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Take On the Street: What Wall Street and Corporate America Don't Want You to Know, and What You Can Do to Fight Back

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Investors today are being fed lies and distortions, are being exploited and neglected. In the wake of the last decade’s rush to invest by millions of households and Wall Street’s obsession with short-term performance, a culture of gamesmanship has grown among corporate management, financial analysts, brokers, and fund managers, making it hard to tell financial fantasy from reality, salesmanship from honest advice.

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Overview

Investors today are being fed lies and distortions, are being exploited and neglected. In the wake of the last decade’s rush to invest by millions of households and Wall Street’s obsession with short-term performance, a culture of gamesmanship has grown among corporate management, financial analysts, brokers, and fund managers, making it hard to tell financial fantasy from reality, salesmanship from honest advice.

In Take on the Street, Arthur Levitt—former chairman of the Securities and Exchange Commission—shows how you can take matters into your own hands. At once anecdotal (names are named), informative, and prescriptive, Take on the Street expounds on, among other subjects: the relationship between broker compensation and your trading account; the conflicts of interest inherent in buy-hold-or-sell recommendations of analysts; what exactly happens—and who gets a piece of the action—when you place an order; the “seven deadly sins” of mutual funds; the vagaries and vicissitudes of 401(k) investments; how accountants engage in sleight of hand to fake impressive company performance; how to find the truth in a company’s financial statements; the real reason for the Street’s hostility to full disclosure; the crisis in corporate governance, and, given these shenanigans and double-dealings, what specific steps you can take to safeguard your financial future.

With integrity and authority, Levitt gives us a bracing primer on the collapse of the system for overseeing our capital markets, and sage, essential advice on a discipline we often ignore to our peril—how not to lose money.

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Editorial Reviews

From Barnes & Noble
In this outstanding book, Arthur Levitt, the former chairman of the Securities and Exchange Commission, exposes Wall Street's duplicitous inner workings while also providing detailed advice that will protect and empower the average investor.
Publishers Weekly
Levitt, the Securities and Exchange Commission's longest-serving chairman, supervised stock markets during the late 1990s dot-com boom. As working Americans poured billions into stocks and mutual funds, corporate America devised increasingly opaque strategies for hoarding most of the proceeds. Levitt reveals their tactics in plain language, then spells out how to intelligently invest in mutual funds and the stock market. His advice is aimed squarely at small, individual investors, as he explains how to look for clues of malfeasance in annual reports, understand press releases and draw more from reliable sources. Woven throughout are his recollections about the SEC boardroom fights he oversaw. While most of them serve to illustrate a point about the market and its machinations, some passages, often outlining a failure or frustration, are oddly apologetic. In particular, when addressing the origins of recent corporate scandals (e.g., those involving Enron and Arthur Anderson), his effort to lay the responsibility equally on indifferent legislators, special interest groups, greedy CEOs and, perhaps most of all, lazy investors, makes it clear that Levitt wishes to avoid criminalizing corporate officers' actions. (After all, many of them are his friends and colleagues.) The final chapters, detailing how stocks are bought after they're ordered ("Pay Attention to the Plumbing") and retirement plans are structured ("Getting Your 401(k) in Shape") return to practical, profitable advice. One in particular, "Beware False Profits: How to Read Financial Statements," is worth the book's price. Levitt's mini-MBA course-sans the lifelong club connections-should be mandatory reading for anyone with a dollar invested in the stock market. (Oct. 8) Forecast: Levitt's high profile, coupled with his authority and integrity, will make him a man in demand by the mainstream media. A 150,000 first printing, a big plug to booksellers from the publisher at BookExpo this past May and a big advertising push may put this business book on the bestseller lists. Copyright 2002 Cahners Business Information.
Library Journal
Good advice to individual investors from the longest-serving chair of the Securities and Exchange Commission. Copyright 2002 Cahners Business Information.
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Product Details

  • ISBN-13: 9780375421785
  • Publisher: Knopf Publishing Group
  • Publication date: 10/8/2002
  • Edition description: First Edition
  • Edition number: 1
  • Pages: 338
  • Product dimensions: 6.44 (w) x 9.52 (h) x 1.15 (d)

Meet the Author

First appointed in 1993, Arthur Levitt was the longest-serving SEC chairman. He was also chairman of the New York City Economic Development Corporation and the American Stock Exchange. He co-founded the brokerage firm that eventually became Citigroup. He lives in Connecticut.

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Read an Excerpt

Chapter One

How to Sleep as Well as Your Broker

If they have it, sell it. If they don't, buy it. That was the whispered joke on Wall Street in 1963 when I joined the brokerage firm of Carter, Berlind & Weill. It was only half in jest. It betrayed the callous attitude many brokers had toward their clients. Brokers are supposed to advise you on which securities to buy and sell, depending on your financial resources and your investment objectives. They offer garden-variety stocks, bonds, and mutual funds, or such exotic instruments as convertible debentures and single-stock futures, to help you shape a portfolio that fits your needs. Brokers may seem like clever financial experts, but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in accounts they manage. They want you to buy stocks you don't own and sell the ones you do, because that's how they make money for themselves and their firms. They earn commissions even when you lose money.

Commissions can take many forms. On a stock trade, the commission is a percentage of the total value of the shares. For a mutual fund there are up-front commissions, or sales loads, which are paid when you make an investment. There also may be back-end commissions, or deferred loads, which are paid when you take your money out. On bonds, brokers don't charge commissions. Instead, they make their money off the "spread," or the difference between what the firm paid to buy the bond and the price at which the firm sells the bond to you.

Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc. and one of the smartest investors I've evermet, knows all about broker conflicts. He likes to point out that any broker who recommended buying and holding Berkshire Hathaway stock from 1965 to now would have made his clients fabulously wealthy. A single share of Berkshire Hathaway purchased for $12 in 1965 would be worth $71,000 as of April 2002. But any broker who did so would have starved to death. While working in the early 1950s for his father's brokerage firm in Omaha, Neb., Buffett says he learned that "the broker is not your friend. He's more like a doctor who charges patients on how often they change medicines. And he gets paid far more for the stuff the house is promoting than the stuff that will make you better." I couldn't agree more. In sixteen years as a Wall Street broker, I felt the pressures; I saw the abuses.

"Levitt, is that all you can do?" Those stinging words rang in my ears at the end of many a week as I struggled to join the ranks of successful Wall Street brokers at Carter, Berlind & Weill. Eleven of us worked out of an 800-square-foot office on 60 Broad Street, in the shadow of the New York Stock Exchange. I divided my time between buying and selling stock and scouting for companies that might want to go public.

When I joined the firm, America was riding high. A postwar economic boom that began in the 1950s marched onward through most of the 1960s, encouraging companies to look to Wall Street to finance their expansion. The growth in jobs and overall prosperity produced much wealth, and people flocked to the stock market in search of easy money. It was a heady time, and I wanted to be a part of it. I was thirty-two, and though I had no Wall Street experience whatsoever, I started calling potential clients right away.

The competition among the partners was intense. We shared one large office so we could keep a watchful eye on one another. Arthur Carter kept a green loose-leaf binder on his desk, and in it he recorded how much gross-the total amount of sales-each of us was responsible for each week. Every Monday morning I stared, terrified, at an empty calendar page, worrying how I was going to generate a respectable $5,000 in sales. When we reviewed the results on Friday, there would be much scolding and finger-pointing. If I wasn't the lowest producer, I joined the others in berating the one who was.

Our mandate was to grind out the gross and recruit new brokers with a proven knack for selling. But on the Wall Street I knew in the 1960s and '70s, the training of new brokers was almost nonexistent. Brokers were hired one day and put to work the next cold-calling customers. At all but a few firms, research was primitive. Starting salaries were a pittance, forcing brokers to learn at a young age that they had to sell aggressively to survive in the business. The drive for commissions sometimes motivated supervisors to look the other way when aggressive upstarts bent the rules.

Today the brokerage industry is a lot more sophisticated. Nowadays brokers sell dozens of savings, retirement, and investment products, and insurance, real estate, and hedging instruments to reduce risk. But with half of all American households invested in the stock market, brokers' responsibility to the individual investor is greater than ever.

Good People in a Bad System

Sadly, the brokerage industry still has numerous flaws. That's not to say that all brokers are commission-hungry wolves on the prowl for naive investors. Some are; others are just inept. Most are honest professionals. They are good people stuck in a bad system, whose problems remain fourfold. First, some brokers are not trained well enough for the enormous tasks they are expected to carry out. Second, the system in which brokers operate is still geared toward volume selling, not giving objective advice. Third, to increase sales, firms use contests to get brokers to sell securities that investors may not need. Most brokers rarely, if ever, disclose to their clients how they are paid or how their bonuses are structured, even though such disclosures would go a long way to resolving the conflict-of-interest problem. Fourth, branch-office managers and other supervisors, who are paid commissions just like their brokers, have an incentive to push everyone to sell more and to turn a blind eye to questionable practices.

Brokers come in many stripes. There is the full-service variety, employed by the large brokerage houses advertised on television: UBS Paine Webber (part of Swiss bank UBS), Morgan Stanley and Salomon Smith Barney (part of Citigroup). The largest of the full-service firms is Merrill Lynch & Co., which employs roughly 14,000 brokers in five hundred or so U.S. locations. Merrill calls its brokers "financial advisers." They manage more than 9 million customer accounts worth $1.3 trillion. Not only do they help clients determine their investment goals and pass on customer orders to their trading desks for execution, but they also provide research from in-house analysts and give advice on a wide range of securities. For these extras, customers pay more. The average commission paid to a Merrill Lynch broker in 2000 was about $200 per transaction.

Then there are the discount houses, which give minimal advice or none at all. Many do not provide proprietary research, although they may make available research produced by other firms. Investors are charged a moderate commission or pay a flat fee for each trade.

Online brokers can be either full-service or discount, though most are discounters. For a flat fee of $9.95, one leading online broker lets customers order up to 5,000 shares. Research and advice were not on the menu when online trading first began, but some online brokers, such as Charles Schwab Corp., have moved upstream into the full-service realm by offering research and advice to customers who maintain a minimum balance.

There's a saying that compensation determines behavior. Firms never seem to run out of novel ways to use commissions to motivate their brokers-and take more money out of your pocket. One popular system is the grid. Typically, brokers receive a percentage of the commissions that they generate, ranging from 33 percent to 45 percent. As their commission sales increase, they can jump to a higher payout level on the grid. Imagine it's December 27. Your broker's payout rate is 33 percent. He has generated $470,000 in commissions so far this year. But if he gets to $500,000 by December 31, his payout rate jumps to 40 percent, applied retroactively. This means your broker can earn a windfall of $44,900 in additional compensation just by generating $30,000 in commission sales in four days. Unless a firm's ethical culture is impeccable, the temptation to sell anything to anyone, no matter how inappropriate, is overwhelming.

It's also common practice for firms to pay large, up-front bonuses to lure a star broker away from his employer. Such bonuses can equal or exceed an entire year's pay. This sum is paid on the presumption that the broker will bring his customers with him to the new firm by telling them "the big lie"-that his new firm offers better customer service and more sophisticated research. The broker, of course, never reveals that the new firm is paying him a huge bundle to move. In such cases, customer accounts are bargaining chips that brokers use to increase their personal wealth, not their customers'. Once a broker moves to a new firm, he must produce. And that means the broker is more likely to push unwanted or unneeded products, especially those paying higher commissions.

Instead of, or in addition to, an up-front bonus, brokers sometimes get what is known as an accelerated payout. This means that instead of the normal 33 percent to 45 percent of the gross commission on every trade, the broker receives 60 percent or more of the commission for several months, or even several years. The justification for enriched payouts is that brokers who jump to a new firm will be preoccupied for months with administrative details involved in account transfers and helping to orient clients at the new firm, leaving little time for salesmanship. But the reality is that such payouts boost the broker's incentive to meddle in client accounts and increase the volume of trading activity.

Commissions distort brokers' recommendations in many other ways. Some firms, for example, have special arrangements to sell mutual funds in exchange for above-average commissions. If a Merrill Lynch broker knows he'll get 25 percent more money for selling a Putnam mutual fund over an American Century fund, guess which fund the broker will try to sell you? Most large brokerage firms today sponsor their own funds, and may try to steer you to one of those. That way, the fee you pay to the manager of the mutual fund remains in-house and adds to the firm's profits. The problem is that brokerage firm funds don't necessarily perform better than, or even as well as, independent funds. According to Morningstar Inc., a fund research company, as of June 30, 2001, the five-year annualized returns of independent funds was up 8.28 percent, and for broker-sponsored funds only 6.92 percent.

One of the worst cases of broker abuse I ever saw took place at Olde Discount Corp., a Detroit-based firm that is now owned by H&R Block. At its height in the mid-1990s, Olde had 1,185 brokers in 160 branches. In 1998, Olde and its senior management, including founder Ernest J. Olde, without admitting or denying guilt, paid $7 million in fines to settle charges by the Securities and Exchange Commission and the NASD. The regulators accused Olde managers of creating an environment that encouraged brokers to make trades in customer accounts without the customers' permission, sell stocks and bonds that were not suitable to client needs, and falsify customer records. The company often hired recent college grads to flog stocks that the firm had placed on a carefully chosen "special ventures" list. These stocks were picked, not because they suited the investment needs of clients, but because Olde held the shares, many of them highly speculative, in its inventory. Olde then marked them up in price and made a profit off the spread between what it paid and the price at which it sold the stock.

The SEC found that Olde's compensation structure paid brokers substantially more if they sold stocks from this select list; brokers who did not meet a quota of select stock sales were sent packing. If customers said they could not afford to buy the recommended stocks, Olde brokers were trained to persuade the client to use margin, which involves borrowing money from the brokerage firm to purchase shares. The firm's two-page account-opening forms included a margin agreement, but many customers didn't understand that they were requesting a margin account.

Why You Should Avoid Buying on Margin

Your broker may recommend that you buy shares with money borrowed from his firm at a fixed interest rate and using your shares as collateral. He may argue that trading stocks "on margin" lets you use the power of leverage to amplify your stock-picking prowess, the way professionals do. Tell your broker you are not interested. Margin borrowing is very risky and, for an individual investor like you, should be avoided at all costs.

Margin simply means buying assets with borrowed money. Such loans are highly profitable to the brokerage firm. They are marketed on the premise that if you invest more without fully paying for the securities, you can lift your returns beyond what you'd otherwise get.

Leverage is a wonderful tool in a rising market. Here's how it works. Say you buy 100 shares of a stock at $50 a share. Normally, you would have to pay your broker $5,000, plus commissions. With a margin loan, you could borrow up to half that amount, and pay only $2,500, borrowing the other $2,500 from your broker. If the stock price rises to $75, and you decide to sell, you get $7,500 ($75 ´ 100 = $7,500). Of course, you have to repay the $2,500 loan, plus interest. But you have gained $5,000 with an initial investment of only $2,500.

Sounds good, except that the process moves swiftly in reverse in a declining market. You could be required to sell your stock to cover the loan or, worse, your broker could sell your stock without consulting you in order to pay off the loan before the market declines further. In the market plunges of 2000 and 2001, many leveraged investors could not raise enough money from the sale of their stock to repay their loans. Again, say you buy 100 shares of a stock at $50 a share, putting up $2,500 and borrowing the other $2,500 from your broker. But the value of your shares declines to $25, or $2,500 for 100 shares. You have now lost all your initial investment of $2,500, and you still owe your broker interest on the loan.

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Table of Contents

Acknowledgments
Introduction 3
1 How to Sleep as Well as Your Broker 17
2 The Seven Deadly Sins of Mutual Funds 41
3 Analyze This 65
4 Reg FD: Stopping the Flow of Inside Information 87
5 The Numbers Game 105
6 Beware False Profits: How to Read Financial Statements 144
7 Pay Attention to the Plumbing 175
8 Corporate Governance and the Culture of Seduction 204
9 How to Be a Player 236
10 Getting Your 401(k) in Shape 257
App.: Power Games 285
Glossary 309
Index 319
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First Chapter

HOW TO SLEEP AS WELL AS YOUR BROKER

If they have it, sell it. If they don't, buy it. That was the whispered joke on Wall Street in 1963 when I joined the brokerage firm of Carter, Berlind & Weill. It was only half in jest. It betrayed the callous attitude many brokers had toward their clients. Brokers are supposed to advise you on which securities to buy and sell, depending on your financial resources and your investment objectives. They offer gardenvariety stocks, bonds, and mutual funds, or such exotic instruments as convertible debentures and single-stock futures, to help you shape a portfolio that fits your needs. Brokers may seem like clever financial experts, but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in accounts they manage. They want you to buy stocks you don't own and sell the ones you do, because that's how they make money for themselves and their firms. They earn commissions even when you lose money.

Commissions can take many forms. On a stock trade, the commission is a percentage of the total value of the shares. For some mutual funds there are up-front commissions, or sales loads, which are paid when you make an investment. There also may be back-end commissions, or deferred loads, which are paid when you take your money out. On bonds, brokers don't charge commissions. Instead, they make their money off the "spread," or the difference between what the firm paid to buy the bond and the price at which the firm sells the bond to you.

Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc. and one of the smartest investors I've ever met, knows all about broker conflicts. He likes to point out that any broker who recommended buying and holding Berkshire Hathaway stock from 1965 to now would have made his clients fabulously wealthy. A single share of Berkshire Hathaway purchased for $12 in 1965 would be worth $71,000 as of April 2002. But any broker who did so would have starved to death. While working in the early 1950s for his father's brokerage firm in Omaha, Neb., Buffett says he learned that "the broker is not your friend. He's more like a doctor who charges patients on how often they change medicines. And he gets paid far more for the stuff the house is promoting than the stuff that will make you better." I couldn't agree more. In sixteen years as a Wall Street broker, I felt the pressures; I saw the abuses.

"Levitt, is that all you can do?" Those stinging words rang in my ears at the end of many a week as I struggled to join the ranks of successful Wall Street brokers at Carter, Berlind & Weill. Eleven of us worked out of an 800-square-foot office on 60 Broad Street, in the shadow of the New York Stock Exchange. I divided my time between buying and selling stock and scouting for companies that might want to go public.

When I joined the firm, America was riding high. A postwar economic boom that began in the 1950s marched onward through most of the 1960s, encouraging companies to look to Wall Street to finance their expansion. The growth in jobs and overall prosperity produced much wealth, and people flocked to the stock market in search of easy money. It was a heady time, and I wanted to be a part of it. I was thirty-two, and though I had no Wall Street experience whatsoever, I started calling potential clients right away.

The competition among the partners was intense. We shared one large office so we could keep a watchful eye on one another. Arthur Carter kept a green loose-leaf binder on his desk, and in it he recorded how much gross-the total amount of sales-each of us was responsible for each week. Every Monday morning I stared, terrified, at an empty calendar page, worrying how I was going to generate a respectable $5,000 in sales. When we reviewed the results on Friday, there would be much scolding and finger-pointing. If I wasn't the lowest producer, I joined the others in berating the one who was.

Our mandate was to grind out the gross and recruit new brokers with a proven knack for selling. But on the Wall Street I knew in the 1960s and '70s, the training of new brokers was almost nonexistent. Brokers were hired one day and put to work the next cold-calling customers. At all but a few firms, research was primitive. Starting salaries were a pittance, forcing brokers to learn at a young age that they had to sell aggressively to survive in the business. The drive for commissions sometimes motivated supervisors to look the other way when aggressive upstarts bent the rules.

Today the brokerage industry is a lot more sophisticated. Nowadays brokers sell dozens of savings, retirement, and investment products, and insurance, real estate, and hedging instruments to reduce risk. But with half of all American households invested in the stock market, brokers' responsibility to the individual investor is greater than ever.

Good People in a Bad System

Sadly, the brokerage industry still has numerous flaws. That's not to say that all brokers are commission-hungry wolves on the prowl for naive investors. Some are; others are just inept. Most are honest professionals. They are good people stuck in a bad system, whose problems remain fourfold. First, some brokers are not trained well enough for the enormous tasks they are expected to carry out. Second, the system in which brokers operate is still geared toward volume selling, not giving objective advice. Third, to increase sales, firms use contests to get brokers to sell securities that investors may not need. Most brokers rarely, if ever, disclose to their clients how they are paid or how their bonuses are structured, even though such disclosures would go a long way to resolving the conflict-of-interest problem. Fourth, branch-office managers and other supervisors, who are paid commissions just like their brokers, have an incentive to push everyone to sell more and to turn a blind eye to questionable practices.

Brokers come in many stripes. There is the full-service variety, employed by the large brokerage houses advertised on television: UBS PaineWebber (part of Swiss bank UBS), Morgan Stanley and Salomon Smith Barney (part of Citigroup). The largest of the full-service firms is Merrill Lynch & Co., which employs roughly 14,000 brokers in five hundred or so U.S. locations. Merrill calls its brokers "financial advisors." They manage more than 9 million customer accounts worth $1.3 trillion. Not only do they help clients determine their investment goals and pass on customer orders to their trading desks for execution, but they also provide research from in-house analysts and give advice on a wide range of securities. For these extras, customers pay more. The average commission paid to a Merrill Lynch broker in 2000 was about $200 per transaction.

Then there are the discount houses, which give minimal advice or none at all. Many do not provide proprietary research, although they may make available research produced by other firms. Investors are charged a moderate commission or pay a flat fee for each trade.

Online brokers can be either full-service or discount, though most are discounters. For a flat fee of $9.95, one leading online broker lets customers order up to 5,000 shares. Research and advice were not on the menu when online trading first began, but some online brokers, such as Charles Schwab Corp., have moved upstream into the fullservice realm by offering research and advice to customers who maintain a minimum balance.

There's a saying that compensation determines behavior. Firms never seem to run out of novel ways to use commissions to motivate their brokers-and take more money out of your pocket. One popular system is the grid. Typically, brokers receive a percentage of the commissions that they generate, ranging from 33 percent to 45 percent. As their commission sales increase, they can jump to a higher payout level on the grid. Imagine it's December 27. Your broker's payout rate is 33 percent. He has generated $470,000 in commissions so far this year. But if he gets to $500,000 by December 31, his payout rate jumps to 40 percent, applied retroactively. This means your broker can earn a windfall of $44,900 in additional compensation just by generating $30,000 in commission sales in four days. Unless a firm's ethical culture is impeccable, the temptation to sell anything to anyone, no matter how inappropriate, is overwhelming.

It's also common practice for firms to pay large, up-front bonuses to lure a star broker away from his employer. Such bonuses can equal or exceed an entire year's pay. This sum is paid on the presumption that the broker will bring his customers with him to the new firm by telling them "the big lie"-that his new firm offers better customer service and more sophisticated research. The broker, of course, never reveals that the new firm is paying him a huge bundle to move. In such cases, customer accounts are bargaining chips that brokers use to increase their personal wealth, not their customers'. Once a broker moves to a new firm, he must produce. And that means the broker is more likely to push unwanted or unneeded products, especially those paying higher commissions.

Instead of, or in addition to, an up-front bonus, brokers sometimes get what is known as an accelerated payout. This means that instead of the normal 33 percent to 45 percent of the gross commission on every trade, the broker receives 60 percent or more of the commission for several months, or even several years. The justification for enriched payouts is that brokers who jump to a new firm will be preoccupied for months with administrative details involved in account transfers and helping to orient clients at the new firm, leaving little time for salesmanship. But the reality is that such payouts boost the broker's incentive to meddle in client accounts and increase the volume of trading activity.

Commissions distort brokers' recommendations in many other ways. Some firms, for example, have special arrangements to sell mutual funds in exchange for above-average commissions. If a Merrill Lynch broker knows he'll get 25 percent more money for selling a Putnam mutual fund over an American Century fund, guess which fund the broker will try to sell you? Most large brokerage firms today sponsor their own funds, and may try to steer you to one of those. That way, the fee you pay to the manager of the mutual fund remains inhouse and adds to the firm's profits. The problem is that brokerage firm funds don't necessarily perform better than, or even as well as, independent funds. According to Morningstar Inc., a fund research company, as of June 30, 2001, the five-year annualized returns of independent funds was up 8.28 percent, and for broker-sponsored funds only 6.92 percent.

One of the worst cases of broker abuse I ever saw took place at Olde Discount Corp., a Detroit-based firm that is now owned by H&R Block. At its height in the mid-1990s, Olde had 1,185 brokers in 160 branches. In 1998, Olde and its senior management, including founder Ernest J. Olde, without admitting or denying guilt, paid $7 million in fines to settle charges by the Securities and Exchange Commission and the NASD. The regulators accused Olde managers of creating an environment that encouraged brokers to make trades in customer accounts without the customers' permission, sell stocks and bonds that were not suitable to client needs, and falsify customer records. The company often hired recent college grads to flog stocks that the firm had placed on a carefully chosen "special ventures" list. These stocks were picked, not because they suited the investment needs of clients, but because Olde held the shares, many of them highly speculative, in its inventory. Olde then marked them up in price and made a profit off the spread between what it paid and the price at which it sold the stock.

The SEC found that Olde's compensation structure paid brokers substantially more if they sold stocks from this select list; brokers who did not meet a quota of select stock sales were sent packing. If customers said they could not afford to buy the recommended stocks, Olde brokers were trained to persuade the client to use margin, which involves borrowing money from the brokerage firm to purchase shares. The firm's two-page account-opening forms included a margin agreement, but many customers didn't understand that they were requesting a margin account.

One of Olde's victims was a married couple with five children, the eldest of whom had Down's syndrome. In March 1993 they opened an account at Olde's Clearwater, Fla., office. The wife had been in an auto accident that left her disabled, and had received an insurance settlement. The couple wanted to invest some of her settlement in a mutual fund and a money market account-nothing very risky. But within a month, the SEC found, the broker had executed fifty trades in their account, using margin to cover half the cost. The couple was unaware that they had even signed a margin agreement. By the end of July, the couple's money had all but disappeared. Their Olde broker had executed more than two hundred trades from the select list without their knowledge.

Profits and Professionalism

In the 1970s, when I oversaw the retail business of our firm, after numerous acquisitions now called Shearson Hayden Stone, part of my job was to hire and train new brokers. While we sought those with proven ability to generate fat commissions, it bothered me that we sometimes overlooked their previous ethical shortcomings, as reflected in numerous customer complaints. The more I felt pressured to hire superbrokers who bounced from firm to firm because of regulatory infractions, but who could generate $1 million a year in gross, the more I felt the need to speak out.

In a 1972 speech called "Profits and Professionalism," given at Columbia University, I lamented, "How can a broker view himself as a professional-as a counselor who considers his client's interest before his own-when his livelihood is dependent upon him taking an action which may not be appropriate or timely to take?" I then called on the industry to develop some way to pay brokers on how well their clients' investments performed, rather than on volume of transactions.

My partner, Sandy Weill-who as Citigroup chairman today oversees Salomon Smith Barney, one of the nation's largest brokerage firms-read the speech and said, "This is ridiculous. I can't stop you from doing this, but I certainly don't agree." Likewise, Hardwick Simmons, our marketing manager at the time and now CEO of the Nasdaq Stock Market, said I just didn't understand the business, and suggested that I stop tilting at windmills.

In the thirty years since that speech, nearly every firm in the industry continues to pay its brokers at least partially on a commission basis. Why so little progress? Resistance from top industry leaders. At a late 1993 dinner at the River Club in New York City, a dozen or so top executives gathered to hear my analysis of what was wrong with broker compensation. I made it clear that I thought there was a problem, and that, as SEC chairman, I expected the industry to do something about it, especially now that millions of individual investors for the first time were pouring into the market and risking their life's savings. I later learned that some of the CEOs left the dinner shaking their heads, grumbling about my "holier-than-thou" views.

In early 1994, I set up a blue-ribbon panel led by Dan Tully, then the chairman and CEO of Merrill Lynch. The panel's orders were to recommend ways to reduce conflicts between investors and brokers by changing the broker compensation system. After a year of study, the Tully Commission produced a code of industry "best practices." These were not pie-in-the-sky proposals but field-tested practices that some brokerage firms were already using. While I was only partly successful in persuading the industry to adopt the best practices, the most enduring achievement of the Tully Commission was getting industry leaders to acknowledge the existence of conflicts.

The panel's work and the way in which some industry leaders opposed it are instructive. Only two of the panel's five members came from the industry. Tully was one, and Chip Mason, chairman and CEO of the Baltimore-based investment bank Legg Mason Inc., was the other. Warren Buffett, who had recently led the investment banking firm of Salomon Brothers while it was dealing with the consequences of serious legal and ethical lapses in acquiring U.S. Treasury securities, agreed to join the panel. So did Samuel Hayes III, a Harvard business school professor, and Thomas O'Hara, chairman of the National Association of Investors Corp., a group representing investment clubs.

I gave the industry the impression that if it did not act, I would seek to impose stiff rules. But I was playing regulatory poker: If I pushed new rules, Republicans in Congress would almost certainly accuse me of overkill and tie my hands, so regulation was out of the question. Having only moral suasion at my command, I solicited the support of ordinary investors by holding town hall meetings throughout the country. When reporters began writing negative stories about some of the more odious compensation schemes, the firms had little choice but to denounce the practices in public. Secretly, however, they were perpetuating them. Tully knew, for example, that some brokerage firm leaders were looking me in the eye and insisting that they were not offering upfront bonuses, when they were. One firm, at that moment, was offering $1 million for Merrill's top producers.

The heightened scrutiny caused firm executives to examine their own houses. Many discovered that their branches were taking part in sales contests, or that brokers were being pressured into making cold calls using a mechanical script, having little or no familiarity with the products they were peddling. Even Tully says he learned that unbeknown to him, some of his branch offices were using contests to jack up sales.

Most major brokerage firms agreed to play ball with the SEC, saying they would commit to the Tully Commission's code of best practices, which included: ending product-specific sales contests; paying brokers a fee based on the percentage of client assets in an account, instead of on commissions alone; and banning higher commissions for in-house, or proprietary, products.

Some firms resisted. Phil Purcell, CEO of DeanWitter Reynolds Inc. (now part of Morgan Stanley), at first refused to jettison a policy of paying higher commissions for in-house products. Dean Witter was especially vulnerable on this point. The percentage of house-brand mutual funds sold by Dean Witter brokers was the industry's highest at 75 percent. At Merrill Lynch the figure was around 50 percent, and at Smith Barney only 30 percent. That meant that three out of every four Dean Witter customers who expressed interest in a mutual fund were steered to a Dean Witter fund, which carried an up-front fee, or load, that supposedly compensated the broker for his objective advice. Dean Witter brokers were getting up to 15 percent more commission for selling in-house funds. According to mutual fund rating firm Morningstar Inc., these funds at the time were not stellar performers, ranking below those of the five largest independent fund groups. When we shared with Purcell the data on how often Dean Witter brokers funneled customers into proprietary funds of subpar performance, he agreed not to resist the recommendation against higher payouts for in-house products.

Surprisingly, Merrill Lynch was also one of the resisters. Tully says he took the blue-ribbon committee job because Merrill had already switched from a compensation system that rewarded brokers for the number of trades they did to one that encouraged brokers to increase the amount of assets they had under management. Today, commissions make up only 25 percent of Merrill's $22 billion in revenues. Tully believed the rest of the industry should follow Merrill's lead. Still, Merrill couldn't hold itself out as a paragon. One of the Tully Commission's most contentious recommendations was to end up-front bonuses. But Launny Steffens, then head of Merrill's retail broker business, balked at ending or even limiting the practice. Steffens, who retired from Merrill Lynch in May 2001, was a highly influential figure in the company. His army of brokers was the backbone of the firm and responsible for about half its profits. But Merrill's Achilles' heel was the very same well-developed system of branch office brokers: every other firm jealously eyed Merrill's brokers, and often tried to recruit them. It was not uncommon for Merrill trainees to get lucrative employment offers within weeks of completing a six-month course, which saved the hiring firm $100,000 (Merrill paid its trainees salaries of $40,000 for six months, and its training program cost an additional $60,000 per person).

Steffens simply would not disarm, and Tully, his boss, refused to pull rank and force him to back down. "I don't think Launny was wrong," Tully says now. "The SEC had its point of view. But Launny lived in the real world, not in a test tube. He understood what the competition was doing, and if he let that happen, he'd lose money and talent." Today, Merrill Lynch continues to pay up-front bonuses, as do most firms in the industry. Recruitment bonuses for top performers are now as high as the signing bonuses some professional sports teams pay for star athletes.

In the end, I failed to persuade all the firms to adopt certain key provisions of the code, and some have since backed away from their pledges. "In all honesty," Buffett told me later, "Dan Tully probably didn't want to change the system much. The system works too well. Merrill Lynch would be in terrible shape if it weren't for investors turning over their portfolios." How serious are the conflicts between broker and investor? Serious enough that a former top official of a major brokerage firm confessed to me privately that he would not send his mother to a full-service broker.

In recent times Wall Street firms have increasingly been using their analysts as glorified salespeople. The analysts make pitches for investment banking deals by promising to write glowing reports on companies if they hire the firm for an initial public offering or a debt issue.

When analysts write reports that gloss over problems in a company, brokers feed that information to investors, who are misled into buying the shares. And when analysts fail to warn that a company is in trouble, even keeping a "buy" recommendation on a stock that has lost most of its value, retail investors are left holding shares long after the pros have ditched them. At times, brokers have unloaded on their retail clients unwanted stock from their firm's inventory. They have even told clients to buy stock that their own analysts are shorting, a speculative ploy that involves borrowing shares in the expectation that they will decline in value. In the great stock market sell-off that began in March 2000 and continued well into 2002, some $7 trillion in market capitalization (the price of all publicly traded shares multiplied by the number of shares outstanding) was lost, much of it by retail investors.

Beware the Online Broker

The explosion in online trading is a direct outgrowth of the high cost of commissions and the lack of trust by many investors in their fullservice broker. Companies such as E*Trade and Ameritrade are electronic brokers that use the Internet to gather retail investors' orders. This new twist in investing caught fire in the mid-1990s, when the bull market was in full swing. Anyone could open an account and begin buying and selling up to 5,000 shares for as little as $8. In most cases, trades are executed within ten seconds. Some online brokers also offer vast amounts of information for free, including research, streaming market data, and news. The ease and low cost of online trading lured 10 million Americans into opening online accounts between 1996 and 2000.

Alongside the online trading revolution came powerful new computer networks, called electronic communications networks, or ECNs, that act much like electronic stock exchanges. They match up buyers and sellers in a split second, and because they involve no human intervention, they do so at a fraction of the cost of the New York Stock Exchange or the Nasdaq Stock Market.

But the online trading revolution comes with its own hidden dangers that investors must know about and avoid. One is "payment for order flow," which involves a rebate to the brokerage firm for every order it funnels to a market-maker. Market-makers are middlemen who post prices at which they will buy and sell stocks for their own accounts and for others.

Online trading is a misnomer. When you place an order with an online broker, you are not trading directly with a stock exchange. Instead, your order is routed to the market of the online broker's choice. Because market-makers will pay a small fee for your order, the chances are pretty good that your buy order will not be executed at an exchange, but will be matched against someone else's sell order, and only the transaction is reported to the exchange.

The problem with payment for order flow is that your buy order may not be exposed to a large number of sell orders, and that may deprive you of a better price. The concept of getting the best possible price in the shortest amount of time is known as "best execution." Under SEC rules, your broker is obligated to get the best execution available for your order. If your broker is funneling orders to the highest bidder and ignoring his best-execution duty, you may be paying a lot more for shares than is necessary.

Now that share prices are quoted in decimals instead of fractions, spreads between buy and sell prices have narrowed, thus reducing the profit that market-makers and others make from spreads. And that, in turn, has made payment for order flow less attractive. But even though payments are declining, the practice persists today.

Say you place an order for 1,000 shares with an online broker, which then routes your order to a market-maker, who then "rebates" the broker a penny for every order it gets at the market price. But another market-maker or exchange not paying for order flow might be able to improve the price by 5 cents, saving you $50 ($.05 ??1,000 shares ??$50). That's five times what most online brokers charge in commissions. The moral is: don't be fooled into saving $5 in commission charges, only to pay far more in hidden trading costs.

Another hidden trip wire for investors is internalization, which happens when a brokerage firm passes on orders to its own market-making subsidiary that matches buys with sells. Economically, internalization is just like payment for order flow, except that the parent company gets to keep all the payments. For the investor, the problem is the same: a buy order that doesn't meet up with a larger universe of sell orders may get executed at a higher price than the best available price the broader market is offering. Charles Schwab & Co. is the king of internalization. Its wholly owned market-making company, Schwab Capital Markets (formerly known as Mayer & Schweitzer), matches the lion's share of orders placed with Schwab brokers or received online. That means many Schwab orders are exposed only to other Schwab customers' orders. The company fulfills its best execution obligation by making sure that customers get the best available price that other markets may be advertising.

New SEC rules, which took effect in 2001, can help you avoid brokers that steer your order to an execution facility for their benefit, not yours. The rules require brokers, each quarter, to reveal where they send orders, and whether they received a rebate. Exchanges, ECNs, and market-makers must also reveal, each month, how well they execute customer orders, and how often they improve prices, on a stockby- stock basis. These data can help you decide if you want to sacrifice speed for a better price-data that were not available prior to the SEC rule. If you don't like the way your online broker is routing your orders, you can switch to another broker with a better record.

In many ways, brokers are inevitable. If you walked onto the floor of the New York Stock Exchange, you would not be able to buy a single share without placing your order through a broker. If you buy and sell stocks through an online trading firm, you're still accessing the market through a broker, albeit an electronic one.

Fire Your Broker

If you have less than $50,000 to invest, you don't need a broker. The strategy that makes the most sense is investing in low-cost mutual funds, especially index funds that match the performance of a stock index. You could start off with a fund that follows the Wilshire 5000, which includes virtually all U.S. stocks, or the Standard & Poor's 500, which mimics the shares of 500 large U.S. companies. As you become more comfortable investing in mutual funds, and as your assets grow, you can move into index funds that track small, medium, and large companies. Or you can buy funds that track fast-growing companies or undervalued ones. As most experts suggest, put a small amount of your assets into an international fund. And for diversification, consider a corporate or government bond fund. Bonds are less risky than stocks, but historically stocks have outperformed bonds.

If you have more than $50,000 to invest, you should fire your broker and find an investment adviser. Brokerage firms would like you to think that they perform the same functions as investment advisers. Many brokers call themselves "financial consultants" or "financial advisers." But they're not the same as independent investment advisers.

Like a broker, an investment adviser can help you create an investment plan that conforms to your lifestyle, income level, and investment goals. Also like a broker, an adviser will help you allocate the correct percentages of your assets into stocks, bonds, and cash, and rebalance your portfolio over time as the various pieces grow or shrink. But many brokers do not have a fiduciary duty-a legal obligation-to put your interests above his or the firm's. True, a broker has to recommend investments that are suitable to your financial status and tolerance for risk, as well as a duty to get you the best execution possible for your trades, as we discussed earlier. But an investment adviser's fiduciary duty is on a higher plane, like that of a lawyer, a trustee, or the executor of an estate.

Investment advice is a big business, and the huge array of advicegivers can be confusing, so let's go over the basics. There are different kinds of investment advisers, depending on their qualifications and how they are paid. Most investment advisers charge fees, which can be an hourly rate, an annual figure, a percentage of your assets, or a feeplus- commissions. I recommend you find a certified financial planner (CFP)-someone who takes a holistic approach to your finances-if you want your adviser to consider your retirement, insurance, tax, and estate-planning needs. You can obtain a list of CFPs near you through the Financial Planning Association (www.fpanet.org/plannersearch). Members must pass a proficiency test and keep up with continuing education requirements. Financial planners who are members of the National Association of Personal Financial Advisors (www.napfa.org) also must pass an exam, but in addition they submit their work to peer review and are not supposed to charge anything but a fee. In either case, be sure to verify a financial planner's certification. If you don't understand what a credential means, ask what the planner did to earn it.

You will need to decide how you want to pay for advice before choosing an investment adviser. A financial planner's fee can be an hourly rate (you should expect to pay at least $100 per hour but $200 is not unusual for an experienced CFP); a percentage of the assets you are investing (usually 1 percent but could go as high as 2 percent); or a flat fee for a set number of visits (a typical rate might be $2,500 for up to five visits) and unlimited telephone access. Some advisers will charge you a fee as well as the commissions that a brokerage firm will charge to execute trades on your behalf or sell you a mutual fund.

Which is the best payment option? That depends on you. I like the hourly fee or the flat rate. Both are fully disclosed, there are no hidden charges, and the adviser's interests won't conflict with yours. If you spend many hours a month managing your money, then you're probably better off paying an adviser's hourly fee. Chances are, you won't be taking up a lot of an adviser's time, so you needn't worry about the ticking clock. On the other hand, if you expect lots of hand-holding because you're just starting out as an investor, don't have the time to manage your finances, or are about to retire and have numerous questions, then you're probably better off paying a flat fee. Look for an adviser who will give you a number of in-person visits plus unlimited telephone access. In the long run, you'll probably pay less than the hourly rate.

Like commissioned brokers, investment advisers can have conflicts. So don't forget to ask: how are you getting paid? Some advisers receive a commission for referring you to a specific tax accountant, for example, or for selling you a certain mutual fund. Or an adviser may have a fee-splitting arrangement that rewards him for sending your trades through a certain brokerage firm. Such fees may signal that the advice you're getting isn't exactly independent. Some advisers can sell only their firm's product line. If so, you may want to find an adviser who can offer you a wider array of investments.

One more important point: Investment advice is not a highly regulated business. A loose patchwork of federal and state agencies oversees the industry. It's up to you to protect yourself by checking an adviser's registration and disciplinary records. The SEC requires investment advisory firms, but not individuals, with more than $25 million under management to file Form ADV, which explains investment strategy, fee schedule, ownership, potential conflicts, disciplinary record, and much more. But the SEC has no competency requirements; firms need only fill out the form and pay a fee. Firms that manage less than $25 million must file with their respective states, some of which also regulate individual advisers. You can check out state-registered advisers by contacting the North American Securities Administrators Association (www.nasaa.org).

It would be helpful if Congress and the SEC created a uniform regulatory regime for all "advice givers," be they brokers or financial planners, large or small firms, or subject to state or federal oversight. In late 2001, the SEC, with the help of NASAA, eliminated some of the con- fusion when it launched a Web site (www.adviserinfo.sec.gov) to help investors find an appropriate adviser. The site contains the Form ADVs of more than 7,000 SEC-registered and 1,700 state-registered investment advisers. The SEC plans to add the remaining 16,000 stateregistered advisers over the coming years to complete the database.

Be Careful, Even If Your Broker Is Fee-Based

If you decide to stick with a broker, it's best to find one whose compensation is fee-based. To its credit, the brokerage industry increasingly is replacing commissions with fee-based accounts. But even these pose conflict-of-interest issues that investors must weigh carefully.

Also called special accounts or managed accounts, fee-based accounts allow investors to custom-tailor a portfolio. Brokerage firms often team up with money managers to create personalized portfolios of stocks and bonds, much like a mutual fund except the individual investor owns the securities. The broker gives an expert in, say, technology stocks or municipal bonds a percentage of your money to manage, depending on how you and your broker have decided to allocate your assets. You won't pay commissions, but fees can be very high, ranging between 1 percent and 3 percent of the portfolio's value, of which the broker typically gets 60 percent and the money manager 40 percent. Most brokerages require at least $100,000 to open such an account, but that minimum is declining as firms aggressively market these accounts.

Brokerage firms like fee-based accounts because they get a steady stream of income whether or not you trade, in place of the sporadic revenues that trading commissions produce. The accounts appeal to investors who want to avoid the capital gains taxes of mutual funds and like the individualized treatment. Your broker may also claim that this method aligns your interests with his and a money manager's, since there are no commissions.

But you should think twice before you choose this type of account. Managed account fees seem sky-high in comparison to the 0.5 percent of assets or less that most index mutual funds charge. And unless you are an active trader, you may be better off paying commissions. If your account has $100,000 in it, and you are paying your broker a 1.5 percent annual fee, you are giving up $1,500 a year. Is it worth it? It is only if you anticipate paying trading commissions of that amount.

Fee-based brokers can be hazardous to your financial well-being in other ways. Because you are paying your broker an annual fee no matter how much activity takes place in your account, he may not pay adequate attention to your portfolio. The burden is on you to make sure this doesn't happen. And many brokerage firms require outside advisers to execute trades through them. If an adviser hopes to get more referrals from the brokerage firm, it's in his interest to give the firm's trading desk as much business as possible. This tying relationship reintroduces the very conflict that fee-based accounts were designed to avoid.

Of course, there are exceptions to my "fire your broker" admonition. One is the broker network of St. Louis-based Edward Jones, whose 7,500 branch offices dot just about every Main Street in America. If you are among the 5.4 million customers of this regional brokerage firm, and are satisfied with the service you are getting, then relax. The 8,000 brokers at Edward Jones work on commission, but they are trained to teach their customers to invest for the long term- that is, to buy and hold for at least ten, and up to twenty, years when possible. Managing Partner John Bachmann says the typical Edward Jones customer holds the same mutual fund for twenty years, against an industry average of four years. That tells me his brokers aren't putting their financial interests ahead of their clients'.

Edward Jones differs in several other important ways. It does no investment banking, so there is no danger that an Edward Jones "buy" recommendation is influenced by a desire to win a stock-underwriting deal. Because the firm caters to the serious, long-term investor, it does not offer Internet trading and it does not sell exotic or high-risk products such as options, commodities, and penny stocks. It does not peddle in-house mutual funds, and thus avoids the conflicts of interest inherent when a firm promotes its own, more profitable products. The firm also has a policy of not paying up-front bonuses to attract star brokers, and it sends every newly hired broker to a four-month training program. A company's culture does matter, and the culture of most brokerage firms encourages transactions. Edward Jones's culture does not.

Look Your Broker in the Eye

If you choose to invest through a broker, don't let him do anything until you have a chance to meet face-to-face. Try to establish a rapport, and keep in constant touch. When I was managing accounts for clients, I noticed that a few of them consistently outperformed the others. They happened to be the ones who nagged me the most, always asking why I bought this bond or why I didn't buy that stock.

Make sure you and your broker map out an investment strategy- and stick with it. Good brokers will suggest investments that match your financial wherewithal and future goals, and help you develop a roadmap to get there. The two of you should write all this down and periodically review it. Remember that your broker is a salesperson, and while he wants you to succeed, he also wants to earn commissions. When shopping for a broker, here is a checklist of questions to ask, so you can decide if this is the right broker for you:

o Does your firm emphasize in-house products over the products of other companies? What percent of in-house products (e.g., mutual funds) does your firm sell, versus products originated by other firms?

o Will the firm allow me to pay a fee, based on the total assets in my account, instead of commissions?

o Does the firm have a training program that pays brokers a salary for a year, instead of a two-month training program, after which the broker is paid a commission?

o Does the firm ever pay up-front bonuses to recruit brokers away from other firms?

o Does the firm hold sales contests to induce brokers to sell more of a certain product, whether in-house or not?

o What is your experience and training? How many brokerage firms have you worked for?

o Where do you get your stock and bond recommendations?

o If you recently changed firms, are you receiving special compensation for having switched firms, or any other kind of bonus plan?

o How many clients do you currently serve?

o Have you ever been disciplined for a violation of the securities laws? You can check the answer by calling the NASD's public disclosure hotline, 1-800-289-9999.

o Can you supply references?

Once your broker does make a recommendation, you should ask: How does this stock, bond, or mutual fund meet the investment goals we outlined? Why are you suggesting this over other options? Is this the best course of action for me, or just one of many possibilities? Does your firm have a business relationship with any of the companies whose shares you are recommending? For example, make sure you know if the broker's firm has helped the company with an initial public offering of stock or a debt offering anytime in the past two years. If your broker recommends a mutual fund, be sure there is a good reason for buying it, beyond that the broker gets a higher payout from that fund company over others.

And don't forget to ask about the risk involved in the securities your broker is recommending. One way to help you understand risk is to ask your broker to describe the worst-case scenario, the best possible outcome, and the most likely result of this investment. It's also good to know how easy or difficult it would be to liquidate, or sell, the investment. Some investments are difficult to unload, and you should know that beforehand.

Of course, you will also want to know what the commission on each transaction will be. Will there be any other ongoing costs? Is the commission negotiable? Remember that commissions reduce the value of your initial investment and thus reduce the returns you get over time. Brokers have an incentive to steer you toward products that pay them a higher commission rather than products that may be more suitable for you but that pay a lower commission. Low-risk investments, in general, pay out lower commissions.

You also have a right to know if your broker is participating in any kind of contest or promotion that rewards him for selling certain prod- ucts. While less common in the business today, contests still exist at some firms. Contests reward a broker, who accumulates points toward a prize, such as a vacation or a stereo. But the prize can skew the broker's advice, especially if he is close to winning the big prize.

Once you make an investment, you will get a piece of mail known as a confirmation slip. Be sure to read it, and then file it. This is the notice that your order has been completed; it will include the price you paid and the commission charged. Sometimes the commission will read "zero," but that doesn't mean the broker isn't getting a fee to sell the product. Sometimes the commission is paid by the company issuing the shares, or by the mutual fund. And sometimes securities are sold to you out of the brokerage firm's own inventory. In that case, the broker gets a piece of the markup.

Keep Up with the Chores

As an investor, you have responsibilities, too. The more you understand these, the more rewarding your investment experience will be.

First, do nothing until you have a strategy. This involves creating a financial plan with your adviser, whether that person is a certified financial planner, investment adviser, or broker. This plan should state your investment goals, such as having enough money to buy a new house or boat, put your children through college, or live comfortably in retirement. The plan should contain a personal balance sheet, or description of all your assets, such as your home and money in bank accounts, and all your liabilities, such as your home mortgage and any personal loans. Finally, the plan should state how much you are willing to set aside each month.

Once you have calculated your net worth and determined how much you want to invest and what you want your investments to help you achieve, there is one more important decision to make: how much risk are you willing to accept? This is a vital question that you and your adviser should talk over. Don't be shy-your adviser needs to know as much as possible about your financial condition and goals, and also needs to know how conservatively or aggressively you expect your portfolio to perform. How would you feel if you lost 10 percent of your initial investment? What about 25 percent? If losses of any kind make you sick to your stomach, you should stick to low-risk investments, such as stocks and bonds of the blue-chip companies- the large, more reliably profitable corporations. But if you can lose 10 percent or 25 percent and take it in stride-hoping that the market will bounce back as it has done historically-then your appetite for risk is greater and you should consider investing a portion of your funds in smaller, fast-growing companies. Brokers also use this information to make sure they are complying with NASD "suitability" rules. These require brokers to recommend only securities that are suitable for your risk tolerance, financial situation, and investment objectives.

In general, the higher the risk, the greater the potential for reward and for losses. Shares of start-up companies, or of companies in emerging markets such as Asia and Latin America, are considered high-risk. Low-risk investments, such as government bonds, are guaranteed to return a steady stream of interest, plus your initial investment. Government bonds, and many corporate bonds, are thus useful for those approaching or already in retirement as a steady source of income. But inflation could eat into your returns, eroding the purchasing power of your income.

You and your adviser should also discuss diversification, or not putting all your eggs into one basket. If one sector of the economy is booming, and you pile all your funds into that sector, you won't be able to offset your losses if the sector goes bust. In 2000 and 2001, many investors learned this lesson the hard way when the bottom fell out of technology stocks. A portfolio with a mix of stocks or stock mutual funds and bonds, plus some money that you can easily convert to cash, such as a money market account, is considered diversified. If your company has a profit-sharing plan or retirement plan that makes contributions in company stock, make sure you balance that with stock in companies that specialize in different sectors of the economy.

To be a responsible investor, you should also keep up with the chores: Keep all correspondence that your investments generate. There will be quarterly statements, annual reports, prospectuses, confirmation slips, and more. Read them and file them. Even if you are prone to stuffing everything into one huge folder, keep it all. You should check every confirmation slip to make sure it matches what your own notes say you bought or sold, and what you were told the commission would be. If you ever have a dispute with your broker, you will need those confirmation slips. Or you may need to pay taxes because your mutual fund sold some of its holdings. If you sell shares of stock, and you owe capital gains taxes on the increase in value between the time you first bought it and when you sold it, you can deduct the cost of commissions from the proceeds of the sale. Any of this valuable information could arrive in the mail throughout the year, and not just when it's time to prepare your taxes.

Reading your financial mail and staying abreast of financial news are important chores, too. It's smart to compare your portfolio each quarter with an appropriate index, such as the S&P 500 if you are holding domestic equities. But don't pay too much heed to the cascade of financial information available to you on television, in the financial press, and over the Internet. You need not watch CNBC all day or scour the business pages of your daily newspaper. It's probably not even a good idea to track the daily ups and downs of your stock holdings. Unless you plan to retire soon, you should view your investment as long term, with a ten-to-twenty-year horizon. A regular perusal of the financial pages of a newspaper or a business magazine at week's end should keep you informed enough to understand the major trends that affect the overall economy and the particular companies you have invested in.

That's not to say you shouldn't read and learn about the major events that affect your finances. You should. But if you have a strategy and stick with it, and if you occasionally keep track of how well your investments are doing and talk over their progress with your adviser, you won't need to spend a lot of valuable free time monitoring the stock market and the Internet. Remember: trust your own instincts. No expert, stock market guru, or financial columnist knows what you should invest in better than you.

[SIDEBAR P. 22-24]

WHY YOU SHOULD AVOID BUYING ON MARGIN

Your broker may recommend that you buy shares with money borrowed from his firm at a fixed interest rate and using your shares as collateral. He may argue that trading stocks "on margin" lets you use the power of leverage to amplify your stock-picking prowess, the way professionals do. Tell your broker you are not interested. Margin borrowing is very risky and, for an individual investor like you, should be avoided at all costs.

Margin simply means buying assets with borrowed money. Such loans are highly profitable to the brokerage firm. They are marketed on the premise that if you invest more without fully paying for the securities, you can lift your returns beyond what you'd otherwise get.

Leverage is a wonderful tool in a rising market. Here's how it works. Say you buy 100 shares of a stock at $50 a share. Normally, you would have to pay your broker $5,000, plus commissions. With a margin loan, you could borrow up to half that amount, and pay only $2,500, borrowing the other $2,500 from your broker. If the stock price rises to $75, and you decide to sell, you get $7,500 ($75 x 100 = $7,500). Of course, you have to repay the $2,500 loan, plus interest. But you have gained $5,000 with an initial investment of only $2,500.

Sounds good, except that the process moves swiftly in reverse in a declining market. You could be required to sell your stock to cover the loan or, worse, your broker could sell your stock without consulting you in order to pay off the loan before the market declines further. In the market plunges of 2000 and 2001, many leveraged investors could not raise enough money from the sale of their stock to repay their loans. Again, say you buy 100 shares of a stock at $50 a share, putting up $2,500 and borrowing the other $2,500 from your broker. But the value of your shares declines to $25, or $2,500 for 100 shares. You have now lost all your initial investment of $2,500, and you still owe your broker interest on the loan.

And there's another twist you must keep in mind with margin buying. By regulation, your broker must tap you for additional money if your equity-the value of your securities minus the amount you owe-goes below 25 percent. This 25 percent is called a "maintenance" margin, and today most brokers have imposed their own, stricter maintenance margins of 30 percent to even 50 percent on riskier stocks. Again, say you have borrowed $2,500 to buy 100 shares of a $50 stock, and your broker requires a 30 percent maintenance margin. If the shares fall to $40, your equity has dropped from $2,500 (the amount of your original investment) to $1,500 (100 shares x $40 minus your $2,500 loan = $1,500). That $1,500 in equity meets the broker's 30 percent maintenance margin requirement (30 percent of $4,000 = $1,200).

But if the value of your shares falls to $25, your equity has evaporated altogether (100 shares x $25 minus your $2,500 loan = 0). Your broker will make what is known as a margin call, demanding additional payment of cash or other securities into your account within two or three days. If you are unable to pay, the firm will sell your shares. You may have to take heavy losses, even if you wanted to stick with your investment in the hope that the share price rebounds.

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  • Anonymous

    Posted December 19, 2002

    Like the no-nonsense approach

    I like the books that are coming out without the fluff and hypocracy of past business books. This one and a few like it are great at telling it like it is, without giving ideas that are a) not feasible in the real world, b) non-implementable, c) written by someone without any experience.

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  • Anonymous

    Posted January 7, 2003

    Good job but no cigar

    The chairman's memoir is less of a kiss and tell confession and more a how to avoid-trouble-and-maintain-common-sense guide. He is surprisingly easy on the obstructionists who blocked the reform bills: Lieberman against FASB's proposal to expense stock options, and Tauzin against auditor independence. There is a funny episode about Steve Jobs disinviting Levitt from joining Apple's board after he read the chairman's speech on corporate governance. There is always the presence of Phil Graham who appears as a kind of Wizard of Oz giving his poo-bah approval on proposed investor bills. In the end, one comes away with the same prejudicial view of the usual Washington lobbying game between well-financed interest groups and political honchos addicted to soft money. Despite the real achievements of the chairman, historical reforms rarely emerge from bull market bubbles, but often surface after titanic scandals, like so few lifeboats, after all the shareholders have drowned. The chairman is like the doomed captain, he must take the blame for whatever accidents happened on his watch. All the icebergs with names like Enron, Worldcom, and Tyco, drifted by his sight during his tenure.

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  • Anonymous

    Posted October 17, 2002

    Honest And Sound Advice

    The easy-to-read writing style and frank advice are only part of the charm of this expose of "insider" advice and information of outstanding value to every investor. It is both practical and frightening to see how much trickery is involved in company statements and how shabbily investors are treated by the management of many companies and by their "trusted" brokers. Although this "Take" on Wall Street is very useful, there are many other aspects of coporate/company life that "...Corporate America Don't want You To Know...". One such perspective is the "inside" look into high-tech industry and how bungling and counterproductive management practices frequently found in such companies can lead to major profit losses and how this is viewed by the highly skilled and educated R&D technical staff on whose inventive genius a company's competitive advantage rests. I therefore suggest that in addition to "Take On The Street" investors serious about the high-tech sector also read the wicked, satirical book, "MANAGEMENT BY VICE" by the scientist/author, C.B. DON. As "Take On The Street" focuses on Wall Street company trickery, so "Management By Vice" exposes true-to-life examples of high-tech project bungling and blunders, managerial self interest, ignorance and bluffing as well as typical attitudes towards investors among others. Both books are a must-read for cautious investors, though from different "insider" angles..."Take On The Street" for investment advice and "Management By Vice" for high-tech management/employee relations "caveats". In this way, these books also provide the necessary ammo and information with which the investor can learn how to cast a cynical eye on blustering management, what to look for in a company's statements and what tough questions to ask of the Board Members, managers & CEOs so as to demand corporate accountabalility to the shareholders!

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