The Game is Still Rigged
Today concludes a series on the main ways that the financial system rips off the average worker and investor.
There have been in the last few years changes proposed in how financial advisors are regulated. Much of this centered around the regulation of 401Ks, which are regulated by the Department of Labor. The changes were mostly to change the standard of care for how advisors treated their clients from one of “suitability” to a “fiduciary” responsibility.
There is a notable difference in these two standards. The suitability standard requires a much lower level of concern for the client. This standard requires an advisor to make recommendations that are loosely defined as meeting the interests of their client. For instance, an advisor may sell a product that benefits the advisor financially, if the product may benefit the client. As was discussed earlier, using the right verbiage on a suitability form is not a difficult task and one that Internal Wholesalers provide all the time.
A fiduciary standard by contrast is a much higher standard and consists of a duty of loyalty and care. This standard requires advisors to put their interests below those of the client’s. The interest of the client is the highest and sole concern of the fiduciary. It means advisors are supposed to do their best to make sure the information they have is accurate and that they seek to minimize costs. Using this standard means that advisors cannot make recommendations that may result in higher commissions for themselves or their firms. If there are any potential conflicts of interest, then the advisor must disclose these to the client.
In the end, after much back and forth the Department of Labor decided against holding all advisors to a fiduciary standard. There were arguments made on both sides, but these need not concern us here. The fact is that even under a fiduciary standard the client is not getting unbiased advice. As discussed previously regarding Advisors who charge a fee based on the assets under management, are just as biased, even if they don’t realize it. That an advisor is incentivized with a stick instead of a carrot does not mean that the conflict of interest is any less real. So, even if the fiduciary standard was required of all advisors the clients are still receiving advice that is bought and paid for.
There are two main reasons why this type of reform will fail. First, it does not get at the root of the problem, which is the money creation courtesy of the Federal Reserve. This flooding of the markets with made up money, as was discussed earlier, will always distort the honest operation of the market and create a degrading effect both economically and morally. This is necessarily so because as was pointed out earlier, the financial services industry was itself created because of this activity on the part of the Federal Reserve. A truly free market would not have a financial services sector anywhere near this large.
Second, if there is revenue sharing there will always be an inherent conflict of interest between the advisor, their broker/dealer, and clients. Clients who are expecting honest, unbiased advice cannot possibly receive any if the advisor is offering products based on payments to their back office. Remember, an advisor does not have to be crooked, only ignorant. Also ignored in all proposed reforms is the activity of providing “marketing support”. This is completely under the radar and most broker/dealers don’t stringently enforce this, even when they officially ban it, as I outlined previously. It is unlikely that there will be any substantial reform of either of these facets of this legalized rip-off, as the need for money creation is too great and the consequent temptations therefore too powerful to resist.
What to Do Immediately
If a policy revolution is going to occur, it will be after the fiscal and monetary breakdown of the United States. That will likely occur within the next decade as the debt service gets too onerous and the fiscal demands of paying for retiring baby boomers break the twin entitlements of Medicare and Social Security apart. It is to the question of what we as investors can do that we now turn.
Investor Self-Defense
The first thing that can enable an investor to defend themselves is the knowledge of how the system is rigged against them. Understanding how most advisors are bought and paid for can do two immediate things for an investor: one, it gives you the incentive to look seriously at low-cost investments. The entire wholesaler party is paid for with client money that comes directly from their account values and acts as a notable drag on returns. Two, it gives those who still want to use an advisor insight as to what type of advisor is likely to, intentionally or not, be a part of the problem. It will at the same time give rise to questions about the advisor and their back office. You can then steer clear of advisors and broker/dealers that are engaging in lots of revenue sharing and offering of conflicted advice.
The best bet for an investor who does not feel comfortable going it alone is to hire an advisor to simply put together a plan based on your goals, assets and risk tolerances. You will pay the advisor for the plan, nothing more. You can then place the trades yourself and keep your overall costs down.
Another alternative is to use so-called “robo advisors”. These are internet-based investment planning platforms that will intake all your information and put together a plan and execute the trade for you. It will also keep you updated as to the changes in your investments and help you to manage your portfolio. There is a smorgasbord of features you can choose from but almost all of them are cheaper than using an advisor selling you actively managed funds.
Regarding your 401K the best defense strategy is to go low cost. Find the lowest cost broadly based index fund that your plan offers and invest in that. You can pair this with the above-mentioned purchased plan to decide when to best reduce your risk as you get closer to retirement as well as begin to think about developing a stream of retirement income.
If your plan does not have a low-cost (at least less than .5% or less in fees) then go to the plan committee (if your employer is large enough to have one) or to your manager or owner to suggest that they make such an investment choice available in your plan. There are a growing number of low-cost choices out there driven by a millennial generation’s growing awareness of the lack of value in higher cost investment products.
Beyond this I would suggest reviewing the philosophy I have outlined on the stewardship page of my web site. This can help orient you toward a long-term strategy that may increase your chances of success.
There are many plans, strategies and information sources that embody this basic investment philosophy. If you find one that makes sense to you, is understandable and is beholden to you the investor or subscriber to the information then you are well on your way to defending yourself against a system stacked against you. Now we turn to what to do if/when the whole system breaks down.
What the Financial Apocalypse Looks Like
Let’s briefly review what the financial apocalypse might look like. First, understand that it is driven by the incessant desire of the government to spend other people’s money. The federal government has appropriated trillions of dollars and spread it out into the economy in a variety of ways. The purpose is not to examine all the minute ways that this program has worked its way into the financial and business ecosystem. Rather the purpose here is to step back and look at the larger context and see what longer-term effects this policy may have on the entire economy.
First, we need to understand how the government is financing all this spending. The federal government is issuing massive amounts of new debt in the form of government bonds. Clearly, if the government issues a substantial number of new debt instruments this will cause an increase in the interest rate. This is because of simple supply and demand. The more bonds that are issued the less each one is worth, therefore the issuer (government) must entice buyers to purchase them. This is done when the government raises the interest rate. Yet, we have not seen rates rise terribly high. This is easily explained by the fact that the Federal Reserve has been “monetizing” the debt issued by the federal government. They do this by creating money out of thin air and using the newly created money to purchase the additional governmental debt (I need not go into the specific mechanism the Fed uses to do this). In addition to this, the Federal Reserve will be buying the bonds of corporations as well as those of the federal government. The immediate effect of this policy is to artificially maintain a lower interest rate, which impacts investors.
The longer-term effect of an inflationary policy on investors is to create a condition of capital consumption. Capital is simply another name for the tools used to produce goods and services. The more capital (tools) we have the more goods and services we can produce. This increase in productivity is the basis of an economy that is expanding and a society growing wealthier. If the economy is consuming capital, then that economy will be able to produce less goods and services and will grow poorer. This process is the financial equivalent of eating your seed corn. This occurs because in an inflationary environment, prices will always be higher than they would be otherwise. This causes businesses to mistake paper “profits” for actual profits and to then underinvest in capital expansion or even maintenance. This process is summed up nicely here.
Of course, all this inflation and artificial lowering of interest rates causes the boom-and-bust cycle of the economy. However, this boom-and-bust cycle cannot go on forever. The endgame, for investors, to all of this is not pretty.
In recent years, most central banks have concentrated on policies that push down selected types of market yields, particularly those in the funding markets for government debt, mortgage debt, and bank debt. However, this has a large impact in other asset markets. In a search for yields, investors increasingly use their funds to purchase, say, stocks and real estate. As a result, these asset prices rise, thereby lowering their future returns. In other words: the zero-interest rate policy of the central banks drags down basically all kinds of yields with it. This may go on for quite a while, as investors have seen.
But once all market interest rates hit zero, the real trouble starts: the boom turns to complete bust. Credit markets shut down, borrowers can no longer roll over their maturing debt, and no investor is willing to lend new funds. To prevent credit defaults and the collapse of the debt pyramid, central banks would presumably step in as “lenders of last resort,” refinancing basically all kinds of borrowers in need (this is where we are currently). An outright inflation policy would begin. Nevertheless, capital consumption and economic regression would set in (as outlined above). The nation’s living standards would nosedive; this policy then throws many people into outright misery.
Applying the Austrian Business Cycle Theory to real-world developments yields the following insights: Central banks have done nothing to put an end to the boom-and-bust cycle. Instead, their unscrupulous interventions in credit markets just prolong the boom. However, it would be mistaken to assume that by bringing market interest rates to zero, a perpetual boom could be created. Such a policy is self-defeating: once the government has forced all market interest rates down to zero, the capitalistic economic system will collapse. Then—at the latest—the boom will completely turn into bust.
The bust at this point will last for a very long time. If the policy is not reversed the currency will eventually implode. The choices at this point are rather stark. Either the government institutes a new monetary regime, or the economy completely collapses. In either case, the dollar would likely lose its reserve status in favor of another currency or perhaps gold. This would leave the United States with no choice but to live within its means and would likely result in a general default of U.S. debt.
Before then you may very well see the U.S., government institute capital controls and engage in activities that will resemble those of less developed nations. Restrictions on capital movement, banning cash transactions, confiscating gold (they did this in 1933), and mandating a Central Bank Digital Currency (which allows for maximum surveillance and control) are tell tale signs the end is near.
What Do We Do Before the Financial Apocalypse?
First, I am NOT offering financial or investment advice. Whatever financial decisions you make are yours, and you, like all of us, must bear full responsibility for those decisions. In any event, I am only offering some ideas to think about. As always, do research and plan carefully.
One thing to think about is to diversify your investments. The bulk of your investments will likely still be in stocks and bonds, likely via a 401K or mutual funds. There are many low cost passively managed choices out there. This can give that portion of your investments wide diversity within the world of stocks and bonds. More diversity than that may, however, be a good idea. The greatest chunk of your investments, and your pay, will be in fiat dollars. That is, in dollars created by the Federal Reserve. To diversify, it might be a good idea to take a portion and save it in real assets. This would include physical gold, land, and collectibles. This might also include Bitcoin. For an excellent discussion about the nature of the monetary system generally, and Bitcoin specifically see Broken Money by Lyn Alden. This is a very accessible book for the lay reader, and goes over the possible benefits of Bitcoin, as well as the potential risks.
The other thing you may consider are private investments. I would suggest that you only do this if you have and are willing to have a personal impact on the outcome of the venture. These are some ways that you can possibly add more safety to your portfolio. These also provide a place to move more of your assets when you see signs of the final breakdown of the monetary system. Which leads to my final piece of advice.
Pay attention to the warning signs. The outcome, I think, is very likely to look like what I have outlined above in this essay. When you see these be ready to take action to protect you and your family’s financial situation by moving to harder, more real assets before the final crack-up.
I don’t wish to sound excessively alarmist about all of this. We could manage a transition to a sounder economic and financial world without a complete meltdown. It’s just that I don’t think it will happen. Also, even out of a meltdown we can repair what is broken. Nonetheless, as stewards of all that God has given us, we need to pay attention, and do the best we can, and as always trust in God.
Praise Be to God
