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15 Inviolable Rules for Dealing with Wall Street

Posted By Barry Ritholtz On October 25, 2010 @ 7:00 am In Apprenticed Investor,Corporate Management,Investing,Really, really bad calls,Rules | Comments Disabled

The never ending parade of stock scandals seems to continue unabated, the stock lending scam [1] 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 . . .


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URL to article: http://www.ritholtz.com/blog/2010/10/15-inviolable-rules-for-dealing-with-wall-street/

URLs in this post:

[1] stock lending scam: http://www.ritholtz.com/blog/2010/10/shared-profits-not-losses/

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