Brokers And Their Biases

     Our economy knows many middlemen: persons and organizations that stand between the original producer of a good and the ultimate purchaser. These past few years, certain categories of middlemen have come under pressure, owing to the rise of the World Wide Web as a retailing tool. Consider how difficult it is for conventional travel agents to compete with the online airline-booking system, for example.

     The essence of middleman operations is the old prescription: Buy low, and sell high. The numbers dictate everything. This can lead to an unhealthful kind of myopia in a period in which the dollar itself has become questionable. We’re in such a period today.

     Financial guru John Pugsley, in his excellent book The Alpha Strategy, relates a case of this kind:

     As a further complication, the businessman tends to count inflationary gains on inventories as profit, when in reality they are not. I was reminded of this recently when, while on vacation, I went into a health food store to buy some honey. The jar on the shelf was priced at $1.00. As I was paying for it, the proprietress and I began to talk about rising prices. She noted how lucky she was to have bought a large supply of honey two years earlier when prices were much lower. The jar I held in my hand cost her only fifty cents, she noted, while now the same jar would cost her $1.10 at wholesale. Many other items in her inventory had risen proportionately. She then made the comment that she was thinking of expanding her little store, as profits had been good.
     She assumed that because she had purchased the honey for fifty cents and sold it to me for $1.00, that she was making a fifty-cent profit. I was a bit embarrassed to point out to her that she had not made a profit at all. She would have been better off not to have sold the honey to me, since now she had to take the dollar I gave her, plus a dime from her cash drawer, just to replace the jar on her shelf. She was going to lose a dime the moment she replenished her inventory. To bring her mistake vividly home to her, I suggested that she would be smart to immediately buy the honey back from me at $1.05, since that was five cents less than she could buy it for at the wholesaler. By her way of thinking, she would have bought all the jars on her shelves herself, made a fifty-cent profit, and then turned around and sold them back to herself at $1.10, and made another dime.
     Like many business owners, she did not understand that a profit is not the difference between original cost and selling price, but the difference between replacement cost and selling price.

     In that final paragraph, Pugsley has proclaimed the Gospel of the Enlightened Middleman…but there aren’t many who are that enlightened.

     I had a chat with my broker Bogdan just yesterday. Like many who have their savings in an Individual Retirement Account (IRA), I’ve seen a considerable decline in its paper value these past eighteen months. Equities of all sorts have declined, as anyone who even glances at the stock market reports will know. Coupled to the high inflation rate, this made me nervous. I asked Bogdan what might be done to brace against it.

     Bogdan was phlegmatic about it. His advice was to stay calm and ride it out – that there wasn’t much chance of losing everything, and that when equities rebound, I’d be glad I’d sat tight. That was probably the best advice anyone could give in these times. However, he related a tale of another client who’s decided to “go to cash:” i.e., to sell everything and merely hold dollars until the markets had settled. As this other client is very high net worth – much higher than I, at least – that had me shaking my head.

     The hell of it is that there are brokers counseling their clients to do that very thing: Sell equities that will probably recover in preference for an “asset” that’s already deteriorating swiftly. Good brokers call that “locking in your losses.” A broker who understands the difference between dollar-denominated price and asset value would not advise his client to do any such thing, even at a time when the dollar is relatively stable.

     Compare this to the preconceptions of the health-food store proprietress in the previous segment.

     Under the veil of Time, few things are certain. When it comes to finance, nothing is certain except fluctuation. True stability is almost unknown in the history of our economy. Thankfully, if you have patience enough (and stomach-lining enough) not to panic when things take a downturn, you can usually endure the negative fluctuations and come out better off in the aftermath.

     The main hazard in times such as these derives from a narrow focus. If you aren’t adequately diversified, as the gurus say, a fluctuation can wipe you out. Diversification lowers the probability of a big win, but it also protects against losing everything by betting on a single investment. The general understanding of this has risen in recent decades…yet there remain a large number of “investment counselors” who strive to steer the small investor toward “a hot thing.”

     Dollar-denominated gains from the hottest of hot things can be a complete illusion when high inflation is part of the mix. But the middleman’s bias — Numbers Uber Alles — coupled to the small investor’s natural desire to trust his “expert” advisor can lead him astray.

     It would be a big giveaway for such a broker to say “Trust me.” Unfortunately, most brokers are too smart to say it. What a pity.