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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Investing With Your Eyes Open

Remarks by

Chairman Arthur Levitt

U.S. Securities & Exchange Commission

Los Angeles Times 4th Annual Investment Strategies Conference
Los Angeles, Calif.
February 12, 2000

Thank you very much. I want to thank the L.A. Times for having me here again, and for their commitment, year after year, to promoting investor education.

I'm here today to talk about some of the recent developments and current practices in today's marketplace, and to review some of the basic principles of sound investing. Of course, the SEC can't recommend or endorse any particular companies, trading strategies, or financial products, but we can help you get the facts you need to achieve financial security.

Last week marked the longest period of economic expansion in our nation's history. Steady growth, low interest rates, low inflation, and record employment have created greater opportunity and better lives for millions of Americans. A new, heightened optimism is fueling an almost unbridled culture of entrepreneurship, innovation, and investing.

With all the wealth being generated by more than a decade of "up" markets, it seems that everyone's attitude toward investing these days is "Who wants to be a millionaire?" Unfortunately, in the stock market, you don't get any "lifelines."

More and more Americans are investing in our stock markets. And today, our markets are more a part of America's consciousness than ever before. Standing in line at the supermarket or the hardware store, you're as likely to hear about the Nasdaq's performance as you are Shaquille O'Neal's game.

And how about the Super Bowl a few weeks ago? It seemed that even truck and beer commercials were overshadowed by the number of advertisements devoted to on-line trading and investment advice. Just three years ago that would have been as unthinkable as the Rams winning the Super Bowl.

But in the celebration of today's prosperity, I'm concerned that some of the basic but important fundamentals of investing are being lost on investors. Or, even worse, simply ignored. There is still much we don't know about what drives today's economy and even less about where it's heading. Unless investors truly understand both the opportunities and the risks of today's market, too many may fall victim to their own wishful thinking.

Now, I'm not saying that investors today don't have a lot to be excited about. But times of unprecedented opportunity and change demand an even greater commitment to staying disciplined and understanding risk. The greatest threat to continued prosperity is a loss of perspective. More than ever, investors must remain focused on what makes sound investing sense for their families, for themselves, and for a more financially stable future.

The Importance of Managing Risk

As an investor today, do you ever stop to ask yourself "What's a company really worth?" or "How do I determine value?" or "How do I manage risk?" If you do, then you probably know that none of these questions has a easy or straightforward answer. The reality is, there's a lot about today's economy that even the most savvy investment professionals and economists simply don't know or are still trying to figure out.

I've been involved with our markets, in one way or another, for over four decades. I've seen markets go up and – unlike many investors today – I've seen them go down. In that time, I've learned one incontrovertible fact: successful investors, through good times and bad, focus a vigilant eye on managing risk. Periods of promise and prosperity are not an excuse to let your guard down. In fact, it's times like these when you need to raise it even higher.

In many respects, today's euphoria is nothing new; history shows us that heightened speculation has always accompanied innovative and dynamic times. Some even argue it lifts creativity and productivity to greater heights. But let's not forget the important lessons America's march of progress over this past century has taught us.

Take, for instance, the automobile industry. In the late 1920's, there were over 100 American companies vying for a piece of this new market. Today, there are only two U.S. automakers. Or look at the canal, steel, or railroad industries. Or, more recently, personal computers. In the end, only a very small number of the companies launched into these new and booming markets were left standing.

If past is prologue, many new companies rushing to market today will not be around for the long haul, perhaps not even a few years from now. Don't fall prey to an urge that tells us it's okay to suspend good judgment and invest with our eyes closed and our fingers crossed. As investors, it's never been more important to manage your risks. And this means researching your investments and understanding what you are investing your hard earned dollars in.

How Do I Tell What a Company is Worth?

So let's start by talking about the age-old question "How do I figure out what a company's worth?" These days, this might be the hardest question of all. Valuing a company has never been an exact science. Most analysts and investors refer to a P/E ratio – that is, the comparison between a company's stock price and it's earnings per share – to gauge growth potential. But in today's market, does it even make sense anymore to look at a P/E ratio? Are some of today's companies really worth 1000 times nothing?

To justify today's valuations, some emphasize future potential and intangible assets that are hard to measure using traditional methods. They see technology's applications as limitless – its true asset value difficult to pin to one function or one market. But any way you look at it, many of today's valuations seem to defy traditional explanation.

Another indication of a company's worth is the price of its stock. But, let's look at how today's multiple stock splits have helped drive up the market value for many of these companies. If a stock is trading at $100 it might look expensive to some investors. But when the stock splits two-for-one, at $50 a share, the price might now look cheap – while the number of shares has doubled, the company's total market value has stayed the same. If more investors dive in and the price shoots back up to $100, the company's valuation is now worth twice what it was.

Increased activity in buying and selling stocks highlights an important difference between trading and investing. Trading is buying on the hunch that the stock price will rise – regardless of what the buyer actually thinks it's worth. It's simply a game of placing bets. As the number of momentum traders increases and market volatility soars, trading today is more like playing the lottery. While studies show that the more times you trade the less profit you make, there's nothing wrong with such a strategy as long as you understand the risks.

Investing for the long term means focusing on the fundamentals that make up a solid company – no matter what the market environment, no matter how revolutionary change is. Ask questions such as does the company have a vision, a business model that works, a strong management team, or a quality product? Is it well-positioned to embrace new technology or innovation? Does it use its resources to become a better company? P/E ratios and other traditional metrics may not be as helpful for some of today's Internet and technology companies, but these time-honored fundamental questions will always have relevance.

More and More IPOs

For investors today, there are also more companies to consider than ever before. Every day it seems another batch of companies is going public. Understandably, there's a big rush to "stake a claim" in the emerging Internet landscape. But let's take a closer look at the push to go public and what's driving the process of more and more IPOs.

With billions of dollars pouring into fledgling start-ups with no discernible track record, naturally investors are looking for big returns. As a result, many of these companies are groomed – very early on – to go public in record time. In this highly competitive market, some of them need quick and large injections of capital just to survive. But sometimes this race to an IPO comes at the expense of laying the foundation for a viable, long-term company. As long as investors stay hungry for public offerings, there will be even more IPOs.

Of course, I'm not saying that all of today's new companies have rejected sound business practices, or that some of them won't become industry leaders someday – maybe even soon. Competition is the lifeblood of the free market. But finding the companies that will thrive in tomorrow's market demands even more work on your part today, particularly in the rush to buy into IPOs.

Right about now you may be thinking to yourself, "What is this guy worried about – where's he been for the last few years?" I realize it seems that just about every IPO today goes up 50, 100, 200 percent in a day. But some don't. And many fall back to levels far below the IPO price. It may not be a mistake to buy into an IPO, but it would be a mistake to consider buying into an IPO as a quick, easy and risk-free way to make money.

Certainly, one reason an IPO's share price increases so dramatically is because investors believe in the company's potential. But there are sometimes other dynamics at work as well.

When a company goes public these days, the number of shares offered to the public often represents only a small percentage of the company's total shares. Now, simple economics tells us that with heightened demand and a limited supply, the price is going to climb. But when current demand is already at extraordinary levels, the price tends to skyrocket.

By limiting the number of shares that are offered to the public, however, the underwriters, venture capitalists, and other select participants have much to gain. They're the ones who own the rest of the stock that wasn't offered in the IPO. While the rest of us are scrambling for a few shares and driving up the price, these company "insiders" can sell their own shares down the road for a much higher price.

In today's market, some brokerage houses are promising better access to IPOs in order to get your business. It's a fine claim to make, but IPOs have always been hard to get in on. Shares often are allocated according to business relationships and other subjective criteria. Before you sign on as a customer, be sure to check out their track record. See how many customers received IPO shares and whether they were big institutions or small investors. Ask how the allocation policy works and who gets priority.

Again, I'm not saying that investing in IPOs is a good or bad strategy, or that there's anything inherently wrong with today's underwriting practices. But you should understand what is really going on and how that impacts your own investment. In the rush to be part of the IPO game, don't invest blindly. Know your options, learn how new shares are allocated, and gauge your own tolerance for risk.

Buying With Borrowed Money

Many people are getting themselves into financial trouble by piling risk on top of risk. I've heard cases of people taking out banks loans or credit card advances to buy stocks. But if you lose your principle, you still have to pay interest on money you don't have. And that's a situation that no investor wants to be in.

What worries me today is a much more common practice that can also be risky for investors – that is, buying stocks on margin. Margin is borrowing money from your broker to buy a stock and using your investment as collateral.

In the past two months, the level of margin debt has surged even faster than the stock market. In too many cases, investors are focusing on the upside – without carefully considering the downside. Understanding the details of your loan agreement could not be more crucial, or the consequences of misunderstanding more severe.

In volatile markets, investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls. Some investors have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin – without any notification and potentially at a substantial loss to the investor. If your broker sells your stock after the price has plummeted, then you've lost out on the chance to recoup your losses if the market bounces back.

Investors must also understand – in quantifiable terms – how these terms impact their investment. If you are thinking about buying on margin, take the time to do the math. Consider what will happen if say, the stock drops 50 percent in a short period of time, and how you would respond if your broker wanted you to put up more money to cover your losses. Remember, when you buy on margin, you can double your money, but you can also double your losses.

Diversifying Your Portfolio

You should also understand how your overall portfolio is tailored for risk. Remember: there is no better way – over the long term – to distribute risk than to diversify your investments.

Sure, there might be some years, or some markets, that will outperform a diversified investment strategy in the short term. That's just a fact. But don't forget that investors who boast of fantastic returns by investing in a single stock or one sector have also assumed the higher risks of a more narrow investing strategy. If that stock or sector starts to spiral downward, there's no other gain to offset the loss. You're also less likely to hear them boasting "Hey, I just lost my entire portfolio by buying only 3 stocks."

One way to diversify your risk profile is to consider mutual funds. But like any investment, before choosing a fund, do your homework. Today, it seems you can't open a newspaper or read a magazine without seeing ads promoting the stellar performance of "hot" mutual funds. And how many funds have you seen claiming to be the "number one performing fund" – some boasting returns of over 100 percent. But, past performance is not as important as you may think.

Maybe a fund invested early in a few successful IPOs giving the fund unusually high returns. If it's a small fund, this would boost the overall performance even more as each stock accounts for a larger part of the total fund. Or maybe a fund had an extraordinary year or two, but over the longer term, has not done as well as recent returns suggest.

Scrutinize the fund's fees and expenses. Over time, expenses and fees can really make a difference. On an investment held for 20 years, a 1 percent annual fee will reduce the ending account balance by 18 percent. Our website also has a Mutual Fund Cost Calculator to help you estimate and compare the costs of owning mutual funds. You'll find the calculator in the investor assistance section of www.sec.gov.

Of course, the strategy you use to invest is certainly your decision to make. But as you think about it, ask yourself some fundamental questions. What is my time frame for investing? What happens to my overall portfolio if a certain investment doesn't do well? Ultimately, maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk and reaching your financial goals.

All Information Is Not Created Equal

Managing your risk also means taking the time to research what you read and hear about potential investments. Unfortunately, it's not always just separating good information from the bad – often, it's a question of gauging objectivity or bias. In many respects, a culture of gamesmanship has taken root in the financial community making it difficult to tell salesmanship from honest advice. And that means, more than ever, investors must stay on their toes.

How many of you have seen analysts from Wall Street firms on television talking about one company or another? I'm willing to bet that not many of you have thought twice about that person's recommendation to buy or sell a particular stock. But you should.

A lot of analysts work for firms that have business relationships with the same companies these analysts cover. And sometimes analysts' paychecks are typically tied to the performance of their employers. You can imagine how unpopular an analyst would be who downgrades his firm's best client. Is it any wonder that today, a "sell" recommendation from an analyst is as common as a Barbra Streisand concert?

The fact is, many of today's business practices often lurk in those grey areas well beyond the bright line of right and wrong. But the Internet – with its low cost, relative anonymity, and unprecedented number of innocent investors – makes it ripe for out-and-out fraud.

Be alert to some of the dangerous practices in the marketplace. Don't fall for the illusion of easy money. And don't be enticed by a fancy web site promising that you'll make a fortune with one quick gamble.

Chat rooms increasingly have become a source of information – and mis-information – for many investors. But, I wonder how many chat room participants realize that if someone is waxing poetic about a certain stock, that person could well have been paid to do it. Chatroom tips have been compared to a high-tech version of morning gossip or advice at the company water cooler. But, at least you knew your co-workers at the water cooler. That just isn't the case on the Internet.

Right here in Los Angeles, we recently caught up with a group of college students and recent grads who cooked up their own scheme to strike it rich at the expense of unknowing investors. As part of the scam, they logged into computer terminals all over the city, posting messages that touted the merits of a particular stock. Then, after the stock price surged, they agreed upon a certain time to dump it and made a small fortune.

Between them they grossed almost $350,000. All except for one student who overslept and ended up with a portfolio of worthless stock. As much as some things have changed, it seems some things never will.

Stay informed. Do your research. Ask specific questions about products and ask questions about those who sell them. If you want to find out about companies, I encourage you to visit the SEC's Internet website, again that's www.sec.gov and click on EDGAR – the SEC's electronic database of filings by most public companies. Type in a company's name and you can retrieve every report they have filed with the SEC in the past five years. I also encourage you to visit the investor assistance section of our site. A more informed investor stands a better chance of avoiding the pitfalls of investing in today's market.


Today's new financial frontier has increased not only the opportunities, but also the risks. Greater investor empowerment demands greater investor responsibility. You have the power and means to be the most informed investors in the history of our capital markets.

I've always believed that protecting investors begins with investors themselves. Don't expect others, including the government, to do all the work for you – even with the greatest show of vigilance, we could not possibly catch everything. The SEC is intended to work in partnership with you.

In today's environment, with all the financial information, advertisements, and advice being fed to us, it is even more important – not less – for investors to focus on the fundamentals of investing. The ease of today's technology isn't an excuse to do less. It's an opportunity and a mandate to do more; to learn more; to be aware of more; to be informed of more and to achieve more – as individuals and as a nation.

Thank you very much.