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Regulations Matter

Regulations Matter

Treacherous Waters

The two pillars guiding our investment philosophy:

  • Everyclient’s money reflects someone’s deep effort to create that 
    • Webalance capital preservation against keeping up with the overall 
  • The money we manage provides a vital tool for smoothing life’s rough spots as well as providing a base for acquiring critical assets (e.g. home or a business).
    • That money needs to be reasonably available when clients need 

Bearing these in mind, our strategy vastly prefers tried-and-true investments over the latest innovations enthralling many investors. However, even the tried-and-true need clear rules-of-the-road to avoid the ambushes and traps that can ruin an account.

 

Securities Regulation is Necessary for Investors

Recently, the Chairman of the Securities and Exchange Commission (the SEC) submitted his resignation. The new President wants an SEC chairman who will reduce regulation and embrace crypto trading. Gary Gensler stood clearly against these developments so was expected to happen.

Going back to our viewpoint on risk, here’s a case where we assess the risk rhymes with the rich history of securities regulation. We remind everyone once again that Wall St. is not any investor’s friend so much as the marketplace for more efficient transactions.

 

Why We Need Rules

Any healthy marketplace requires a diversity of views and players to function efficiently. By contrast, imagine a world where everyone holds the same view. In that world, there is no one to sell any stock when everyone believes they need to own it. Without differing opinions, views and agendas, we lose the delicate balance healthy competition brings to an efficient marketplace.

To create that diversity in our past, we embraced a “buyer beware” concept for all stock transactions that assumed adults could be trusted to make rational investing decisions. With fewer rules, we expected healthy opinion diversity to keep markets reasonably rational; however, without the education necessary for all investors to make those assumed better choices, trouble reared its head.

Over the 1920’s, naïve investors plus few safety rules created more of a carnival than a stock market. In those days, almost any investor could buy a share of stock, then borrow money against the current price of that share to buy another share of stock and so on and so on (known as leveraging one’s investments) through “margin loans.”

By 1929, so many “new” investors had borrowed so much money against the value of their stocks that any pullback in the market would trigger a margin loan repayment tsunami. Those initial repayments would further trigger mindless stock selling that left nearly every margin borrower completely wiped out.

Note: Any time the market closes with a stock price below the margin on a loan backed by the price of that security, the lender requires the borrower to post more stock/money or the lender sells the security the next day. Margin loans still exist, and are strictly limited as to who and how much any investor can borrow to avoid another 1929.

When 1929 stock prices inevitably cycled downward, margin loan liquidations pressured all stocks, which triggered even more margin loan liquidations. Each time a loan was called, the stock backing that loan was sold for any price in the market. With far more sellers than buyers, nothing stopped prices from falling far further than would have happened in today’s better regulated markets.

In the resulting chaos, many people went bankrupt, we had the Great Depression and Congress enacted various new securities rules to address the weaknesses. One of these required lending banks to exit most aspects of the securities business for tighter discipline in stock markets; and it worked very well for many decades.

In the 1990’s, as large international banks were able to out-compete US banks who were barred from engaging in the US securities business, we felt increasing pressure to deregulate pieces of the system the kept us safe for so long. Within almost a decade of allowing US banks to participate fully in the securities business, we experienced the worst recession since 1929.

With fewer rules to protect investors, banks exploited a hole in sub-prime (or crappy credit risk) mortgages. The resulting Great Financial Crisis required government bailouts, prevented home builders from keeping up with growing demand for new houses and resulted in new regulations that subsequent Republican administrations are slowly dismantling.

We can reliably predict where there are fewer rules to protect investors, jungle behavior grows, and that raises the risk for everyone involved. Some like that elevated risk because higher volatility can lead to higher returns if you get it right, but for most of us it’s a bad thing.

 

Do Rules Always Make the World Better?

As much as we like rules when it comes to investing, we should also point out that some rules are stupid and produce the opposite of their intent. And there have been, in our opinion, many stupid rules over the years.

For example, regulators today require us to store copies of brokerage agreements on behalf of our clients when the brokers (in this case, Charles Schwab) already do that perfectly. By requiring us to also hold sensitive client information, regulators have simply doubled the chances a security breach could leak sensitive client info. We agree regulators need to review these documents but this is a lazy solution when sensitive documents should reside in as few places as possible.

In our case, we use one of the most secure reporting systems on the planet. Nevertheless, we don’t think most financial advisors are experienced cybersecurity professionals (Mark Tennenbaum co-founded the email security company Microsoft bought 20 years ago. Lela Kelly and Mark are still active in a successor email security company today), and we understand these issues better than most. We think this is a stupid rule to make a bureaucrat’s life easier instead of keeping our clients safer.

Stupid rules aside, most strike us as prudent and we embrace the need for regulators to patrol the field. Again, our business as advisors is to look after client needs first. The rest of the industry doesn’t really care about anything beyond keeping markets efficient and turning profits.

 

When Rules Change, Risk Changes Too

Let’s start by adding a caveat to that – rule enforcement also impacts risk. In our history, we have not always been good at rule enforcement; and one of the most famous cases involves Bernie Madoff. For over a decade, a Boston- based advisor repeatedly told the SEC that Madoff was reporting fraudulent data. The SEC never completed the most basic investigation (checking with the central depository whether Madoff owned the securities he claimed) that would have exposed the fraud – embarrassing. Rules without enforcement is a nonsense.

When we loosen the rules, we should know whether this helps investors or market professionals. If we change rules to embrace crypto as a “hard asset” (and it is not in any way a hard asset), that clearly advantages the professionals. Who is going to help investors understand what is important about these newer and exciting innovations? We’ve seen many investor-friendly rule changes over the years that make stock ownership far more accessible to most Americans, but in all our discussions with a wide range of investors over several decades, we find investor education is still woefully bad.

We have concluded long ago that the rules alone do not provide adequate protection. But let’s now make matters even worse. What happens when we loosen the rules for uneducated investors to join a party from which they had been previously excluded – predictably bad things follow.

We’ve witnessed some of these over the last few years – meme stocks, NFT’s, SPAC’s and the various crypto exchanges that no longer exist.

We expect meme stocks and SPAC’s will always be around in some form (penny stocks traditionally filled these roles), because Wall St. repackages bad ideas for new groups of investors unaware of the past. When we change the rules to make riskier investments more accessible to investors, who is that really for?

While not intending to be completely negative, we further observe President-elect Trump has always preferred looser to tighter when it comes to regulation. We can reasonably expect more rule loosening, and that makes for more treacherous waters.

Our task is to sidestep the craziness in favor of more established investments.

Life UnLocked Partners, LLC is a Registered Investment Advisor (RIA) registered with the state of California, providing investment advisory services where registered or exempt from registration. Registration does not imply a certain level of skill or training. Investing involves risk, including potential loss of principal. Past performance is not indicative of future results. This material is for informational purposes only and does not constitute investment advice or a solicitation to buy or sell securities. For more information, please request our Form ADV or visit www.lifeunlocked.partners.