Recently I suggested that someday it might be illegal for untrained citizens to invest in stocks of individual companies because it is too risky. As regular readers know, I sometimes throw out provocative ideas just for the fun of it. I didn't think much about that idea until after I wrote it. But the more I mulled it over, the more it started to make sense. So I'm going to develop that argument here.

I remind you that I lean libertarian (without the crazy stuff) so all of my impulses are to allow people the freedom to hurt themselves any way they choose, so long as their corpses don't block my driveway or cost me anything. So the argument I am about to make offends even my own sensibility. The troubling part is that it makes sense.

Let's begin by noting there are already plenty of restrictions on personal freedoms when the consensus is that these restrictions somehow protect people from themselves, or they protect society as a whole. For example, where I live you can't legally...
  • - Drive without a seatbelt
  • - Ride a motorcycle without a helmet
  • - Commit suicide
  • - Practice law, medicine, or other professions without a license
  • - Operate a motor vehicle while under the influence
  • - Gamble in most places
  • - Carry an Uzi down the street
  • - Buy dynamite

The list goes on, and that doesn't even include the many restrictions on underage activities. So there is nothing unusual or unprecedented about legal restrictions on freedom when an argument can be made that it protects lives or property.

My argument against allowing individuals to invest in stocks is that unless you have insider knowledge, which is already illegal, your odds of beating the index averages are slim. It is nothing more than gambling.

The myth of stock investing is that a person who does more research has better results. But there is no science to support that view. Indeed, the person who understands the most about individual stock investing avoids them completely and invests in ETFs or index funds.

The problem with doing your own research on stocks is that you must rely on the information coming from the management of a company, and managers are generally misinformed or lying. Even the most seasoned investment professionals running mutual funds perform worse than the indexes on average. Brains and research can't overcome the fact that much of your data is deliberately tainted at the source.

When people go to Vegas to gamble, they usually set some sort of limit for their losses. And they go with the full knowledge that winning is unlikely. It makes sense for that sort of activity to be legal, within limits, because it is viewed as entertainment and not investment. But if it were common for people to bet their retirement savings on Blackjack, you can be sure it would be illegal.

We don't allow unlicensed people to practice law or medicine, sell real estate, or even build a house. It is entirely consistent to restrict the untrained from making risky stock investments.

I reiterate that this runs against my own libertarian philosophy. I would feel I had lost something important if I couldn't invest in individual stocks. But it is also true that my net worth would be larger if I had never done it. And it would be larger still if I hadn't allowed professionals to do it on my behalf.

If anyone comments to this post by saying, "I do my own research and I made money in the stock market," it is proving my point. And if you don't see why that proves my point that further proves my point.

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Dec 19, 2008
Umm, Scott... It's already illegal for non-rich people to make some risky investments. Has been for a long time. You can't buy into an IPO unless you meet the minimum wealth criteria.

I don't think this law's purpose is to protect people, just like Harvard's purpose isn't to educate people. Its purpose is to reserve the best wealth-making opportunities for the rich and maintain the social order.
Dec 19, 2008
There is evidence that some people, employing the right logic and temperament, can consistantly beat the market averages over many years, above what chance would allow. Google "the superinvestors of Graham and Dodsville" and read the essay. It tackled the issue of chance head-on.
The problem is that this type of investing required emotional fortitude not commonly found. You can't restrict those that do have it from making money, though.
You assume that it is impossible to reliably make money in stocks beyond what pure chance would allow. You base this assumption on that statistical fact that beating the market is very rare, even for professionals. You then continue to stipulate that this is because managmenent are liars. This entire line of reasoning is flawed. The statistics don't mean that NOBODY can do it, just that very few do (beyond what chance would allow). And the reasons that few professionals are able to beat the averages has nothing to do with managment lting, and more to do with other factors, some objective (limitations on transactions fund managers are allowed to do, necessity to focus on short-term, yearly results and the need to provide liquidity when people pull money out of the fund, fees etc) and some emotional (herd mentality, for example).
Bottom line, your suggestion would penalize the few who can for the masses who cannot. That's not fair.
Dec 19, 2008
I haven't been reading this blog forever, so my apologies if this has already come up... but while you're exploring the implications of govenmental restrictions for individuals, how about discussing the restriction of something that could really change the world for the better: Licenses (parental standards) for having kids.

I could write way more about this, but I think instead I'm just going to hope that maybe you'll write a post about it sometime. Hoping is way less effort on my part than defending.
Dec 19, 2008
Someone was telling me about the 911 attacks being linked to the stock market. The theory was (details a bit sketchy in my memory sorry) that Osama sold a lot of futures in WTC companies on the inside knowledge that the stock prices would go down, thus profiting immensely from the attack. And he used the profits to pay for the costs associated with the attack.

So it sounds like the terrorist business model is geared to take advantage of stock market and they have the ability to cheat the system to their advantage - whereas there is no legal avenue for everyone else.

So you could argue that the whole system should be outlawed for security purposes.

Dec 19, 2008
Scott, have you heard of levered ETF's? Currently, the most we can get now are triple-leveraged funds (google Direxion), but as Gillette can attest, three is never enough.

If you mandate everyone has to invest through ETF's, you can bet your ass that five, ten, fifteen-x funds aren't far off and we'll be back to square-one.

As someone has already mentioned, if you take away the ability for people to invest in companies, all your new-energy startups will pretty much whither and die without the needed capital.

Finally, while you didn't mention it in your post, I'm going to assume you can only buy long-ETF's as well? If so, this is another short-sighted thought (pardon the pun)... but I'll leave that for another comment in case I'm assuming too much.

Dec 19, 2008
All stocks can be divided into two categories: those that are purchased through index-based tracker funds and those that are not. If the market as a whole goes up by x%, the tracker fiunds go up by x%. The math means that the stocks bought by investors or fiund managers who do their own research also go up, on average, by x%. These latter stocks though, have management or transaction fees associated with them so, on average, are less profitable than trackers.

Given this math, only a very small proportion of managed funds will ever beat the market (i.e. the trackers). Most investors have no better way of guessing which they are than they have of guessing which stocks will be the most successful. The few serious investors who can read and beat the market rely on the large number of non-experts to fund the market so they can win.
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Dec 19, 2008
I like your willingness to go dig into things that aren't your cup of tea - fun for everyone! I think the crux of the issue is not an individual freedom one (like the seatbelt or suicide example), but how in the aggreagate, some policies and freedoms are terribly risky for the greater population. We limit freedoms in those cases all the time when it comes to security, but clearly not enough when it comes to the economy.

I think individuals buying stocks is not a risk to the economy, even in the macro, as by definition, half the people who buy stocks are wrong and half are right. The damage is limited.

What we know, is that when the rich as a subclass of people, strive for more riches as a group, dangerous things happen. Sometimes, this happens by abusing the uninformed (both rich and poor), and sometimes through political or other power. If we want to remake capitalism, a better move is probably to enact policies that make retaining and growing large personal wealth more difficult. This is not a radical idea, it simply means that remaining rich is something that requires success. Policies like...
- Extra Taxes on Saving (to encourage the rich to spend)
- Abusive tax rates on CEOs that make more than 20 times what the lowest paid employee does (rebuilding the consumer class)
- Lower taxes on companies that employ lots of people (rebuilding the consumer class)
- Mandatory dividends on large companies (puts money in circulation to be spent)
- 90% inheritance tax (again, to encourage spending)
- Capping the number of shares a company can have (to encourage responsible borrowing)
- etc...

Those are all half baked ideas, but the point is that it is only reasonable to curb individual freedoms when they will, as an aggregate, be a negative, and it's pretty clear that more damage is done per capita by rich folks than "every day" people (it only took a few bankers to make bad loans).
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Dec 19, 2008
There's actually a key word in Scott's post -- "untrained".

The question is how much training we'd require before we allow someone to gamble his retirement savings away. I'd guess similar to that required to legally drive a car, and a lot less than to become a certified financial adviser.
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Dec 19, 2008
I've only been burned by stocks. I can see how you'll make money by playing it like Vegas, playing the odds of winning...but the market always dips again, so any long term investments have a very large chance of losing money... I put about $3500 in mutual funds in 1999, then the dot.com bubble burst, and it dropped to about $2000. Then it started rising again...to about $2700 or so. Now it's back below $2000. (I know, this is a strange way to invest...but you don't blame me for not putting more in since then, do you?) Long term investmests suck. For me at least.
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Dec 19, 2008
I'm not sure about the (hidden) assumption that most of the losses in the stock market are caused by individual investors investing in individual companies. It may well be that a lot of people who don't know anything give their money to mutual funds, etc and then those professionals (who usually have some sort of professional certification or designation already, so they're most likely to get the liscenses you speak of) lose a ton of money every year.

Additionally, you've read Influence, you know that people hate having anything taken away from them, much like trying to take a bone from a dog. Additionally, losses are valued much higher than gains in the human psyche, so that can be kept in mind.

Interesting idea.
Dec 19, 2008
It strikes me as a slippery slop. "A Fool and His Money Are Soon Parted" is the fundemental engine that drives the economy. What's the difference between "investing in stocks" or "buying a PC with Vista"? Chances of acheiving happiness with either is remote.

Stick to your libertarian principles, Scott. You can't make a system foolproof, even to protect yourself, because the universe keeps making better fools. Just accept the penalty for the liberties you enjoy as a fool-tax, and move on.
Dec 19, 2008
Actually, this is a theory that has been advanced by many financial professionals of late. They call it Modern Portoflio Theory, and the premise is that because all information is already a factor in a stocks price, all stock price changes are random (the Random Walk Hypothesis). So proponents of Modern Portfolio Theory say you just need to pick an acceptable level of risk vs return and live with it. So I suppose any type of investing in stocks would be gambling of sorts according to this theory.

However, I still don't think this theory holds water. There was a study done by Eugene Fama and Ken French a number of years ago that found that certain things did influence stock prices, and that it was possible to make money by investing in certain stocks. They found that companies with a higher book value to market value ratio consistently outperformed ones with low ratios. Also, stocks with low P/E ratios overperform when compared to high P/E ratios.

The real reasons people don't make money off stocks are:

1) Investors hate to lose, so they hold onto losing stocks longer than they should.

2) Investors are illinformed and tend to overreact or under-react to new information.

3) Investors love patterns and tend to find them even where they don't exist

4) Investors are overconfident in their own stock picking abilities, and therefore underestimate risk.
Dec 19, 2008
This is the stupidest thing I've ever heard of in my life. Are you seriously insane? The free market system is set up to allow investors to purchase companies that they feel are a good business to be invested in. Companies, in turn, do things like secondary stocks offerings to raise cash to expand their businesses. Ultimately, money is routed to the best performing companies. By not allowing people to purchase the companies that deserve to have good stock prices or selling the companies that are bad, free market capitalism essentially dies as the only thing you'd have to do as a company is essentially get listed on an exchange or within an index and people would be forced to own your company. Put down the bottle and think about what you're writing next time. It makes it even worse that you thought this was a great idea out of the hideous concoction of garbage that was dumped on here like an elephant dung pile a couple days ago.
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