The never ending parade of stock scandals seems to continue unabated, the stock lending scam being only the most recent. As history has shown us — from Mexico to Orange County to analyst banking crisis to Derivatives to etc., when the Street comes aknockin, best for you to hide your wallets.

For reasons we are all too familiar with, many of you rubes have no choice but to deal with the sharpies from the finance division of America. Whether its floating a bond issue to build a new bridge or hospital, managing a pension fund, or simply handling cash flow, for county, city and state execs, non-profit organizations, and private companies, you will eventually “get serviced” by Wall Street.

Those of you who have to interact with the sharks should learn the following rules:

15 Inviolable Rules for Dealing with Wall Street

1. Reward is ALWAYS relative to Risk: If any product or investment sounds like it has lots of upside, it also has lots of risk. (If you can disprove this, there is a Nobel waiting for you).

2. Overly Optimistic Assumptions: Imagine the worst case scenario. How bad is it? Now multiply it by 3X, 5X 10X, 100X. Due to your own flawed wetware, cognitive preferences, and inherent biases, you have a strong disinclination – even an inability — to consider the true, Armageddon-like worst case scenario.

3. Legal Docs protect the preparer (and its firm), not you: Ask yourself this question: How often in the history of modern finance has any huge legal document gone against its drafters? PPMs, Sales agreement, arbitration clauses — firms put these in to protect themselves, not your organization. An investment that requires a 50-100 page legal document means that legal rights accrue to the firms that underwrote the offering, and not you, the investor. Hard stop, next subject.

4. Asymmetrical Information: In all negotiated sales, one party has far more information, knowledge and data about the product being bought and sold. One party knows its undisclosed warts and risks better than the other. Which person are you?

5. Motivation: What is the motivation of the person selling you any product? Is it the long term stability and financial health of your organization — or their own fees and commissions?

6. Performance: Speaking of long term health: How significantly do the fees, taxes, commissions, etc., impact the performance of this investment vehicle over time?

7. Shareholder obligation: All publicly traded firms (including iBanks) have a fiduciary obligation to their shareholders to maximize profits. This is far greater than any duty owed to you, the client. Ask yourself: Does this  product benefit the S/Hs, or my organization? (This is acutely important for untested products).

8. Other People’s Money (OPM): When handing money over to someone to manage, understand the difference between self-directed management and OPM. What hidden incentives are there to take more risk than would otherwise exist if you were managing your own assets?

9. Zero Sum Game: If I am winning, who is losing? And who wins if I lose? Does this product incentivize any gunslingers to make bets against my investments –or my firm?

10. Keep it Simple, Stupid (KISS): Its easy to make things complicated, but its very challenging to make them simple. The more complexity brought to a problem, the greater the potential for things to go awry – and not just wrong, but very, very wrong.

11. Counter-Parties: Who is on the other side of your trade? Any income/revenue/dividend hedging you do means there is a party that stands to win if you lose. Who are they, what are their motivations?

12. Reputational Risk: Who suffers if this investment goes down the drain? Who gets fired or voted out of office if this blows up? Who suffers reputational risk?

13. New Products & Services: The rules of consumer technology also apply to finance: Never buy 1.0 of anything. Before buying a new-fangled service, is there a compelling reason not to wait an upgrade cycle? Why not let some other schmuck be the guinea pig?

14. Lawyer Up: The people on the street buy the best legal talent on the planet, with money no object. Make sure you have damned good lawyers working for you as well . . .

15. There is no free lunch: Repeat after me: There is no free money, no riskless trade, no way to turn lead into gold. If you remember no other rule, this one wills ave your bacon time and again.

The list above will help prevent you or your organization from becoming financially disadvantaged by bad financial advice, excessively expensive services or inappropriate/unsuitable products.

Don’t say you were not warned . . .

Category: Apprenticed Investor, Corporate Management, Investing, Really, really bad calls, Rules

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

37 Responses to “15 Inviolable Rules for Dealing with Wall Street”

  1. Niskyboy says:

    Great selection of topics on your blog this morning, Barry. Way to go.

  2. [...] Inviolable Rules for Dealing with Wall Street" – epic.  (TBP) [...]

  3. Sechel says:

    Excellent piece.
    No matter how much time goes by, investors/buyers still believe the documents are written for their benefit and not to protect the seller. It is also amazing that they continue to not ask the hard questions when approaching an investment. This same piece is very appropriate for real estate investors when approaching a mortgage or those buying from a real estate from a sponsor or developer.

  4. dead hobo says:

    The Other Rules:

    1) When you are using OPM, most of the above rules don’t apply. After all, you will always be paid, even if the cash provider loses. The only risk is “how much”.

    2) If you are investing your own cash, read the above and ask yourself “do you feel lucky?” If the answer is “Huh?”, then just go for safe, not free cash off the pavement. If you’re young and have another income, then go for it, if you feel lucky.

    3) Don’t expect any regulator to look out for your best interest, unless you are investing OPM. Then you own the place.

    4) Just as there is always someone richer, handsomer, more clever, or smarter, there will always be someone who brags about their excellence on making the right calls while you didn’t. Especially if they get paid by commission using OPM.

    5) Everyone on Wall Street makes money by either taking it from someone else or by taking some of what the Fed prints. Your gains came from someone else or from the printing press. You losses went to someone else who is probably laughing at you right now.

  5. [...] When dealing with Wall Street its worth taking precautions. Here are 15 to start [...]

  6. ACS says:

    “Reward is ALWAYS relative to Risk”

    Not when you’re TBTF.

  7. dead hobo says:

    One more rule:

    The Fed is Wall Street’s personal bitch. Anything that looks to the contrary is scripted to maintain appearances. A secret PPT was only the beginning. Now they don’t even bother to hide what they do (cash to primary dealers, where it ends up in minutes in the markets on a regular basis, several time per week)

    QE2, if it occurs as expected, will turbocharge this cycle. Wall Street will be the beneficiary, as will be all commodity investors. Losers will be wage slaves, people with savings accounts, bond holders, and anyone who does not put cash into hard assets as an investor (not as a consumer), except for housing, although even housing will probably benefit from a big enough QE2. The Fed has blessed ‘price targeting’ which is also known as inflationary expectations, although they will probably go ballistic if this inflation starts causing wages to rise. Rising interest rates will only beget QE3.

  8. Sechel says:

    The Fed is an organization of bankers. So even if they are not out to screw the public, they very much have a bias. Should be no wonder that the primary mission of the Fed is to protect/save the banks, even if it is at the expense of the greater economy. Maybe they honestly believe this is the right thing to do… but even if that is the case, it doesn’t much matter.

  9. dead hobo says:

    Wall Street To Fed:

    “Bitch, print me some money. Don’t look at me like that, I’ll slap your ass into next week. Now, give Daddy some sugar.”

  10. dsawy says:

    These can all be distilled down to one rule:

    “Everyone on Wall Street is out to screw you, every day, in every way possible. Act like you know you’re the prey.”

  11. Tarkus says:

    A used car salesman in an expensive suit, is still a used car salesman.

  12. dead hobo says:

    last post:

    oops: I just proofread a post above.

    if QE2 happens and is large enough, winners will include people who put cash into commodities as investors, not as consumers. Somehow, I wrote the opposite.

  13. Excellent list. It should be stapled to the forehead of every kid graduating high school

  14. Bruman says:

    I like to multiply by the square root of 2 or pi when dealing with overoptimistic assumptions. Somehow tthrowing in an irrational number helps me remember where these things come from.

  15. number2son says:

    Now you tell me.

  16. bulfinch says:

    “Bitch, print me some money.”

    Seeing words written which will never come out of any person’s mouth in a certain sequence in an entire life time makes me laugh like nothing else.

    Thank you, Mr. Hobo: you’re damn good.

  17. Kerim says:

    An excellent list, Barry. Thank you for posting it.

    One small point:

    … no way to turn lead into gold

    There is a way to turn lead into gold.
    And to do it means your certain economic disaster!
    Which is what I think you were getting at in the first place.

    Modern physics, using nuclear transmutation showed us the way and demonstrated it
    (although it is easier to change mercury into gold). However, by any measure it is easier to
    get gold the old fashion way; either to work for it or to find it in the ground. I did a back
    of the envelope calculation once and price gold would have to go up about a factor of a 1000
    (from today) or the cost of electricity drop by the same factor or a combination of the two
    before one would start to break even.

    The Obituary of Dr. Glenn Seaborg
    http://query.nytimes.com/gst/fullpage.html?res=9D0CE3DC153CF934A15751C0A96F958260

    http://en.wikipedia.org/wiki/Nuclear_transmutation
    http://en.wikipedia.org/wiki/Synthesis_of_noble_metals

    ~~~

    BR: heh heh I should have said profitably!

  18. “9. Zero Sum Game: If I am winning, who is losing? And who wins if I lose? Does this product incentivize any gunslingers to make bets against my investments –or my firm?”

    I do not believe this capition is entirely accurate, at least for equity markets:

    1. Equity Markets are not a ‘zero sum game’ – in equity markets, every long is not offset by a short — for example, when equity markets go higher, the majority of investors gain…..(in the futures markets, every long is offset by a short so you could argue that futures markets are more of a zero sum game)

    2. Perhaps the point should relate to product incentives & complexity — ie, the more complex a product is, then the more you have to understand regarding the incentives behind those who created the product !

    ~~~

    BR: If you buy something, someone sold it to you. At the very least, your gain is their missed opportunity . . .

  19. Mark Down says:

    16. Sign Here. The 3rd. copies yours.

  20. JerseyCynic says:

    I WANT OUT OF WALL STREET

    I say anyone over 50 that can pay off their mortgages with their retirement funds do so now. Get out of wall street and let the big boys (the 1%) have at it. In exchange for giving the banks some real(?) cash, waive our penalties for early withdrawal. If the big boys can keep the market (and big corporations) going on their own, maybe we’ll jump back in after a year or two of saving. We will remain debt free and resist the urge to refinance and stimulate (buy crap) the economy. Since we’ll be mortgage free, we will save up our money and decide if we want to get back in. Maybe we’ll just stimulate our local economies only. If they don’t want to play nice (keep jobs here), why would we want to be a shareholder?

  21. While the republic may have been founded on Lockean principles of freely conveyable and contractable property rights, it must always be remembered that Hegelian principles still apply. Life is always a war of all against all, no matter that the bullets and blades are now just words in a contract.

    Good to always keep that in mind, but especially when dealing with Wall Street traders, red in tooth and claw.

  22. Long term says:

    @BR

    “Whether its floating a bond issue to build a new bridge or hospital, managing a pension fund, or simply handling cash flow, for county, city and state execs, non-profit organizations, and private companies…”

    This one sentence adds wonderful context. I could not visualize “having” to deal with the street until you made it all-to0-familiar.

  23. [...] 15 inviolable rules for dealing with Wall Street.  (Big Picture) [...]

  24. er, “Hegelian” principles should be “Hobbesian” in previous post. My brain files got the “H” philosphers mixed up while my fingers were busy typing.

  25. nweaver says:

    I’d add a 9.1:

    9.1: Zero Sum “Investments” aren’t investments for at least one of the parties.

  26. peter north says:

    @BR: Sharp list. But I can think of one exception to #15: The banks that can borrow at zero and loan it right back to the government in the form of treasuries seems like the best real life arb I can remember.

  27. Ltdata says:

    Very shrewd. Also known as the 15 lines you’ll Never see in a contract given to you.

  28. “BR: If you buy something, someone sold it to you. At the very least, your gain is their missed opportunity . . .”

    I do not disagree with the statement above regarding missed opportunity…

    However, the equity markets are different in that you can borrow shares and sell short…..which when you think about it there really is no other side….

  29. Michael says:

    Barry,

    You’re not keeping up with the latest research! You state that “Reward is ALWAYS relative to Risk”. But this is NOT true, e.g. CCC bonds do not out perform BBB bonds. There are many other examples where extra risk does NOT equal extra reward.

    Checkout Eric Falkenberg’s research at Falenblog. He has links there to both his research and others. I understand that even Eugene Fama now admits that risk is not related to reward.

    Regards,
    Michael

  30. ToNYC says:

    @peter north

    In no way is ZIRP a free lunch. It is a 100% confiscatory tax against the interest deserved by all the US bank depositor savers. There is no other medium of exchange that is not closely reflective of the real Domestic GNP stored value of US work efforts.

  31. Bruman says:

    I agree that not everything is zero sum (though it is, more often than not). What’s missing in the equity sale example is that there may be different needs for each party. One party wants more liquidity, the other party wants more risk and return. Who is to say that one party must lose if the other wins : in this case, you have mutual gains from voluntary exchange. At some level, you can argue that the seller missed out on an asset rise (if the asset did in fact rise), and it is zero sum in a purely accounting sense, but in the utility world, both parties are better off, because the seller used their cash for whatever they wanted it for and the buyer got a gain.

  32. jad714 says:

    I personally would put a very small amount of my investments into stocks, and for those of you who live dangerously, who live their lives based on stock trading, don’t do it without help:

    http://www.philstockworld.com

  33. [...] – 15 inviolable rules for dealing with Wall Street. [...]

  34. [...] 15 Inviolable Rules for Dealing with Wall Street [...]

  35. peter north says:

    @ToNYC: Oh, believe me, I agree with you! I was just saying for the big guys with access to the Fed Funds window it is a great arb. But I know it is zero-sum, and the rest of us are taking it in the butt.

    I just find it amazing that there is so little outcry over the fact that the big banks can borrow from the government at effectively zero percent, and turn around and loan it right back to the government by buying the 10-year, and they pocket the 2.67% difference. Someone explain to me how that is not a stealth ongoing bailout. Madness.

  36. [...] 15 rules that apply even if you have yr own private banker. Remember that most PBs are rewarded like brokers and relationship mgrs: The more they sell you, the bigger their pay. And the riskier the product, the bigger the commissions. [...]

  37. [...] 15 Inviolable Rules for Dealing with Wall Street (The Big Picture)–Barry Ritholtz offers a slate of rules to live by for anyone dealing with a Wall Street person or institution.  These rules apply as much to the most experienced Wall Street veteran as they do to a novice amateur. [...]