Brokers Rake in Record Profits No Matter What

Americans got ripped off during the financial crisis. Right? Nope! That began decades earlier when financial wizards invented a myth called the "efficient market hypothesis" based on Burton Malkiel's Random Walk.

The Random Walk

Burton Malkiel's students tossed coins. Each day at market close, they recorded heads as a rise and tails as an equal decline in a stock's price. Eventually, Malkiel's chart looked like a stock chart, so he claimed stock buying and selling were random acts -- just like coin flipping.

The "law of averages" from statistics says that if you flip a coin over a very long period of time, the probable outcomes will be equal. The coin will come up heads just as many times as it comes up tails. But if you only flip a coin once or even several times in a row, there is no way of predicting whether that coin will come up heads or tails in the short-run.

This was true of investing too, said Malkiel. You couldn't predict stock prices in the short-run, only in the long run. Malkiel attributed actual rising of prices for the whole stock market over the long run to increased earnings of companies during the early part of the 20th century. However, earnings are only one of many factors that affect stock prices.

The actual price of stock is determined by the relative supply and demand for shares. Demand for a stock can be virtually infinite, but supply is capped by the number of existing shares. A high volume of buyers will send price of a "good" stock higher. Then comes "bad news." Sellers start selling, buyers cease buying and down goes the price -- until the company wins back investors' confidence. That's why up-and-down stock charts mimic Malkiel's coin-toss chart.

As we've learned, investing isn't based on mere chance -- it's based on human expectations. Malkiel saw a pigeon and thought because it had wings, it was a duck.

Brokerages and fund managers looking at Malkiel's chart saw a golden goose. A yearly 2 percent management fee on an investor's entire account would eventually transfer 60 percent of that money into the pockets of mutual fund creators and sellers over the long run. "Buy, hold, and make us rich" was born.

The efficient market hypothesis (EMH)

According to Wikipedia, "One of the strongest arguments for the buy and hold strategy is the efficient-market hypothesis (EMH): If every security is fairly valued at all times, then there is really no point to trade." In other words, if investing were random, just as with flipping a coin, you'd come out even over the long-run.

But if not by mere luck, how did buy and hold succeed for decades? Because brokers made it work. As the saying goes, "When the tide rises, all boats rise with it." Brokers talked novice investors into buying additional shares of mutual funds every month -- even if prices were going down. Brokerages also lobbied government to set up IRAs and 401Ks so even more investors would buy mutual funds.

Regular monthly purchases and new buyers of shares in mutual funds lifted up the entire stock market. The number of mutual funds in the US skyrocketed from 360 in 1970 to over 15,000 funds by 2010.

Investors were happy. Demand drove up their mutual fund prices. Fund managers collected a variety of fees from investors in funds. Brokerages collected distribution fees (12b-1 fees) for selling mutual funds and transaction fees as more and more mutual funds bought and sold stocks.

The role of time in investing

High tide doesn't last forever. As the 21st century began, electronic trading changed everything. Risk wasn't mitigated merely by a mutual fund's or broker's particular mix of stocks in one's portfolio. There was another way to reduce risk -- speed up the trading process -- day-trades or short-term trades.

The time gap between buying and selling shares permits huge gains -- or losses. Because shares represent "ownership" of a piece of a company, what happens to a company influences investor expectations. Earnings reports, product releases, patents, new managers, or disasters affecting raw materials are some examples. Time decay means that more unexpected events, good or bad, can occur and affect investor expectations, and as a result, stock prices.

After the tech-bubble burst in 2000, short-term stock trading became much more popular with investors. Collecting electronic transaction fees for more frequent buying and selling of shares of stock was a big "hit"with brokers too.

The parimutuel "house" always wins

Casinos can have an unlucky night. As Donald Trump discovered, a casino-type "house" can have many bad nights. But not so the parimutuel-type "house." Buy and hold, or buy and sell quickly, either way, brokerages always get their fees! And it is they and fund managers who stand to profit most from the ensuing bubble if Social Security is ever privatized.