Backstage Wall Street: A Book Review

While trolling the Barnes and Noble web site for interesting investment books, I found one written by Joshua M. Brown: Backstage Wall Street:  An Insider's Guide to Knowing Who to Trust, Who to Run From, and How to Maximize Your Investments. I knew that the book had to be about scandalous behavior by the brokerage industry that would give an "inside look" at what we think might be happening, but no one will admit to.  Most of it is old news to me.  But for the average investor, it should be a real eye-opener.

I don't know what Mr. Brown studied in school, but do know that he has an undergraduate degree from somewhere. He first worked in a "boiler room", a brokerage house that no one has heard of.  His job consisted of making cold calls to prospective investors throughout the United States, trying to convince prospects to become customers who would execute trades and pay him brokerage commissions.  He eventually walked away from this job, which had become very lucrative, when he met Barry Ritholtz, an independent investment advisor (also known as a Registered Investment Advisor, or RIA), who runs his own business.

I planned to quote a few passages from the book that many of you might find of interest, but there were so many that I gave up trying to bookmark each one and instead decided to concentrate on the most important points that he makes.
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Brokers are required to pass a regulatory exam called the Series 7.  Here is how Mr. Brown describes the exam:

"The Series 7 is the primary license that stockbrokers (called registered representatives in the regulatory vernacular) must attain to begin selling securities to the public.  It is a 250-question exam that teaches the young and aspiring broker absolutely nothing of any utilitarian value.  There is virtually zero knowledge that the broker takes from this test and puts to good use once his or her career begins.  The sections of the test on ethics are obvious to the point of stupidity.  All the securities laws you learn about date back to the 1930's and are totally irrelevant in the context of the abuses that are so prevalent today.  The test itself is merely a six-hour barrier of entry so that not anyone off the street can sell securities.  And as far as barriers go, it is a weak one; I've known people who could not tie their own shoes who have past the test over the years."

That is not to say, of course, that all brokers are clueless.  They do learn on the job, and some of them hold advanced degrees, such as an MBA in Finance.  They may also hold other licenses or certificates of value, such as the Chartered Financial Analyst, Certified Public Accountant, or Certified Financial Planner designations.  All of these rigorous courses of study and exams have relevance to investments, and individuals who hold these titles have gained valuable knowledge that will benefit their clients.

He also does a good job of differentiating between the fiduciary standard (for Registered Investment Advisor) and the suitability standard (for brokers, also known as Registered Representatives)

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Mr. Brown describes his move from being a broker to being an independent investment advisor:


"I was now in a situation where my clients' success meant success for me and for my practice all at once -- a virtuous and symbiotic relationship for all parties involved."  In contrast, brokers make money whether you do or not.
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Mr. Brown does a good job differentiating among the different types of advisors who are permitted by various regulatory bodies to interact with investment clients.  I hesitate to say that brokers are giving advice, because in many instances, they have clients sign a contract that says that the client is making all the final decisions (and is making "unsolicited trades") in order to reduce the likelihood that the client could sue them successfully.  After all, they were only making a suggestion, you made the decision to invest!

He says:

"The vast majority of contact between the investment industry and its individual clients is facilitated by two very different types of 'professionals'.  The irony is that as different as they may be, the American public looks at them as though they are one and the same."  He goes on to describe three different fee arrangements:  fee-only independent investment advisors (who are not brokers), brokers who work for commissions, and brokers who use a mixed model (what some call "fee based" advisors, but he refers to as a "hybrid broker-advisor" model).

A critical issue with "hybrid broker-advisors" is that they will take off their fiduciary hat (a higher standard) and put on their suitability hat (a lower standard) if they decide to sell a client a commissionable product, such as an annuity, rather than charging a fee calculated on a percentage-of-assets basis.  There are clear conflicts of interest, and clients typically have trouble distinguishing when the advisor is acting as an advisor or a broker.
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On another subject, Mr. Brown claims that 401(k)s are largely limited to investing in high-cost mutual funds, and he describes how this development evolved and how it is changing.  If you are contributing to a 401(k) plan, I would encourage you to read Chapter 10.

If you invest in mutual funds with a broker, and want to know how the different classes of mutual funds differ in terms of their costs, read Chapter 10.
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Mr. Brown also sprinkles throughout the book reasons why non-professionals should consider hiring an investment advisor.  Here are a few nuggets of wisdom on this subject:

1. "The truth is, there is no more precision in financial services that there is in medicine or architecture or computer science.  Things go wrong, people act emotionally, and not everyone has the best intentions at all times."

I believe this is true.  Investing is part art and part science. It is about assessing and evaluating information gleaned from reading annual reports and regulatory filings of public companies and Morningstar mutual fund evaluation reports.  It is about assessing whether or not individual securities are undervalued or overvalued.  It is about reading newspapers and other publications, researching on the Internet, and deciding which investments should perform better in the current and future economic and political environment.  It is about evaluating what mix of individual stocks, individual bonds, mutual funds, ETFs and possibly other investments will be the best one for each client, or yourself, if you are going it alone.

2. "Hold their hands, be reassuring", Mr. Brown was told at the advent of his career.  He goes on to say "You'd be amazed at how true this statement actually is, particularly in the midst of a crisis. But what good is offering my hand to an investor if I believe, as he does, that we are both about to tumble off a cliff?  It turns out that to that investor, my grasp is more important than oxygen itself, I have come to learn."

It is understandable to worry in the midst of a crisis.  However, the value of the entire stock market will never go to zero, the entire economy as we know it will not cease to exist.  It is important to realize that crises, too, shall pass, and crises always present opportunities for big gains if you are willing to either hold on or jump in when the future looks the bleakest.

3. "The truth about civilian investors is that, in the aggregate, they will almost always enter and exit stocks and bonds at the wrong time.  This has been proved over and over again, whether we are looking at mutual fund inflows and outflows, 401(k) contributions, retail brokerage firm margin debt, or almost any other gauge that tells us what the average investor is up to."

"While there are those who have found success investing on their own, the great majority of what we'll call 'ordinary' people would be better off getting some help.  This is certainly not to say that they should take and pay for the advice of just anyone who is willing to give it!"

4. Mr. Brown also describes as bad investments, including SPACS (special purpose acquisition corporations), Chinese reverse mergers, one-drug biotechnology stocks, private placements and private REITS.  He says that most "civilian" investors are not in a position to properly evaluate these, and that staying away from them is best.

He also describes "Brown's law of brokerage product compensation":

The higher the commission or selling concession a broker is paid to sell a product, the worse that product will be for his or her clients.

He also outlines other investor traps, including one that Bernie Madoff's clients fell into:

"Financial advisors who self-clear or self-custody clients funds.  (Always be sure that there is another pair of eyes on your money, preferably a large corporation's.)"
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There are a few sentences in the book about which I take issue.  For example, Mr. Brown writes the following:

1. "The market is made up of buyers and sellers, both of whom believe they are on the right side of a given purchase or sale."

This is not exactly correct.  People buy and sell stocks for many reasons, not necessarily because they think a stock or bond will rise or fall in price in the near future.  For example, some clients invest for income.  Others sell stocks to fund major purchases, such as homes, autos and education, or to pay a major health expenditure.

2. "And if this all sounds futile to you, keep in mind that it's only gotten worse with the advent of exchange-traded funds and the growing realization that active management is a farce anyway."

No, active management is not a farce.  It has a critical role to play in insuring that the income generated from a client portfolio meets a client's ongoing spending requirements.  With exchange-traded funds and mutual funds, it is not possible to accurately predict the amount of income that will be thrown off by the investments in the portfolio, because they are always changing.

It also has a critical role to play in managing a client's tax burden.

I would encourage you to pick up a copy of this book. 





Barry Ritholtz writes a blog that may be viewed at the following link:  www.ritholtz.com.  Mr. Brown writes a blog at the following web site:  www.thereformedbroker.com.