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U.S. Securities and Exchange Commission

Speech by SEC Acting Chairman:
Timeless Principles of Investing in an Electronic Age

Remarks by

Acting Chairman Laura S. Unger

U.S. Securities & Exchange Commission

2001 Los Angeles Times Investment Strategies Conference
Los Angeles, California

May 6, 2001

I want to thank the LA Times for inviting me to speak to you today. Apparently, as the "Acting" Chairman, I qualify for a part in an LA gig. If anyone knows of a good agent, let me know after I finish speaking about some of the recent developments and current practices in today's marketplace, and a review of some of the basic principles of sound investing. I promised my sister – who lives here in LA and is sitting in the front row – that even a wannabe investor would understand my remarks today.

This is the fifth consecutive year that the Chairman of the Securities and Exhange Commission has had the privilege of addressing the Investment Strategies Conference. So for the fifth time, SEC lawyers have insisted that you be reminded that 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.

1. New Challenges for Investors and the Industry

I'd like to begin today's discussion by talking about the regulatory challenges that confront the Commission, starting with the Internet. The Internet has opened a new world for the individual investor. The ease of access, the unprecedented availability of online investment information and reduced transaction costs have empowered individual investors to enter the financial markets in record numbers. Approximately one-half of U.S. households invest in our securities markets, and about 20% of those investors now trade online.

However, the Internet also poses risks for investors. Research shows that too many investors are not well informed about such investment basics as transaction costs, margin trading, and best execution.

Just this past week, the SEC launched an online investor behavior survey available on our webiste – www.sec.gov. Some of the things we hope to learn from the survey include:

  • The sources of financial information that investors rely on;
  • Customer expectations at online firms;
  • The level of knowledge and experience of the average online investor;
  • The trading frequencies of online investors versus investors trading at traditional "bricks and mortar" firms; and
  • How online investors analyze risk.

I hope that we can use the survey results to improve our investor education efforts and learn more about investors generally.

2. New Rules to Improve Disclosure on Trade Execution

Now, this question isn't on the online survey I just mentioned, but how many of you would pay $100 dollars in order to save $10 on a securities transaction? I'm guessing not many. But that's what happens to some online investors every time they trade.

In the past, customers have generally trusted their brokers to make decisions about how and where to execute trades. But the information age has created a new investor who is more informed, more inquisitive, and more in touch with our markets than ever before. New technologies and faster, cheaper computing power also make it more possible to include customers in the order execution process.

That's why the SEC adopted new Order Execution and Routing Disclosure Rules. The new rules will go into effect this summer, giving investors previously unavailable information about how their trades are executed.

Here's how it will work. Let's say an investor wants to buy 1,000 shares of a particular stock. If that investor chooses a particular broker because the broker's commissions are $10 instead of $20, the investor saves $10 dollars. Now let's say the $10 broker sent the order to a Wall Street intermediary that filled the trade at a price that was ten cents a share higher than the $20 broker. That investor just paid $100 more in transaction costs just to save $10 dollars in commission costs.

Obviously no investor would make this choice knowingly. Previously, however, there was no public information available to investors to help them understand that trading costs aren't just about commissions – they are also about transaction or execution costs.

Our new rules require market centers, including exchange specialists, OTC market makers, and ECNs, to make publicly available monthly reports with uniform statistical measures of execution quality on a stock-by-stock basis. The rules also require brokers that route customer orders to prepare quarterly reports that describe their order routing practices.

Of course, at some point, a customer may want to sacrifice the chance of a better price for speed and vice versa. But in order to make an informed choice about that trade-off, a customer needs relevant information about the cost of that choice.

At the very least, we hope that improved disclosure will allow investors to know the differences between brokers and to make better-informed decisions when choosing a broker. Optimally, increased disclosure could motivate brokers and order execution centers to seek continual improvement in service and better prices for investors – leading to a market-wide improvement in execution quality.

3. Exploring the Role of Financial Portals

Another area of interest created by the electronic age is the rise of financial portals on the web. As many of you know, "portals" are web sites that serve as a passageway for web surfers to areas of interest to them. Financial portals focus on money management, providing a central location where investors can find all types of financial information. Some of you may use a financial portal to check quotes, research stocks and other investments, and view your brokerage, bank, and credit card accounts in one place. There are portals that even give users "one-touch" access through a hyperlink to the trade execution screens of their online brokerage accounts.

When portals first came on the scene, broker-dealers saw the portals as a cost-effective and benign means of attracting new customers. But as portals have gained in popularity, broker-dealers are increasingly finding themselves competing with the financial portals for customers. At least one of the questions broker-dealers ask is – why aren't the portals registered?

My first question as a regulator though, is: what are the portals doing? What are their relationships with the broker-dealers they hyperlink to? What are the portals' business arrangements and compensation arrangements? How do the hyperlinks work, and what do they look like?

Figuring out the answers to these questions isn't easy without actually talking to the portals – which we don't regulate. To start this dialogue, I've just announced a roundtable to discuss some of these issues later this month. The roundtable will include participants from a cross section of broad- and narrow-based portals, broker-dealers, lawyers and academics.

4. The Impact of Reg. FD

In case you didn't already know, I am a big fan of roundtables. Last month, we held a roundtable on a different subject. How many here have heard of Regulation FD—or Reg. FD for short?

FD stands for "Fair Disclosure." Reg. FD requires companies that release material information to release it to everyone at the same time. Reg. FD is intended to level the playing field for all investors. It's aimed at stopping closed-door conversations about non-public material information between companies and the analysts who cover them.

Before Reg. FD, news about whether a company will meet or fall short of earnings estimates would often leak out slowly to analysts and fund managers, among others. That allowed some investors to trade on the news before others, at the expense of individual investors who often got the information last.

Now that approximately six months have passed since Reg. FD went into effect, I thought it was important for issuers, analysts, and investors to have an opportunity to share their initial experiences. That's why I held a roundtable two weeks ago to discuss the impact of the regulation.

So far companies seem to be releasing information more often. By one count, the number of conference calls open to individual investors tripled in the past year. Webcasts of those meetings quadrupled. But I'm told some are concerned that companies are unsure of what they can and cannot say, and as a result they may be talking more but they are not saying more. In fact, by many accounts they are saying less.

As I've said before, I intend to monitor closely the impact of Reg. FD on information flow in the markets—including how it affects the quantity and quality of information. I will issue a report on the roundtable – including some findings and recommendations – in the next month or so.

5. Analyst Conflicts

While we're on the subject of analysts, how many of you have seen analysts from Wall Street firms on television talking about one company or another? How many of you read analyst research reports? 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 what would happen to an analyst who downgrades his firm's best client. Is it any wonder that today that you're more likely to see dollar a gallon gasoline than a "sell" recommendation from an analyst?

The most frequently discussed potential conflict involves the blurring of the line between research and investment banking. When a brokerage firm underwrites a company's public offering, the brokerage firm has a number of financial interests in seeing that the offering performs well. It also has a reputational interest; better performance will improve its competitive standing.

If the brokerage firm wants to develop a business relationship with an issuer, and it offers research coverage of the issuer, by necessity, the brokerage firm compromises its objectivity. The tension arises because the firm's research analyst typically becomes part of the investment banking team formed to promote the offering for the issuer.

How can a brokerage firm manage those two competing interests? Unfavorable analyst reports are bad for sales and a bad way to nurture a lucrative long-term investment banking relationship. The natural incentive, therefore, is to avoid releasing an unfavorable report that might alienate the company and impact its future investment banking business.

This is not an irrational fear, either. In a recent survey of 300 CFOs, one of five acknowledged that they have withheld business from brokerage firms whose analysts issued unfavorable research on the company. What happens when an issuer, its investment firm, and the firm's analysts all have a common financial interest in seeing that the company performs well? How can analysts provide independent research when they are part of the marketing team?

Until brokerage firms deal with these conflicts, I would recommend investors consider a healthy dose of skepticism about what a buy recommendation really means.

6. New Challenges for Investors

Now let's talk about the challenges that investors face today. Many of you might have been here last year when former SEC Chairman Arthur Levitt stood on this stage. With the Nasdaq on the verge of hitting 5,000, Chairman Levitt warned that he was concerned that a "Who Wants to be a Millionaire" mentality had overtaken the markets. Too many investors had forgotton about the fundamentals of investing and were investing with their fingers crossed and their eyes closed.

As it turned out, his warnings were right on target. Now, the show "Survivor" may more aptly describe some investors' feelings about the market.

People may have lost sight of the fundamentals when markets did nothing but go up and up, but in any market investment, you stand a chance of losing your principal. Let me underscore that last point. You might even write it down. Those who meditate may want to make it your investment mantra. Investing is not risk free – the higher the return, the riskier the investment.

Investing for the long term requires 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?

You can start your research on a company by visiting the SEC's website at www.sec.gov. Click on EDGAR, the SEC's electronic database, and you can retrieve every report a public company has filed with the SEC in the past five years.

The EDGAR database is just one of the tools you can use to invest wisely and avoid costly mistakes. Another is our new margin calculator.

A few words about margin. Some investors have been shocked to find out that their brokerage firm has the right to liquidate the investor's account to meet a margin call. This means the firm can sell stocks in its margin customers' accounts–without any notification and potentially at a substantial loss to the investor. The stock price may rebound, but the investors are stuck paying principal and interest for stock they no longer own.

As investors have increasingly used margin to leverage their buying power in recent years, the number of complaints we've received from investors about "margin sellouts" has increased. It's currently the 6th most common complaint. But many of those complaints—and more importantly, the financial losses—could have been avoided had the investor fully appreciated the costs and risks of investing on margin.

Recognizing the need for more investor information about margin, last month we launched a new interactive calculator to help investors estimate their likelihood—based on the past performance of their individual holdings—of getting a dreaded margin call in the next month, quarter, or year. The calculator also computes the costs of investing on margin.

Remember what I said about "transaction" costs earlier. Margin is another transaction cost that investors don't have enough information about. With the margin calculator, if you borrow $5,000 to buy $10,000 worth of stock, you can find out just how much money you're paying on that loan in interest. There's never been anything like this calculator before, and it's available for free on our website. Just go to www.sec.gov, then click on "Interactive Tools" under the "Investor Information" banner on our website.

7. Ferreting Out Fraud on the Internet

I mentioned the EDGAR database as a valuable source for researching a company's fundamentals. EDGAR is just one of the ways the Internet has empowered investors—giving them timely access to financial information like never before. And it now serves as a way for companies to communicate with investors more quickly and efficiently.

The Internet offers investors access to information that was unthinkable just a few years ago. But as I mentioned earlier, the Internet also has a downside. There's no button on your computer to separate the good information from the bad.

With its low cost, anonymity, and large number of innocent investors—the Internet is ripe for out-and-out fraud. You need to be wary of illusions of easy money, or fancy web sites promising you'll make a fortune with one quick gamble. Remember the mantra-the higher the return, the riskier the investment.

The most common types of securities fraud on the Internet are:

  • First, market manipulations or so-called "pump and dump" schemes where the fraudsters hype a stock and sell out at the peak, leaving ordinary investors holding overpriced stock. We recently sued a group of UCLA students who used UCLA computers to falsely report a pending takeover of a penny stock company. Their efforts took the stock price from 13 cents to 15 dollars overnight! The moral of the story: Treat predictive information you come across in chat rooms and on bulletin boards as no more trustworthy than a horoscope.
  • Second comes Offering frauds characterized by promises of unrealistic returns with little or no disclosure of risks and in many cases involving the outright misappropriation of customer funds; and
  • Finally are newsletters written by fraudsters who recommend or "tout" a company's stock without telling investors that the company paid them to do so.

You should also be proactive in looking for tell tale signs of fraudulent activity. In recent weeks, we've seen a surge of suspicious offerings tied to today's market conditions. The scams are not new. Only the pitches have changed. The scamsters are trying to capitalize on fears of a recession, of an energy crisis, and stock market instability.

The subject lines of spam e-mails now read: "Beating the market;" "Stocks are down: Currencies are on the Rise;" "Big profits despite market meltdown;" "Take a break from the crashing market."

The promises are extraordinary. One states in bold print, "Currency Trading Made Simple," and continues, "200% return in less than 90 days!"

The spams promise that the schemes are "100% risk-free." A pitch for investors to buy accounts receivable states, "Make 48% annually. . . through Guaranteed – Fully Secured Account Receivable Acquisitions."

As securities Regulators, our responsibility for investor protection takes on added urgency in the electronic environment. I've already asked our Enforcement Division to follow up on these potential scams. But I particularly want investors to be aware of them. They are real, they are circulating out there, and I don't want people to be taken in by them and lose their money. Always remember these four things when making a decision whether to invest:

  1. If it sounds too good to be true, it is!
  2. Investigate thoroughly before you invest. Never blindly follow the advice of strangers on the Internet or elsewhere.
  3. Understand what you are purchasing.
  4. And most of all, remember that returns are directly related to risks. Remember the mantra. The higher the return, the riskier the investment.

The California gold rush is a thing of the past. In other words, there simply are no quick and easy routes to riches – successful investing takes time.

8. Tips for Sound Investing

Each investor must ask herself some fundamental questions about your investment goals.

1. What is your time frame for investing? Are you a long or short term investor?

2. Have you minimized risk through diversification?

Ultimately, maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk and reaching your financial goals.

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 – like maybe your brother-in-law – by investing in a single stock or one sector have also assumed the higher risks of a more narrow investing strategy.

Another way to diversify your risk profile is to consider mutual funds. But like any investment, before choosing a fund, do your homework.

3. Remember that past performance is no guarantee of future performance.

Today, it seems you can't open a newspaper or read a magazine without seeing ads promoting the stellar performance of "hot" mutual funds. Be aware however that a fund may have 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.

4. Scrutinize 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. Say you started out with $10,000. And you averaged a 12 percent return for 20 years. That one percent higher fee just cost you $14,000. You could have had $78,000, but instead you have $64,000. That's pretty good, but what did you get for those higher fees? That is the $64,000 dollar question.

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 Information" section under "Interactive Tools."

You should also consider the effect taxes will have on your mutual fund returns. Earlier this year we adopted a new rule that requires funds to provide you with that information.

5. Most importantly, do your homework.

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, or salesmanship from honest advice. I've heard some Angelinos tend to spend more time choosing a cell phone plan than researching their investments. Whatever you do, don't just invest based on a "tip." There is lots of solid investment information available today – consult it and use it before putting your money at risk.


The story of America's capital markets is one of the greatest success stories of all time. In recent years, in record number, Americans have turned to the markets to achieve their share of the American Dream, whether it's buying a first home, sending children to college, or saving for retirement.

But our markets will remain strong and vibrant only as long as investors have confidence in them. Thus, it can only follow that the integrity of our markets relies fundamentally on the integrity of market information available to investors.

We're going to do our part. The things I've mentioned are only the beginning. But investors have a responsibility as well.

Whether you trade online or with a traditional broker, whether you get your information from company reports, the newspaper, or the Internet, you still need to know what you're buying or selling—and why.

Investors will always need access to high quality information to balance their investment objectives with their tolerance for risk.

Even in an electronic age, no technological advance can ever alter the fundamental relationship between risk and return. The timeless principles of investing still apply. Remember the Mantra!

Thank you very much.



Modified: 05/10/2001