have proliferated, what is

needed are value added brokers who would get paid nothing - with the exception

of out of pocket execution costs - if their clients did not make money following

the advice they provide).

Here’s how the investors (i.e. people who have actually gone out and

made some investments) fared in the survey:

Only 18% could answer at least seven of these eight very basic questions.

This points to a huge gap in knowledge of the very basics of investment. Fully

one third could not even answer four questions correctly! (Sitting ducks).

So there is an undeniable gap in both information and knowledge (by

which we mean knowing how to use that information). There is a striking failure

of training and knowledge transfer in this much touted age of information. There

is also a prima facie case that the investment knowledge field is not level even as

far as the ABC’s are concerned, let alone more sophisticated information and the

very considerable traffic in insider information that exists (much of it illegal).

Here are some other zingers from the survey:

33
 „ 62% of investors thought no-load funds involve no sales charges or fee

(Which would imply that the financial industry offers them out of the

goodness of their heart). The truth is that all mutual funds impose a fee of one

sort or another;

„ Almost half the respondents (49%) did not know that diversification is

undertaken primarily to reduce risk.

„ 45% thought that the Securities Investor Protection Corporation protects

investments up to $500,00 if the market goes down!

„ Only 35% knew that when interest rates go up prices of most bonds go down.

(Since bonds are where the most risk averse investors do a lot of investing this

lack of basic knowledge has some important implications for people’s

financial well being).34

Who or what is this IPT, this protector of the average investor David against the

financial Goliaths? The money for the IPT came from Salomon. No not King Solomon

the 10th century b.c. king and David’s son, but Salomon Brothers the New York Goliath

(now Solomon Smith Barney under the ownership the Travelers insurance group). The

Investor Protection Trust was founded in 1993 as part of a multi-state settlement to

resolve charges of misconduct on the part of this leading Wall Street firm.35

Arthur Levitt, Jr., Chairman of the Securities and Exchange Commission, has

summed up the situation well when he said in a speech on May 22, 1996 that “there is a

wide gap between [individuals’] financial knowledge and their financial responsibility”.36

34
 And these individual investors, many of whom we have just seen leave something

to de desired in the area of financial expertise, are faced on the other side with the rocket

scientists of the financial industry who have the benefit of the computers and inside

information and the huge financial and other resources of their wall Street Corporations

behind them. The old David had a much easier task with his Goliath.

Let’s close this chapter with some quotes at length from one man in the know.

Someone who has himself become a giant in the financial industry by pointing out some

of the very things we are trying to say here, and offering products to relieve part, but just

part, of the problem.

John Bogle, who is Chairman of the colossal mutual fund company Vanguard, the

second largest fund group in the United States, has this to say:

On the role of the press and the control of information: “Since the role of the

press is to shine a light on the significant events of the day, it’s fair to ask why so many

facets of the mutual fund business are hidden in darkness”37

35
 On the utility of the mass of information in the press: "Numbers should not be

confused with knowledge. Too much is also made of the ephemeral events of the day,

such as the latest “hot funds”... it hardly qualifies as a step on the road to wisdom; indeed

such reportage may take us in the opposite direction".38

On the track record of the press: “..is it too much to suggest that an obligation

then exists to periodically revisit these favorites [of the press]?” He gives some examples

of how the press fails to do so: One magazine e.g. publishes an honor role of funds that

substantially underperforms the Wilshire 500 index (including in the last 12 of 13 years);

another magazine pronounces itself “..reasonably content with our earlier selections”, but

fails to mention that the ten funds it chose had a returns in the previous year of only two-

thirds of what the S&P 500 index returned; another newspaper has an ongoing

competition between five well known investment advisers and loudly proclaims who has

won in each quarter, but fails to mention that over the life of the contest even the top

performing advisor has fallen short of a the S&P 500 index.39

Mr. Bogle correctly calls for more self criticism by the press. “Such self appraisal

would increase public skepticism about the ease of picking the winners. And that would

be the beginning of wisdom” (emphasis ours)40

On the utility of the new mutual fund “supermarkets”: “There is no question that

supermarkets contribute to the casino mentality, because it appears to be “free”. Yet they

are anything but free”. He added that speculation leads to increased trading and higher

36
trading costs that are borne by all investors in a fund whether they trade often or not. And

fund companies pay the supermarkets distribution fees to get their funds on the shelves

and investors finally pay for those fees.41

On the costs borne by investors: "I estimate the annual cost paid by mutual-fund

shareholders have risen from $320 million to $16 billion”42 over the last 15 years far

outstripping the growth in assets in mutual funds".

On the benefits to investors: “High fees are paying for huge profits to fund

mangers...., who as a group are consistently underperforming the financial markets in

which they participate”

On whether the supermarket owners’ put their money where their mouth is:

“Maybe its my Calvinist streak, by I am troubled by the idea that one’s personal

principles can so blatantly contradicts one’s business principles”. Later he confirmed

that he was referring to Charles Schwab who he sees as valuing long term investments for

himself but creating a firm based on the opposing strategies of “Switch and get rich” and

“Pick hot managers”.43

Enough said.

37
1
Kungl. Vetenskapsakademien, October 7, 1996
2
Quoted in an Associated Press story in USA TODAY-ONLINE, IPO really means’ important people
only’, October 22, 1996
3
Gene G. Marcial, The Secrets of the Street, McGraw Hill, 1995, p. 176.
4
Ibid.
5
Ibid.
6
Quoted in Michael Siconolfi, SEC Broadens Spinning Probe to Corporations”, Wall Street Journal,
December 24, 1997, p. C1.
7
Associated Press, Ibid.
8
The following examples are from Failure to Disclose, Bloomberg Magazine, September 1993, pp. 42-49.
9
Greg Ip, Traders laugh Off the Official estimate on earnings, Act on Whispered Number, Wall Street
Journal, January 16, 1997 p. C1.
10
Roger Lowenstein, Coming Clean on Company Stock Options, Wall Street Journal, June 26, 1997, p. C1.
11
E.S. Browning, IPO's Often Come Dressed Up With Best Figures, Studies Say, Wall Street Journal,
March 10, 1998, p C1.
12
Ed Leefeldt, The Economical Truth, Blooomberg Magazine, September 1995, p. 8.
13
Floyd Norris, 2 at Presstek Pay S.E.C. Penalties of $2.9 Million, New York Times, December 23, 1997,
p. D1
14
Calian, Sara, and McGee, Suzanne, Kaweske Gained from Stock Picking Long Before His Funds, Wall
Street Journal, January 17, 1994 pp. C1.
15
Michel Siconolfi and Robert McGough, SEC Case Against Fun firm may Influence "Spinning" probe,
Wall street Journal, March 2, 1998, p. C.2.
16
Gene G. Marcial, Secrets of the Street: The Dark Side of Making Money, McGraw-Hill, New York,
1995, p.6
17
Jonathan Fuerbringer, Mr. Boesky Goes to Main Street, New York Times, April 16, 1997, p. D1.
18
Ibid.
19
Edward Felsenthal, Big weapon Against Insider Trading is Upheld, New York Times, June 26, 1997, p.
C1.
20
See e.g. Manne, Insider Trading and the Stock Market, New York, The Free press, 1966, Chapters 10
and 11. Also see Deryl Martin and Jeffrey H. Peterson, Insider trading revisited, Journal of Business
ethics, 10, 1991, pp. 57-61.
21
For a discussion of MCC see Wehane, Patricia H., Ethical Issues in Financial markets: The American
Experience in Argandona, Antonio (ed.), The Ethical dimensions of Financial institutions and Markets,
Springer, Berlin-Heidelberg, 1995, pp 136-163.
22
McGee (1988) p 37., about AQUINAs, Summa theologiae, II-II, q. 77, art. 3 (4) quoted in Koslowski,
Peter, The Ethics of Banking, in Argandona (ed.), Ibid, p 212.
23
Meulbroek, Lisa K., An Empirical Analysis of Insider Trading, Journal of Finance, Vol. 47, No.5 pp
1661-1700, 1992.
24
CNNfn, April 29, 1997; 8.02 p.m. ET.
25
Christina Duff, Eyes on the Price,Wall Street Journal, January 16, 1997 p. A1.
26
Daniel Kadlec, Doctoring the Dow, Time, March 24, 1997 p66.
27
Karen Damato, Many Funds’ 10-Year Figures to Get a Lift, Wall Street Journal, July 9, 1997 p C.1
28
Susan Antilla, Marketing the Index That Never Was, Bloomberg magazine, July 1997, p. 95.
29
Gregory J. Millman, First pop the hood, U.S. News and World Report, February 3, 1997 p 70.
30
Robert McGough, At Dead-Last Steadman, Past is Prologue, Wall Street Journal April 15, 1997, p. C1
31
Scott Bernard Nelson, Many investors remain easy targets for fraud and abuse, survey finds, Kiplinger
Online, May 14, 1996.
32
Investor Protection Trust, Survey, Ibid.
33
Survey Questions as reported in Nelson, Ibid.
34
Here are the answers to the survey questions: Stocks; Decrease; False; No; False; Bond prices go down;
Based on the amount and type of investments they sell; Stock of an established company with a history of
paying dividends.

38
35
Survey, Ibid.
36
Quoted in Business Week., June 3, 1996, Ibid.
37
John C. Bogle, “A Plea to the Press”, Bloomberg Personal, May/June 1997, p. 40.
38
Ibid, p. 41.
39
Ibid pp. 41-42
40
Ibid. p 42.
41
Elen E. Scultz, “Bogle Assails Mutual Fund ‘Supermarkets’”, Wall Street Journal, November 12, 1996
p C1.
42
Ibid
43
Ibid.

39