Tuesday, May 21, 2013

Morgan Stanley is not your friend

Not if you are their client. Not if they're underwriting an IPO you're purchasing. And certainly not if they're just trading on the other side of the market against you.

What, did you expect something else? Is this surprising to you?

Then I have bad news for you. You have no business picking your own shares to day trade in equity markets.

The Greek sent me this interesting Atlantic article about the debacle surrounding the Facebook IPO.

It's rather long, and I have mixed feelings about it, so let me give you the quick version.

Facebook had a big IPO coming up. As the date neared, they realised that revenue projections were going to be lower than expected, because more people were switching to (low ad revenue) mobile services than they'd forecast. They released a form with the SEC that buried this news while meeting technical disclosure requirements. Institutional investors figured this out from their brokers and banks. Joe public did not.

There's an interesting story here, but I found it hard to get through, because it started in the following manner:
Uma Swaminathan tuned the television set in the living room of her ranch style home in the suburbs of East Brunswick, N.J. to CNBC. It was 9:00 a.m. on May 18, 2012, a day the retired schoolteacher thought might make her rich. She logged onto her Vanguard brokerage account on her computer and placed an order for 5,000 shares of Facebook at $42 a share.
Like a bad movie, I already knew how the rest of this was going to play out from the first paragraph. The author clearly has sympathy with the lady in question, and invites the reader to as well.
With short hair, brown skin, and few wrinkles, Swaminathan looks much younger than her 68 years. She spent most of adult life as a suburban mom, making tofu for her daughter's friends at theater rehearsals, taking her three sons to soccer practice and Boy Scouts, and volunteering in the local community. She served a term as president of the Indian American Association of New Jersey.
My immediate responses are threefold:

1. These sound like admirable things to do.

2. A similarly glowing list could be compiled about just about anybody.

3. If this is story about financial markets, what about the above listed background made her think she was an ideal candidate to start trading actively?
Her interest in the stock market didn't develop until her husband died about 13 years ago. Her four children had already moved out to attend college or to pursue their careers. Swaminathan was left with her late husband's 401(k) retirement account, when she started dabbling in the market, investing in stable companies like Microsoft. Not long after, she began to follow the news coverage of initial public offerings (IPOs) -- when private companies enter the public market -- and came to know of the phenomenon known as the first day "pop." On the day that companies would debut on the stock market, the price would tend to shoot up before stabilizing. A year earlier, she watched as social networking site LinkedIn's stock price closed up 109 percent on its opening day.
Okay, we're going to hear a lot of sympathetic stuff later in the article. But let's just unpack some of these statements. Roll the tape again:
[She] came to know of the phenomenon known as the first day "pop." On the day that companies would debut on the stock market, the price would tend to shoot up before stabilizing.
So IPOs historically go up, on average (we'll come back to that phase in a second) on their first day. So what? Do you think that you're somehow owed a large first day return? For what? What did you do to earn them?

And in a question that might be viewed as immensely patronising, except for everything revealed by her subsequent actions: do you think that positive average returns are the same as uniformly positive returns?

Financial markets combine two distinct roles. There is a positive sum problem of real resource allocation - prices send signals about which companies should be able to expand their operations, and what the economy should produce more of. But there is also a zero sum problem of trading - if I buy and the share goes up, I make money relative to the alternative case if I hadn't bought. But the guy I bought it off loses money relative to if he hadn't sold.

So this woman might have made money. But who would have lost? Whose story is not being told here?

Most of the time, the company who sold it to her. The standard answer in the finance literature is that IPO underpricing is about companies getting ripped off by their unscrupulous advisors. So finally, the academics get their way, and Facebook is definitively not ripped off with its IPO price. So instead the story gets written about the woman who bought the Facebook shares and lost money. But that's inevitable - if someone makes money, someone else loses.

[Diversion: Academics have written hundreds of papers on the reason IPOs are "underpriced" because of the first day pop. But really, do you think CEOs look at stories about the 'biggest IPO flop ever' and think to themselves, 'Wow, that's what I want! That Zuckerberg guy managed to get absolute top dollar for his worthless shares!'. And if they don't, can you really blame them?]

But it's more than that - the woman wasn't buying shares in the IPO from Facebook, but in the open market. She was buying them off some other investor. Maybe she was buying them from Goldman. Maybe she was buying them from some other small investor who doesn't get an Atlantic story written about them. Who knows.

The point is, suppose she'd made money. Someone else sold too low immediately on the open. Would you feel equally sorry for them? Maybe if they'd gotten a glowing article written about how they volunteer at their local soup kitchen or whatever, but ordinarily, no, you wouldn't.

As the grievance studies professors are fond of saying - some narratives are privileged, and others are not.

Let's jump back to a statement at the beginning.
[O]n May 18, 2012, a day the retired schoolteacher thought might make her rich.
You thought you'd get rich trading IPO stocks as a retired schoolteacher.

The Greeks have a word for the feeling I experience reading those words, and it is catharsis.
She'd never placed such a big bet on just one stock, but she felt a personal connection to Facebook. She had been using the site to connect with family and friends since 2009, and almost everyone she knew had an account.
Facebook shares hit the market at an opening price of $38. Minutes later, Swaminathan's online order was executed, and the retired schoolteacher had just spent approximately half her life savings.
You put half your God damn life savings into a single stock? And an IPO stock at that? Are you out of your mind?

First of all, this shows that you have absolutely no idea about even the very basics of finance. Idiosyncratic risk? Diversification? Anyone? Anyone at all?

Second, it shows that you don't even understand the strategy you're implementing. IPO underpricing is a statement about average returns to a strategy of buying a ton of IPO stocks. It is not  a strategy for putting all your money into a single stock. If you are counting cards in blackjack, you want to place lots of bets over and over because the odds are in your favour. You do not want to put all your money on one hand. If you don't understand this, again, you don't understand the very basics of finance. 

I want you to remember this, reader. Because there's an entire article about how this is all JP Morgan's fault, and Vanguard's fault, and NASDAQ's fault, and FINRA's fault.

Madam, I submit to you the following - your belief that you would make tons of money by putting half your life savings into Facebook stock was not something you learned from JP Morgan, or Vanguard, or NASDAQ, or FINRA. It was not something you got from financial academia, or textbooks, or even moderately sophisticated blogs. I don't know where you got it. I suspect from naive extrapolation.

Don't get me wrong. There is another side to the story, one about investment banks giving selective advice to their favoured clients and the game being rigged against small investors. This is all true. But you don't need me to tell you that story - the whole article is about that. We can argue about what, if anything, should be done to fix this problem.

But to my mind, this is just a smokescreen. Why?

Because if you're putting half your life savings into a totally fair and not rigged IPO stock, there's a large chance that the story would still have the same ending. That's what happens when you take a huge bet on a single volatile asset. If I had to hazard a rough guess without looking at the actual data, I'd say it's a bit less than a 50% chance for a one-off bet, since IPO stocks do rise on average on the first day. But if you're doing this strategy multiple times, it starts becoming way more likely.

Financial markets are like a circular saw. You can use them to fashion a beautiful oak table if you know what you're doing.

You can use them to chop your own leg off if you don't.

You may think this is all rather harsh. Some poor woman still lost a ton of her life savings. Don't I feel sympathy for her?

Of course I do. It's a tragic story. She clearly had no idea what she was doing, and got fleeced by Wall Street.

As the great Theodore Dalrmpyle put it, people can both be figures of sympathy and also acknowledged as being significant architects of their own misfortune.

One can, in other words, be a victim, but also partly responsible. The two are not at all contradictory.

And this is worth mentioning, because this is not really a human interest story. It is, after all, a policy story. The author wants you to believe that this unfortunate woman's losses are primarily the fault of Wall Street Greed and Crony Capitalism.™ More taxes on crooked banks! More regulation!

The real problem here is the one that the author doesn't want to talk about - there are plenty of individuals investing in financial markets who have not the vaguest clue what they are doing, and a number of them are going to lose a lot of their life savings.

One way to deal with this is to load up on paternalism - only let sophisticated people with demonstrated knowledge trade. This might solve the problem. Then again, it might not. It would also come with a number of undesirable side effects.

The other way to deal with this is reflect on the sad and imperfect universe we live in, and the wisdom that the Gods of the Copybook Headings would have told us, much more in sorrow than in scorn:
"A fool and his money are soon parted."


  1. Hector Lopez:

    The Atlantic article is interesting. The author of the article seems to have a singular focus on the failure of the anti-competitive actions...when it was quite evident that those actions weren't the strongest. In the end, the banks got fined under the 'don't be a dickhead' provisions of their respective market regulations...which is very different to having to establish proof re the anti-competitive offences. In the end, you can only play the game within the rules set by the regulator.

    On a slightly different note though, but on the same topic of banks behaving badly:


  2. In the end, the banks got fined under the 'don't be a dickhead' provisions of their respective market regulations...which is very different to having to establish proof re the anti-competitive offences.

    True story. Yeah, there's always a set of catch-all offenses that most governments keep up their sleeves as a last resort to crack down on behaviour they don't like. In the personal sphere, fraud (anything vaguely dishonest) and disorderly conduct (whatever johnny copper doesn't like) always seemed outrageously broad when you looked at the actual text of the law. It doesn't surprise me they'd have something similar for banking.