Speech by SEC Chairman:
Investing With Your Eyes Open
by Chairman Arthur Levitt
U.S. Securities & Exchange Commission
Investors Town Meeting
July 25, 2000
I'm here to talk about today's marketplace and 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.
We are amidst the longest period of economic expansion in our nation's history. A new, heightened optimism is fueling an almost unbridled culture of entrepreneurship, innovation, and investing.
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 you're as likely to hear people talking about the Nasdaq's performance as you are the latest Harry Potter book.
Even truck and beer commercials seem to be outnumbered by advertisements for on-line trading and investment advice. Just a few years ago, that would have been as unthinkable as a Labor Day weekend in Cleveland without the Air Show.
But, I'm concerned that some of the basic but important fundamentals of investing are being lost on investors. Unless investors truly understand both the opportunities and the risks of today's market, too many may fall victim to their own wishful thinking.
These times demand an even greater commitment to staying disciplined and understanding risk. 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.
We must not 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. This means researching your investments and understanding what you are investing your hard earned dollars in.
Let's start with the age-old question "How do I figure out what a company's worth?" Most analysts and investors refer to a P/E ratio that is, the stock price and the 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?
Consider how today's multiple stock splits have helped drive up the market value for many of these companies. If, for example, a stock splits two-for-one, while the number of shares has doubled, the company's total market value has stayed the same. If more investors dive back in and the stock shoots back up to where it was, the company's valuation is now worth twice what it was.
Today's 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.
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. But you might be better off at Northfield Park. At least when you're betting on horses you know the odds are against you.
Investing for the long term means focusing on the fundamentals that make up a solid company. 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?
Another common practice today that can also be risky for investors is buying stocks on margin. In too many cases, investors are focusing on the upside without carefully considering the downside. When you buy on margin, you can double your money, but you can also double your losses.
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. Many investors are stuck paying principal and interest for stock they no longer own.
If you're margined, and the market moves against you, and you can't get a hold of your broker you might be in some trouble.
More generally, you should also understand how your overall portfolio is tailored for risk. There is no better way over the long term to distribute risk than to diversify your investments.
Now, some years or some markets 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.
But remember, if a one-stock or one-sector portfolio 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 some boasting returns of over 100 percent.
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. Or maybe a fund had an extraordinary year or two, but over the longer term, has not done as well as recent returns suggest. If past performance were all that mattered, the Cleveland Indians would be in first place.
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.
I'm reminded of a story that Bob Hope used to tell. When he was growing up in Cleveland, he helped his family make ends meet by selling the Cleveland Plain Dealer in front of a small grocery store on East 105th. One day Hope sold a copy to none other than John D. Rockefeller. This was back in 1909. Rockefeller handed Hope a dime for the two-cent newspaper, and made Hope run into the grocery story to make change. Even one of the richest men on earth cared about even relatively small amounts of money. You should, too.
Know the effect that taxes will have on your mutual fund returns. 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. I've known people to spend more time comparison shopping for paper towels than they do for their investments. There is just no excuse for that.
Ask yourself some fundamental questions about your investment goals. 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.
As you do your research, ask specific questions about products and ask questions about those who sell them. For example, let's look at money market funds. I have a few of their prospectuses here with me now. When I look at some of their names, I see reassuring words like "Trust" "Liquid" "Government" "Cash" "U.S." "Ready Assets."
Well, I don't care if a fund is named "The Rock-Solid Honestly Safe U.S. Government Guaranty Trust Savings Fund." In any market investment, you stand a chance of losing your principal. Let me underscore that last point. It's a fundamental fact of investing. You might even write it down, and remember it whenever you invest: With any investment, you stand a chance of losing your money.
Managing risk also means researching 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, or salesmanship from honest advice.
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. Some analysts' paychecks are 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 rare as an empty seat in the "Dawg Pound" at a Brown's game?
What's more, the Internet with its low cost, anonymity, and large number of innocent investors makes it ripe for out-and-out fraud. Be wary of illusions of easy money, or fancy websites promising you'll make a fortune with one quick gamble.
Chat rooms increasingly have become a source of information and mis-information for many investors. I wonder how many chat room participants realize that if someone is waxing poetic about a certain company's stock, that person could well have been paid to do it.
To research a company, visit the SEC's Internet website, again that's www.sec.gov and click on EDGAR, the SEC's electronic database. You can retrieve every report a public company has filed with the SEC in the past five years.
The SEC requires that the annual reports filed by companies be certified by independent auditors. Auditor independence is a covenant between auditor and investor that says the auditor works in the interests of shareholders, not on behalf of management. This covenant says the auditor must steer clear of having financial interests in the companies he or she audits. The auditor's work must stand separate and apart from the clients' business.
We're seeing ever more complicated audit engagements and interwoven business relationships. It's become abundantly clear that a more modern and effective approach to self-regulation in the accounting profession today is an absolute necessity.
When I get back to Washington tomorrow we will hold a public hearing on an SEC rule proposal that addresses two aspects of the auditor independence issue: stock ownership by auditors and the types of services that auditors provide to their audit clients. I invite you to visit our website, read about the proposed rule, and tell us what you think.
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.
I've been involved with our markets, in one way or another, for over four decades almost as long as Dick Goddard's been doing the weather on television in Cleveland. I've seen markets go up, and I've seen them go down and stay down for extended periods. 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 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.