If you are like me, perhaps nagging questions keep you awake at night. If the average 401(k) has lost 40% of its value, where did the money go? Was it all fantasy money? How is it that a brokerage can go back and "fix" a trade that originally took place a week before? Who exactly am I selling to and buying from? Why is there never a stock glut like a housing glut? The effort to put these questions into words trivializes the questions and makes them seem silly, but still, the financial pundits seem to be missing something. I freely admit that I am merely one of those fairly well-educated people some politicians say should be perfectly capable of handling my own money better than anyone else.
The people on the other side of my trades are not other investors, as my brokerage intimated, but the market makers on NASDAQ, called specialists on the NYSE. The brokerage told me that market makers match up buyers with sellers, like real estate agents. Actually, that's not usually how it works. Real estate agents do not buy the house from the buyer and turn around and sell to the seller. But that's what market makers do. They must buy from everyone offering to sell, and they sell to everyone wanting to buy.
The brokerage also said that the stock market is like an auction. The price offered for sale is the Ask price; the price offered to buy is the Bid price. The market maker makes his money on the difference, or spread, between the two prices. But it turns out that because the market maker is on the other side of both the buy and sell transactions, the market maker sets both the Bid and Ask prices.
Who are these market makers that have such great privileges. Every stock on the market is assigned to a market maker. Each market maker registers with two or three of the big stocks and thirty or forty of the little ones. They manage two accounts simultaneously, their inventory account and their personal account. They have lots of room to maneuver. The greater the volatility of the stock market, the greater their profit.
Market makers also have access to what is known as Tier 1 data. It is the best, fastest, most up-to-date info on the ever-changing conditions of the market. Although news can influence the market, it is the market makers who decide if they will use any particular news item as cover for the price fluctuations the market makers control. By comparison, the brokerages pay a hefty price for subscriptions to Tier 2 data, a little slower than the Tier 1 data. You and I are stuck with Tier 3 data, the slowest of all.
But good luck getting your brokerage to explain any of this stuff to you. I first got wind of the different tiers of information when my brokerage advised me to stay away from pre-market and after-market trading. "You cannot compete," she said. "Instead of bidding with all the market players, you will be buying and selling directly with another trader." What could be bad about that, I asked. Those traders have access to better information than you, she replied. How so, I probed. I've said too much already, she demurred.
You see, I was constantly on the phone with my brokerage. I had two accounts, the real one with the brokerage, and its mirror image on Yahoo Finance. The Yahoo Finance portfolio was doing great. The real portfolio was a mess of misexecuted trades, trailing stops triggering on rising prices, and general chaos. My brokerage said I was losing money hand over fist because of my bad decision making.
Did I mention my brokerage is an online discount broker of the type that markets its services as something anybody can use? But when there is a problem they tell me their services are only for experienced investors. My cognitive dissonance arose from the apparent anomaly that my bad decisions with the real portfolio were good decisions with the Yahoo Finance twin. One day, a brokerage representative, perhaps feeling sorry for me, said something entirely incoherent about market makers. No matter how hard I tried I could not get him to clarify.
No matter. I was off and running. I discovered the secret role of the market makers, also known as specialists. I also discovered that their role is not so secret. All the financial planners know about them and consider the market makers' cut of the market part of the cost of doing business. But little investors are chickens ready for plucking. What little investors do not understand is that because of the data access differential, sooner or later, their money is going to end up lining the pockets of the market makers.
One last thing: We have all heard that the first rule of investing is to invest only money you can afford to lose. Financial planners will tell you that means invest money you won't need for the next five to eight years. I am going to say we should take the first rule of investing very literally. What we have learned is that responsible baby boomers who did the right thing and contributed to their 401(k)s or IRAs have discovered that money set aside for retirement is money they could not afford to lose. But they have lost it, and they have no time wait for the market to possibly recover. They will never get it back in time.
Financial planners know that retirement money should not be in stocks. That's why they advise recalibrating your portfolio as you get older from stock-heavy to bond-heavy. They snicker at the "risk adverse" who put protecting the principal above all else, pitying those pathetic people who forfeited the historical stock market gains for safety and smaller returns. Their smaller returns are making them look pretty smart right now. 4% of something is a far cry better than 12% of nothing.
Financial planners are still trying to get baby boomers to buy stock. Honestly, if you are debt-free, have all your obligations covered, with your retirement savings secure, then and only then should you consider the stock market, and then only with money that if you up and flushed it down the toilet, you wouldn't care. If you are young, maybe you can buy blue chip stock at bargain prices, let it ride for the next thirty years and cash it out. Or maybe you are a baby boomer who bought blue chip stock thirty years ago, hoping to cash it out today. Surprise, surprise.
So where do I stand with my brokerage now? They will no longer talk to me. They say I am too stupid. (Actually, they said I seem unable to understand the answers provided to my questions). They have unilaterally restricted the account so that the only orders they will accept are liquidation orders. Any advice out there? Thanks.