Investing by yourself– Do you know what you are doing?

I always shudder when someone tells me that they are managing a few million dollars of their own money through a discount brokerage firm. Do they actually know what they are doing?

I randomly asked a few friends who have been investing on their own for years. How do you select the stocks that you buy and how do you know when to sell, I asked? The answers are not what you should expect.

No one professes to have a crystal ball. At the same time, few actually look at the financial information that companies file with the SEC. Professional investors all over the world use fundamental securities analysis to compare balance sheets between companies they are considering for investment. Self-directed investors rarely tell me that they even know how. It seems that a great many of the investment decisions that they make are emotional rather than rational.

More than one has told me that they get tips from a pundit on TV or a newsletter that they have come to respect. And how did they earn your respect, I ask? By being right more than wrong is the best answer I got but even that tells you nothing about the methodology behind the recommendations.

Remarkably, many people do not seem to trust the large wire houses and investment banks and the registered representatives that work for them. People use words like “crooked” and “conflicted” when they refer to these firms. If a research analyst at one of these firms writes a report regardless of quality, many people seem to dismiss them as dishonest.

More than one person told me that they invest in companies that have great new products coming out. You know that we believe that the fact of the new product is factored into the price of the stock as soon as the product is announced, I asked? For the most part, people, even those investing seven-figure accounts of their own money do not know what I am talking about.

The problem becomes more obvious when you ask: how do you know when to sell? Do you set targets or use stop losses? You really don’t think that I got a single affirmative answer, do you?

When I visit my financial adviser during the trading day, he may have half a dozen screens on; a financial news station with a live ticker; specialized screens following specific stocks that his clients own or which he is considering buying. He follows the market and “his” stocks, all day, every day. Is that how you manage your portfolio?

Even if you are well schooled in balance sheet analysis what do you know of the global markets, global economics and global politics. Forty years ago, Proctor and Gamble was a primarily domestic company. Today it operates in so many markets and has suppliers in so many others that its earnings can be affected by things that you cannot imagine, let alone identify and analyze.

As I got older, I came to realize that part of being wise is knowing what it is that you don’t know. It is true in life and especially in investing.

Ending fixed commission rates was a step toward market efficiency. The idea of discount brokerage firms where customers could purchase mutual funds and set up simple portfolios by themselves was likewise efficient.

The step from there to “do it yourself” with all of your money is a big one. Most self-directed investors do not have what it takes to avoid stumbling.

Emotional, irrational and uneducated investors contribute to market inefficiency. Every time that the market crashes more and more self directed investors come away with significant losses. Investing profitably is a lot harder than it looks. It takes time, attention, data and the knowledge of how to use that data.

If you do not think that you could pass one of the mid-term exams that I used to give to my students, hire an investment adviser.

Due Diligence and Reg. D

Due diligence was originally a judicial construct that provided a defense for underwriters who were jointly and severally liable for fraud perpetrated by the companies they brought to market. If the underwriter could not have discovered the fraud after a diligent investigation of the issuer, then the courts reasoned that there was not much more that the underwriter could do.

The due diligence investigation fell to the lead underwriter who was well paid for its efforts and upon whom other members of the selling group could rely. The underwriter’s due diligence investigators would consult with the issuer’s attorneys and accountants, pour over legal documents, ledgers and spreadsheets and visit factories, properties and sales offices. A good due diligence investigation included a look at the company’s customers, suppliers and competition, as well.

Due diligence has been a staple for underwriters for more than 40 years. The SEC has acknowledged the process in its new crowdfunding rules. Every legitimate brokerage firm underwriting new issues of securities employs some kind of acceptable due diligence process with one glaring exception: firms that underwrite Reg. D offerings sold to retail accredited investors. .

FINRA has codified the requirement of a diligent investigation by member firms selling private placements under Reg. D. The FINRA standard is specific; the member firm should verify the facts that are being given to investors. In a great many cases, a diligent investigation just does not happen.

When Reg. D was enacted, in the early 1980s, the vast majority of private placements were purchased by large institutional investors. These firms had the ability to review and analyze the offerings by themselves. Institutional purchasers would send their own lawyers and accountants to the issuing company before they sent their money.

Reg. D allowed wealthy individuals to invest in private placements as well. The rule set the threshold for “wealthy” investors at above a $1 million net worth. Wealthy individuals, it was reasoned could afford to sustain the losses if they occurred. Reg. D calls these wealthy individuals accredited investors. At the time there were fewer than 1 million millionaires in the US. Today there are 10s of millions.

A due diligence investigation of a company seeking to raise capital from investors is not difficult. My partner and I conduct due diligence investigations for VC funds, angel investors, family offices and broker/dealers. Individual investors, unless they are making a large investment, rarely call us.

The SEC estimates that $800 billion dollars worth of private placements are now sold every year, a very significant the vast majority of the funds coming from individual accredited investors. Experience has shown that some brokerage firms, including those that sell billions of dollars of private placements to individual accredited investors, do not diligently investigate the offerings that they sell. Hundreds of billions of dollars in investor losses are directly attributable to that fact.

After the credit market crash in 2008, many companies that had used Reg. D to raise billions of dollars were shown have been frauds. More than a few were Ponzi schemes. The latter, in many cases, were facades that had no business, just a good story about how investors were going to get paid high returns.

In some cases, more than 100 FINRA broker/dealers signed on to raise money for these Ponzi schemes. If they had done any investigation of these companies, they would have seen that the represented business did not exist. Selling a Ponzi scheme is usually a prima facie example of a firm that did not conduct a diligent investigation and probably conducted no investigation at all.

FINRA, the SEC and the state regulators did not impose significant penalties against firms that sold Ponzi schemes to investors. Civil recoveries by investors against the brokerage firms that sold the Ponzi schemes have been negligible. There is nothing in the market to incentivize a brokerage firm to conduct a real due diligence investigation; nor anything detrimental if they fail to do so.

The Dodd-Frank Act requires the SEC to re-consider the threshold for accredited investors every four years. If the SEC raised the threshold for net worth to $5 million, it would simply be an adjustment for inflation during the 30 plus years since the $1 million figure was set. It would also reduce the number of potential investors and the amount of capital that is available to this market.

The SEC seems intent upon expanding the amount of capital available to this market rather than contracting it. The Commission has already approved a change to Reg. D that makes it easier for firms to solicit potential Reg. D investors. No new protections for individual accredited investors seem to be forthcoming.

Many real estate and energy companies are serial issuers; they fund project after project using Reg. D. You can spot these professional sponsors at meetings and conferences where they wine and dine brokerage firm executives to get their offerings noticed and sold.

Brokerage firms will continue to give lip service to due diligence investigations but not perform them diligently. Ponzi schemes and other fraudulent offerings will continue to be sold to investors under Reg. D. Individual accredited investors will continue to bear the brunt of the losses.

Some things about the future of markets are easier to predict than others.