With respect to individuals, the financial services industry is largely made up of financial advisers, stock brokers and bankers who approve loans, including home mortgages.
Over the years, individual investors and borrowers have tended to believe two myths: (1) that homes are a good investment; and (2) that stock brokers and financial advisers will help individual investors to achieve better than average investment results over time.
Neither is true. What is true is that fees paid by individuals to financial advisers, brokers and lenders for home and related puchases have escalated dramatically the past few decades. In fact, the money paid to these intermediaries has harmed the financial results received by individuals big time.
During the home price bubble days from 1995 through 2006, home buyers borrowed too much and paid high fees and expenses to buy expensive homes. Then when the bubble burst and home prices collapsed, the biggest source of individual household wealth disappeared.
We wouldn't even consider buying a share of stock with no or little money down, but we did it with the homes we bought when we took out a mortgage for 95% or more of the amount loaned. That's nuts. But with stocks we did something almost as bad. We paid comissions and fees often amounting to 15%-20% of the annual investment return. And we received little if anything in return from the adviser or broker in the way of investment results that we couldn't have achieved by ourselves.
And instead of investing in stocks on our own and not paying 15%-20% or more of the gross investment returns in commissions and annual fees to brokers for nothing of value in return, individual investors traded too much and got in and out of the stock market at the wrong times. We had a clear tendency to buy high and sell low.
Together these two "myths" of can't miss home prices and the expertise of salemen disguised as financial advisers have cost individuals dearly and left far too many of us without finanacial security for our retirement years.
Let's Look Closer
My view is that if we knew what it is that many of us do not know about the negative impact of relying on the advice of our "trusted" financial advisers and bankers, we would act differently and be much the better for it.
So let's look closer at these two myths which contribute in large part to our individual financial woes.
The issues concern (1) expensive and non-value added commissions and fees charged by financial advisers and (2) the irresponsible growth in mortgage credit assumed by homeowners during the bubble years.
The situation is well summarized in The Perils of Feeding a Bloated Industry:
"It is worth remembering that the credit crisis and ensuing economic downturn followed a spectacular expansion in the financial business, compared with other industries. . . . the financial industry accounted for 7.9 percent of the nation’s gross domestic product in 2007, up from 2.8 percent in 1950 and 4.9 percent in 1980. Finance’s share of G.D.P. grew faster since 1980, they found, than it did in the previous three decades. . . .
One part of the industry that has contributed greatly to the rise, they found, is money management. Fees generated by asset managers, like those for mutual funds, hedge funds and private equity concerns, account for 36 percent of the growth in the financial sector’s share of the economy, the study concluded.
Driving that increase is the puzzling fact that asset management fees over all, typically charged as a percentage of the money overseen, have not fallen substantially. Much of the increase here, therefore, has to do with the rise in asset values, which generate higher fees for money managers even though the cost of providing their services does not increase. A soaring Dow Jones industrial average is very lucrative for these folks.
Yes, investors can cut expenses by buying low-cost mutual funds, like those mirroring stock indexes.
But most active managers continue to levy the same percentage fee on assets that have risen in value significantly, generating big gains for themselves . . . .
But the stubbornly high fees charged by these managers are a troubling transfer of wealth from savers to finance workers, Mr. Scharfstein added. Over time, these costs have a huge impact on how well an investor will live in retirement. In other words, the few benefit at the expense of the many.
“Normally you would think that competition should drive down prices,” Mr. Scharfstein said in an interview. “But that doesn’t seem to be working except for index funds. Part of the answer must be a lack of sophistication on the part of individual investors. But many public pension funds and other large institutions, which are supposed to be sophisticated investors, pay high fees — in many cases for pretty lackluster performance.”
THE second major contributor to the ever-growing finance sector is the cost of household credit, mostly those costs associated with mortgages. Household credit costs, the professors reckon, have accounted for almost 40 percent of the increase in finance’s share of G.D.P. in recent years.
This is not surprising, given that household credit, mainly mortgages, ballooned from 48 percent of gross domestic product in 1980 to 99 percent in the credit boom . . . . This was largely a result of an expanded securitization market that enabled lenders to originate home loans and bundle them into securities for sale to Wall Street and then to investors.
But this process, while highly profitable to the sector, undermined financial stability, the professors argue. Participants failed to understand the risks, amplifying the panic when the market turned sour.
And making household credit more available let borrowers pile on dangerous amounts of leverage, introducing more volatility into the system.
These are the social costs of the vast increase in this type of credit: The financial system became more complex and borrowers were imperiled. Over the last five years, we have witnessed millions of foreclosures, trillions in investment losses and an economic downturn we are still struggling to overcome.
“It’s probably good to be in a place where households can get access to credit,” Mr. Scharfstein said, “but the question is, at what cost?”
Fact is, we are still tallying it."
SUMMING UP
Self help is both necessary and appropriate in managing our individual financial risks and investment returns. To each of us it's MOM at stake, whereas to the financial intermediaries, it's simple OPM. I'm for MOM.
When it's caveat emptor, as it is in buying stocks, houses and other things, being an informed buyer is of utmost importance in every market transaction.
Accordingly, financial literacy is the clear responsibility of each of us. It's one of the better things we can learn to do for ourselves and our families, and basic competency is not that hard to achieve.
Accordingly, I recommend that a simple course in financial self reliance is something we all should pursue.
The time spent getting up to speed will be well worth it, and the investment return on MOM will be materially greater, if for no other reason than we won't be paying financial advisers.
And while we're at it, let's learn the truth about the risks involved with taking on household debt for home purchases as well.
We'll be glad we did.
Thanks. Bob.
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