EPILOGUE
The Invisible Squeeze
Since the global financial crisis (GFC) of 2007-2009, the world has become increasingly aware of two major problems. The first is the danger of systemic financial risk and breakdown. Due to the complexity and interconnectedness of the global financial system, a sudden domino-like series of failures seems possible at any time. The second problem is the justifiable concern over the financial industry’s concentrated political influence, achieved through contributions to political candidates, the revolving door between the financial industry and government positions, easy access to officeholders, and money spent for media campaigns. The simple advice that we recommend to you in Part I can help to mitigate these problems, through an important secondary benefit that we call the Invisible Squeeze.
In the late 18th century, economic philosopher Adam Smith coined the term “invisible hand” to describe how people acting in their own self-interest to maximize their gains may also benefit society, even if those people have no benevolent intent. In much the same way, when individuals and institutions (investors) seek to maximize their gains by pursuing the simple, low-cost strategy that we advocate in Part II, we assert that society will benefit as profits are squeezed from Wall Street and the financial sector. This profit squeeze will happen invisibly and unintentionally as investors pursue the best course to meet their own objectives.
PRODUCT AND PRICE CONFUSION: THE KEY CAUSES OF PROBLEMS
As we pointed out in the introduction, the high profits reaped in finance are the result of a unique combination of product and price confusion, enabling the industry to sell ordinary, inferior, and sometimes even worthless products at extraordinarily high prices. The proliferation of such products and services, facilitated by clever marketing, is the primary cause of investor confusion.
Customers of the financial industry can and should ignore the array of complex-sounding and opaque products, services, and advice that create no value but add enormous charges. We hope we have helped you understand that in finance, in the vast majority of cases, most features add no value as compared to simple low-cost alternatives. Avoiding these products and services will help increase transparency and reduce complexity, and stanch the torrential flows of fees from customers to the financial industry.
Beyond advising you to steer clear of complicated investment products and services, which can be relatively easy to spot, we also hope to have demonstrated that even mainstream investment options can have an enormous cost to your long-term financial health. Many basic mutual funds, for example, are able to charge 1% and higher annually based on an expectation of substantially outperforming a low-cost alternative, an expectation that is impossible to promise and rarely realized. These basic investment options drain your investment accounts unnecessarily and by a greater amount than most investors even dare imagine.
Widespread adoption of the investment strategy recommended in Part I would significantly reduce the impact of these problems. How? It’s simple. The more that investors implement strategies that avoid extra costs and complexity (with its unseen risks), the less fragile the system will become and remain. And the more each person chooses effective and low-cost investment options, the more industry revenues and size will shrink, reducing its influence. Each person who follows our recommendation could reduce his or her contribution to the investment industry’s revenue by as much as 75% to 90%. Investing in the Simplify Wall Street portfolio will help solve the problems of systemic risk and runaway political influence by simplifying the financial system, without making it less useful or efficient, and by reducing the huge and unproductive flow of funds from investors, large and small, to the superwealthy of finance.
THE RISE OF THE FINANCE INDUSTRY SUPERRICH, ANECDOTALLY
A guest article appeared in mid-2011 on the website of G. William Domhoff, a sociology professor at the University of California-Santa Cruz, by someone whom Domhoff knew years ago, an investment manager who works with very wealthy clients and chose to remain anonymous for obvious reasons.1 The article was updated by the article’s writer in December 2013.2 The writer, a very successful investment advisor, says, “I sit in an interesting chair in the financial services industry. Our clients largely fall into the top 1%, have a net worth of $5,000,000 or above, and—if working—make over $300,000 per year. My observations on the sources of their wealth and concerns come from my professional and social activities within this group.”
The writer points out that the 1% are not truly wealthy, however, until they reach the top half of the 1%. Moreover:
The higher we go up into the top 0.5% the more likely it is that their wealth is in some way tied to the investment industry. … Folks in the top 0.1% come from many backgrounds, but it’s infrequent to meet one whose wealth wasn’t acquired through direct or indirect participation in the financial and banking industries.
In the 2013 update, the writer concludes, “Wealth and income are streaming to the very top of the system and, particularly, to those who are direct or indirect beneficiaries of the financial industry…. The years 2009-2012 saw an enormous transfer of wealth upwards to the top 1% and, particularly, the top 0.1%.”
The writer shares other observations as well.
Recently, I spoke with a younger client who retired from a major investment bank in her early thirties, net worth around $8M…. Since I knew she held a critical view of investment banking, I asked if her colleagues talked about or understood how much damage was created in the broader economy from their activities. Her answer was that no one talks about it in public but almost all understood and were unbelievably cynical, hoping to exit the system when they became rich enough.
The writer concludes, “I think it’s important to emphasize one of the dangers of wealth concentration: irresponsibility about the wider economic consequences of their actions by those at the top.”
THE RISE OF THE FINANCE INDUSTRY SUPERRICH, EMPIRICALLY
Thanks to the recent work of several diligent economic researchers, a lot of empirical evidence has been gathered that shows how flows of funds from customers to the financial industry have greatly enhanced its wealth. For example, economist Thomas Philippon, an associate professor at New York University’s Stern School of Business, compiled total payments by the U.S. nonfinancial sector to the financial sector in a paper for the National Bureau for Economic Research.3 Those payments came to almost 9% of the U.S. GDP in 2010, a near-doubling of finance’s share since 1980. The U.S. GDP in 2010 was $14.5 trillion; hence, 9% of that, or more than $1.3 trillion, was paid by the nonfinancial sector to the whole U.S. financial industry in 2010.
In another paper,4 Philippon and coauthor Ariell Reshef, an assistant professor of economics at the University of Virginia, state that until 1990, workers in the financial industry earned the same compensation as workers with the same level of education in other industries. But by 2006, the average worker in finance received 50% more than those in other industries. The finance industry has not improved so much or in such a manner that it would explain or justify that significant increase. This difference was much more pronounced at the upper levels of the pay scale, say Philippon and Reshef. Workers in the top decile in finance earned 80% more than workers in the top deciles of other industries, and executives in finance earned 250% more than executives in other industries.
Who Receives This Increased Income?
Evidence points to the conclusion that much of the vastly increased flows from the nonfinancial sector to the financial industry in the United States in the last 30 to 40 years has gone to the very top of the nation’s income ladder.
Economic researchers Thomas Piketty of the Paris School of Economics and Emmanuel Saez of the University of California-Berkeley, find that “the share of national income accruing to upper income groups has increased sharply in recent decades, particularly in the United States…. This comes mostly from the very top. The top percentile income share itself has more than doubled, from less than 10% in the 1970s to over 20% in recent years.” Furthermore, Piketty and Saez say, “The top 1% alone has absorbed almost 60% of aggregate U.S. income growth between 1976 and 2007.”5
Evidence presented by three other researchers, Jon Bakija of Williams College, Adam Cole of the U.S. Department of Treasury, and Bradley Heim of Indiana University, narrows this down to the top 0.1% of income earners.6 These researchers state that
the percentage of all pre-tax income (excluding capital gains) in the United States that was received by the top 0.1 percent of income earners rose strikingly from 2.2 percent to 8.0 percent between 1981 and 2006…. We find that executives, managers, supervisors, and financial professionals account for about 60 percent of the top 0.1 percent of income earners in recent years, and can account for 70 percent of the increase in the share of national income going to the top 0.1 percent of the income distribution between 1979 and 2005.
Of these, the largest portion, 18.4%, are directly employed in the financial professions; 15.0% are salaried nonfinance executives; and 13.6% are executives of non-finance-related closely held businesses.
Have the increased revenues to the financial industry and finance professionals produced any benefit? Defenders of the industry argue that it has developed highly efficient systems to transfer and diversify risk and to allocate financial resources where they are needed.
Yet in his research on this question, Philippon found that the financial industry is no more efficient at its job of financial intermediation—of transferring financial resources from their sources and allocating them to their uses—than it was decades ago when it received half as much as a share of GDP.7 It merely gets paid more.
Of course, in any industry, most firms and most people seek to generate as much profit as possible. But when an industry doubles its share of the nation’s GDP and its average worker increases his or her pay by 50% relative to other workers in a few short years, we have to ask why that is so. We believe it is simple. The industry benefits from a series of lies, myths, and misdirections that confuse the consumer, who would otherwise be the natural check on and arbiter of market pricing. But you can change that—at least for your own investments.
THE SPIRAL OF INCREASING COMPLEXITY
As we noted in the introduction, the increasing complexity of financial products and services creates a wall of impenetrable, misleading, and deceptive information. This confusion adds greatly to the cost to customers of obtaining correct and truthful information and of doing financial transactions. Furthermore, the proliferation of products, strategies, and marketing noise tends to make even the more mainstream investment options harder to evaluate because they float in an overwhelming ocean of inscrutable information.
And when investors are confused, they seek ways to understand or even take advantage of the complexity. In turn, opportunistic providers of financial products and services exploit investors’ quest for this elusive and tantalizing “advantage” by producing increasingly complex-sounding and generally costlier offerings accompanied by cleverly designed marketing pitches. This self-feeding cycle does nothing but continuously perpetuate the confusion and complexity.
As we have all so recently seen and experienced, this complexity does not beneficially distribute risk throughout the financial system; on the contrary, it increases global financial systemic risk. For example, in the run-up to the GFC, both investors and regulators did not—and, worse and more likely, were not able to—properly evaluate the individual and systemic risks of pooled subprime mortgages and loans known as collateralized debt obligations (CDOs) and insurance contracts known as credit default swaps (CDSs). Ratings agencies were not able to evaluate them, either—or at least they had an incentive to allow their evaluations to be manipulated by their clients, the large investment banks that issued the CDOs. Neither investors nor regulators knew what was happening. But the financial industry did—or should have.8
When this kind of opacity builds up in the financial system, it puts the entire system at risk. The Global Financial Crisis, still too recent and casting too long a shadow for us to forget it, showed just how risky it is.
A LIFELINE TO A SOLUTION
As we’ve seen, the financial industry is what some have called a “rogue industry”9 that poses dire risk to the entire global financial system. The enormous differentials between compensation in the financial industry and compensation in other industries, plus the huge size of the industry, have contributed to and solidified its economic and political power, and the widening of economic inequality. An upper echelon has emerged that is increasingly isolated from the socioeconomic realities of the vast majority of citizens. Furthermore, too many talented university graduates are drawn by the high pay to an unproductive industry—talent that could otherwise contribute to society in other areas.
Solutions to these problems have been sought through increasing regulation; in breaking up banks; in restoring moral values and good business ethics. But the banks have captured the regulatory system, and there has been no meaningful attempt to shrink them (and thus the risk). In fact, the largest banks are bigger than they were before the crisis. As for restoring moral values and good business ethics, we’ll merely say that that doesn’t fall under your control, and it’s a goal that is definitely not easy to accomplish.
But there is a simple, effective, and more obvious (once you think about it) solution, one that adheres to the basic laws of economics: the Simplify Wall Street (SWS) portfolio, introduced in Part I. It’s not only the best portfolio you can invest in for your own financial good; but the more people adopt it, the more it will squeeze from Wall Street a large portion of the profits that allow it to maintain its oligarchic hold on the regulatory process and maintain its oversized influence on the U.S. economy.
Investing in the SWS portfolio need not be an explicit “boycott” of Wall Street or the mainstream financial industry. You should pursue the SWS for your own good—because it’s the best investment strategy available. As if guided by Adam Smith’s “Invisible Hand,” however, each investor pursuing his or her own best investment interest will result in the best interest of society, because these choices collectively can significantly reduce systemic financial risk and concentrated economic power. The actions of individuals acting freely can accomplish what no regulation ever could.
We hope that we have cut through much of the confusion and made it clear that a very simple, least-cost option is easily available to all investors, whether individual or institutional. It will benefit you—and all of us as well.