Deadly Sin 5: Wealth-Destroying Costs
The returns in our stock market-whatever they may turn out to be-represent the gross returns generated by the publicly owned corporations that dominate our system of competitive capitalism (and by investment in debt obligations). Investors who hold these financial instruments-either directly or through the collective investment programs provided by mutual funds and defined benefit pension plans-receive their returns only after the cost of acquiring them and then trading them back and forth among one another. Don't forget that our financial system is a greedy one, consuming from 1 to 2 percentage points of return, far too large a share of the returns created by our business and economic system. So we must recognize that individual investors and pension funds alike will receive only the net returns, perhaps in the 4 to 5 percent range, after the deduction of those costs. To significantly enhance that return, less conventional portfolios using "alternative" investments will have to deliver returns that far exceed their own historical norms. To say the least, that is one more speculative bet.
Deadly Sin 6: Speculation In The Financial System
Speculation is rife throughout our financial system (and our world). High stock market volatility; risky, often leveraged, derivatives; and extraordinary turnover volumes have exposed the markets to mind-boggling volatility. As I note earlier, some of this hyperactivity is necessary to provide the liquidity that has been the hallmark of the U.S. financial markets. But trading activity has grown into an orgy of speculation that pits one manager against another-one investor (or speculator) against another-a "paper economy" that has, predictably, come to threaten the real economy where our citizens save and invest. It must be obvious that our present economic crisis was, by and large, foisted on Main Street by Wall Street-the mostly innocent public taken to the cleaners, as it were, by the mostly greedy financiers.
Deadly Sin 7: Conflicts Of Interest
Conflicts of interest are rife throughout our financial system: Both the managers of mutual funds that are held in corporate 401(k) plans and the money managers of corporate pension plans face potential conflicts when they hold the shares of the corporations that are their clients. It is hardly beyond imagination that when a money manager votes proxy shares against a company management's recommendation, it might not sit well with company executives who select the plan's provider of investment advice. (There is a debate about the extent to which those conflicts have actually materialized.)
But there's little debate in the mind of Lynn Turner, former chief accountant of the SEC: "Asset managers who are charging corporations a fee to manage their money have a conflict in that they are also trying to attract more money which will increase their revenues, and that money often comes from companies who set up retirement accounts for their employees. There is not disclosure, from the asset manager to the actual investors whose capital is at risk, of the amount of fees they collect from the companies whose management they are voting on. It appears the institutional investors (including managers of mutual funds) may vote their shares at times in their best interests rather than the best interests of those whose money they are managing."
In trade union plans, the conflicts of interest are different, but hardly absent. Insider dealing among union leaders, investment advisors, and money managers has been documented in the press and in the courts. In corporate defined benefit pension plans, corporate senior officers face an obvious short-term conflict between minimizing pension contributions in order to maximize the earnings growth that market participants demand, versus incurring larger pension costs by making timely and adequate contributions to their companies' pension plans in order to assure long-term security for the pension benefits they have promised to their workers. These same forces are at work in pension plans of state and local governments, where the reluctance (or inability) to balance budgets leads to financial engineering-rarely disclosed-in order to justify future benefits.
Extracting Value From Society
Together, these Seven Deadly Sins echo what I've written at length about our absurd and counterproductive financial sector. Here are some excerpts regarding the costs of our financial system that were published in the Winter 2008 issue of Journal of Portfolio Management: "...mutual fund expenses, plus all those fees paid to hedge fund and pension fund managers, to trust companies and to insurance companies, plus their trading costs and investment banking fees ... have soared to all-time highs in 2011. These costs are estimated to total more than $600 billion. Such enormous costs seriously undermine the odds in favor of success for citizens who are accumulating savings for retirement. Alas, the investor feeds at the bottom of the costly food chain of investing, paid only after all the agency costs of investing are deducted from the markets' returns ... Once a profession in which business was subservient, the field of money management has largely become a business in which the profession is subservient. Harvard Business School Professor Rakesh Khurana is right when he defines the standard of conduct for a true professional with these words: '"I will create value for society, rather than extract it.' And yet money management, by definition, extracts value from the returns earned by our business enterprises."
These views are not only mine, and they have applied for a long time. Hear Nobel laureate economist James Tobin, presciently writing in 1984: "...we are throwing more and more of our resources into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity, a 'paper economy' facilitating speculation which is short-sighted and inefficient." (In validating his criticism, Tobin cited the eminent British economist John Maynard Keynes. But he failed to cite Keynes's profound warning, cited earlier, that business enterprise has taken a back seat to financial speculation.) The multiple failings of our flawed financial sector are jeopardizing not only the retirement security of our nation's savers but also the economy in which our entire society participates.
Excerpted with permission of the publisher, Wiley, from The Clash of the Cultures: Investment vs. Speculation by John C. Bogle. Copyright (c) 2012 by John C. Bogle. This book is available at all bookstores and online booksellers. Look for Bogle's solutions to the problems in the November Big Picture column in Financial Advisor magazine.