Speech by SEC Commissioner:
Does the Internet Empower or
Just Excite Investors?
Commissioner Laura S. Unger
U.S. Securities & Exchange Commission
The Harvard Club,
New York City
September 10, 1999
The views expressed herein are those of Commissioner Unger and do not necessarily represent those of the Commission, other Commissioners, or the staff.
Thank you for inviting me to speak about the future of online trading. It seems that my fellow panelists are in a much better position to tell you where the industry is headed. Besides, I think that it should always be a cause for alarm when a regulator predicts the future of any particular industry.
As many of you know, I held a series of roundtables on online trading more generally earlier this year. During those roundtables, I had the opportunity to hear from a number of industry representatives on the future of the industry and I am now in the process of writing a report to the Commission on my findings.
Because I have had the opportunity to speak to a number of market participants this year, and because the now closely watched month of October is just around the corner, I thought that it would be appropriate to focus my remarks today on one particularly nettlesome policy question: what should be the rights and responsibilities of participants in online trading? By participants, I am focusing on broker-dealers and investors.
I started thinking about the issue of responsibility when I gave a speech last January at the American Conference Institute entitled: Online Customer Expectations: Are They Your Obligations? The question still on my mind is whether obligations and expectations have changed in this new era of wireless-every-second-counts trading.
I have heard a couple of competing theories about the effects of online investing. I would call the first theory, the "investor empowerment" theory. A number of roundtable participants observed that the Internet empowers investors to make their own investment decisions, without relying on a broker to provide information. Online investors have an unprecedented amount of information about potential investments at their fingertips literally and brokers no longer act as the sole gatekeepers for that information. One issuer's representative stated it succinctly, "investors want today's news today." I would venture to say that today's news is too late for many investors.
Individual investor "empowerment" has pushed the industry to accommodate the "new" investor in a number of ways. Brokers and exchanges have moved to provide after-hours trading capabilities for the thirty to forty percent of investors who enter their orders at night. New electronic trading systems have become formidable and numerous competitors to the established exchanges.
The traditional exchanges have responded to this competition by planning their own IPOs. Issuers have begun to open up their conference calls and make the investor relations section of their web pages much more interactive and user-friendly. Brokers are competing by providing unprecedented amounts of research to investors, to the point of giving it away. And of course, investors no longer have to look at the newspaper or call their broker to get real-time quotes or even value their portfolios.
More choices mean more power to investors in their interactions with brokers. Investors can easily comparison shop and presumably, easily switch among brokers based on their preferences price, a trusted brand, or level of service. Brokers understand how costly it is to attract investors. They are using incentives, much like the new telephone companies did after the breakup of AT&T, to compete for investors.
But there is a flip side to this empowerment theory, which I would call the "investor excitement" theory of online investing. Excited to be empowered, investors seem to trade more frequently online. According to Bill Burnham, formerly an analyst with CS First Boston, during the First Quarter of 1999, 15.9 percent of all equity trades occurred online, up from 13.7 percent in the Fourth Quarter of 1998.
He noted that, in previous quarters, off-line investors coming online generated new trading activity but that, in the current quarter, established online investors drawn by low prices and easy access appeared to account for the new trading activity. In fact, the average number of online trades per online account at the leading online broker increased from 3.3 to 4 during that first quarter of 1999 - a 21 percent increase. According to this report, online firms seem to be generating higher activity levels in their existing customer bases in part by providing more personalized information and by pushing information such as breaking news to customers.
Clearly, increased trading activity generates increased commission for brokers. Because commission revenues comprise about half of total revenues for a number of online brokers on average, I have to conclude that the increased velocity of trading is good for brokers. . . . . But is it good for investors? According to at least two commentators, the answer is no. In a forthcoming article in the Journal of Finance, Professor Terrance Odean of the University of California at Davis found that trading is hazardous to the wealth of investors. Based on a review of nearly 78,000 households at a large discount broker between 1991 and 1996, Professor Odean concluded that investors who traded the most earned an annualized return of 11.4 percent as compared to 18.5 percent for those investors who traded infrequently. A different study, by Dalbar, Inc., found that over the last fourteen years, the average equity mutual fund investor achieved returns of only a fifth of the S&P 500 Index, partly due to jumping in and out of stocks at the wrong times.
So, which theory more accurately describes online investing? Does online trading empower investors to trade wisely or just excite investors to trade frequently? Well, I'm assuming, and it's a big assumption, that the answer to that question depends on who the investor is. It may also depend on who the broker is. Because higher trading velocity is still tied to the bottom line of an online broker that depends on transactional revenue, there is an inherent conflict between online brokers' interests in investors trading more often and investors' interests in trading less often.
In fact, we all saw the share price of a number of online brokers drop this summer after they reported what appears to be temporarily lower trading volume. This conflict may just be heightened by the online investors' propensity to trade more frequently. But if the answer isn't clear, then what can we say about the responsibilities of the parties in an online transaction?
Most online firms would say that investors online are responsible for their own investment decisions. In fact, firms say that they have no suitability obligations for their customers' investments because they provide execution only and do not recommend specific securities. Since these firms don't recommend securities, they do not have an obligation to "know" their customers the way that full-service firms do.
Today, or maybe yesterday, that may have been true. A quickly developing trend makes this a different question for tomorrow. Apparently many online firms are close to adopting significant data mining capabilities about their customers' habits and some may have done so already. In developing customer profiles, it may be fair to assume that the firms intend to target investment-related information to those customers.
Data mining will help online firms reach what has been described to me as the "holy grail" of online trading automated advice. You only have to look at today's rock bottom commission prices to conclude that providing trade execution for less than the $7.95 cannot be the end of the future business plans for online brokers.
Instead, online brokers will differentiate themselves by providing advice. I assume that many investors who are overwhelmed by the amount of information available today will welcome the capability to personalize or "mass customize" the delivery of investment-related information.
Technology has enabled investors to trade online but it has not necessarily made them able to analyze information about 10,000 public companies, 50,000 municipal issuers, and an alphabet soup of derivative instruments. Investors now need to make sense out of all of these choices. They also need to understand common investing principles such as the benefits of asset allocation, and buy-and-hold investing.
The imminent advice revolution tells me that we will need to resolve who has what responsibilities online. I would not advocate eliminating suitability obligations. That would eliminate a cornerstone that sets investment professionals apart from others and which allows them to earn investors' trust. If brokers make recommendations, they must be suitable for the investor.
The more practical question is how broadly or how narrowly regulators should interpret suitability obligations. What is a "recommendation" in the online environment? It is certainly more subtle online. Some may argue that suitability obligations are triggered whenever a broker brings a security to the attention of an investor.
Interpreting suitability obligations too broadly, however, may stifle information delivered to investors the opposite of what the Internet is about. Interpreting suitability obligations too narrowly though may undermine the effectiveness of the rule for investors. Examples in behavioral studies teach us that it is very hard to get investors to fully consider risks once they are motivated to buy.
So how far do firms have to go to get investors to consider risks before they buy? Or, more bluntly, up to what point should firms protect investors from themselves? This is a particularly difficult question in today's market environment investors seem to feel impervious to risk.
Last week's Time magazine cover pondered the question of why people take risks. The author noted that Americans are taking greater risks in higher numbers than ever before: from participating in extreme sports, changing jobs, accepting uncertain first-time jobs, and even in investing. With respect to investing, the author pinned responsibility squarely on the long bull market that has lulled investors into a sense of security. (I would add to that the spectacular valuations that we have seen in many Internet stocks.)
Based on anecdotal information, I agree that the bull market has skewed our perspective on the effect of risk. The July 1999 Index of Investor Optimism, a joint effort by Paine Webber and the Gallup Organization, found that investor optimism about the stock market has reached record levels. Investors expect their investments to return 16.6 percent, which is a record high. Investors with less than five years of investing experience have the highest expectations. They expect the market to return 21.1 percent in the short term, compared with 14.7 percent for investors with more than 20 years of investing experience. The historical average return on securities is actually around 13 percent.
So, should we have helmet laws for investing? I doubt it, except in extreme circumstances, such as for options, penny stocks, or possibly day trading. Investment risk taking has become deeply ingrained in human nature, from the early trading adventures, such as the East India Company, to the momentum traders of today. Historically, it has proven extremely difficult to regulate risk taking. Paradoxically, investors' risk taking is what fuels the capital markets.
Given that it would be impossible to regulate risk taking thankfully that is not the Commission's role I want to urge brokers to consider how they can manage investors' expectations. One obvious place to start would be in the area of risk disclosure. Do investors fully understand the market risks that may affect their investments?
Truly effective risk disclosure would enable the customer to focus on both the possibility and the degree of risk before he makes his investment decision. In short, refrain from shouting the benefits but whispering the risks of particular investments. Brokers should consider that when the market changes, so will customers' expectations.
But what, if at the end of the day, a broker ends up in arbitration over whether a particular investment was suitable for an online investor? I would urge brokers to consider data mining not just as a marketing tool, but as also as a tool to help establish that they considered a specific investment to be reasonable for a particular investor. I would listen very closely to a broker who argues that it had a reasonable basis for making a recommendation based on the profile that it had developed about that investor using data mining techniques. One caveat this, of course, is that depending on the circumstances, information gathered through data mining may not completely satisfy the broker's obligation to gather all of the relevant facts about an investor.
This is just one of the more difficult issues facing regulators today. We want to give guidance and clarity, but we want to do it right. I want to encourage the industry to contact me at firstname.lastname@example.org about their concerns regarding suitability.