How Wall Street made their Bones

April 9, 2020

This is the first page from the coming series of essays titled “Save like an American”

Over One Hundred and Ten years ago, an experienced game designer by the name of Elizabeth Magie, whose friends called her Lizzy, filed a patent for a little board game she called The Landlord’s Game. Over the next Thirty Years, this little game that she created would evolve into a staple in the board-game world known as monopoly. Monopoly was originally designed to show people of all ages the principles of the new “progressive” economic system and philosophies that were born out of the gilded age in America.  However, this timeless classic also discreetly shows us a principle that is not always discussed in personal finance. The house never loses or in this case, Wall Street. 

In any service industry, there are only two ways to get paid, fees and commissions. A popular radio ad here in Tennessee claims that because they are paid exclusively on fees from their clients accounts that they are more trustworthy than those who are paid on commission.  However, if you actually found out that fees will cost you more money over time, regardless of how well the market does, would it bother you?

Fees are, over time, one of the greatest detriments to the American public’s wealth. This brings in a few concepts that we’ve discussed earlier in this book, such as compound interest, opportunity cost, and capital. In a private anonymous study, online investment firm Personal Capital found that “At the lowest average advisory fees (0.82 percent) and lowest total fees could cost an investor with a $500,000 could cost an investor an average of$502,407 over 30 years.” What they are saying is that over time, as fees are paid year over year, their impact on the account they service can be dire. Fees take from the investors’ hands, and if that money is going to be used to retire on, it can eliminate vast amounts of wealth before the government even touches it. Writer Johnathan Todd says it this way: “The impact of fees is twofold: An investor pays an ever increasing amount in fees as account balances grow, because the fees are based on a percentage of assets. And fees also strike a blow to the portfolio’s returns. That’s because every dollar taken out to cover management costs is one less dollar left to invest in the portfolio to compound and grow. So, in addition to paying potentially hundreds of thousands of dollars in avoidable fees, our research shows that an investor gives up many times that amount in lost portfolio returns over time.” This is because fees are paid by us, not the company itself, so that money could have been invested, instead of funding the adviser’s lifestyle. 

Another great illustration comes from an article titled “The Tyranny of Compounding Costs.” Although the issue was related to mutual funds and the fees within them, the disparity between what the client could have had and what they ended up with is telling. The story starts with benefits expert Brooks Hamilton disputing the claims of John Bogle, who founded the Vanguard Group. The article displays the table on the next page:

“The table breaks down Bogle’s example of the impact of compounding and compounding costs over the long term. On the left it shows the growth of $1,000 invested by an individual at age 20 until his or her death at age 85, assuming 8% annual growth. On the right, it shows what happens to that same $1,000 assuming a 2.5% annual cost, such as a mutual fund management fee. Over 65 years, these annual fees eat up a staggering 79% of what the investor would have earned with no management fees.”

This issue causes us to examine exactly how products are recommended. Conventional wisdom would tell us that the commissioned salesman is just trying to sell us a product for the money, while a fee based advisor is impartial, and simply doing what is right for us. There was an unconfirmed story of President Barack Obama in 2014 telling the head of one of the life insurance lobby groups, “I don’t believe that you can make an impartial recommendation while earning a commission.” This sentiment is repeated over and over in magazines and in the media. Recently in Forbes, an article was published that claimed the difference between fees and commissions was, “Basically, you can divide adviser into two types: commission based and fee only. The commission people sell you investment products, like stocks and mutual funds, and get paid for it—that is, they get a commission. The fee only advisors don’t sell you anything but recommend an asset allocation that you put into effect. They get paid either by a share of your assets or by flat fees.”

This evidence has led me to conclude that many in the financial industry don’t actually have a plan, they have a product sold as a plan.  If this crisis has shown us anything, I believe it’s rather self-evident that these products are totally useless to defend against market risk.  This revelation leads us to the next logical question, what are the goals of a sound financial plan?