by Archie M. Richards, Jr., CFP^®
August 6, 2001

Have you heard the one about the fellow who invested $700,000 and, sixteen months later, was left with only $403.95?

It's no joke. It happened to John Teeples, 45, who retired at the end of 1999 from 80-hour work weeks at Microsoft. Cashing in his Microsoft stock options, he set up a $700,000 investment account with two brokers at Morgan Stanley Dean Witter. Knowing nothing about investments, he told them he wanted a conservative approach and a reasonable rate of growth.

In just over a year, his $700,000 grew all the way down to $403.95. Oh yes, and Teeples owned $40,000 to the IRS from sales of his Microsoft stock options.

Teeples got belted by the bear market, of course. But we can't blame anyone for that. Bear markets aren't consistently predictable.

The brokers didn't buy options, which are extremely risky. No blame there.

From The New York Times article about Mr. Teeples's travails, it doesn't appear that the account was traded rapidly - the cause of many investment disasters.

The costs weren't unreasonable. Mr. Teeples was persuaded to adopt a "wrap" account, in which the fee is a percentage of the market value per year but securities can be bought and sold without commissions. Morgan Stanley's fee was approximately 1.5 percent, which is higher than I would like, but not too bad.

So much for things we can't blame. But we can cast plenty of blame at Morgan Stanley. That firm bases its fees for wrap accounts, not just on the customer's money, but also on money the customer borrows. The entire fee is shared with the brokers, who are therefore encouraged to persuade clients to adopt margin accounts. With uninformed clients, it's easy to make much of the growth potential (which is uncertain) and to make little of the risks (which are high). By pushing margin excessively, Morgan Stanley increased its income from both fees and interest.

No firm should place its own interests so far ahead of that of its clients.

Morgan Stanley can also be blamed for encouraging brokers to acquire the stocks of companies with which the firm has investment banking relationships. Investment banking business - the selling of new issues of stocks and bonds - is very profitable indeed, more so than regular commission business. Of the twenty-three companies whose stocks were acquired by Mr. Teeples, twelve had investment banking relationships with Morgan Stanley - another conflict of interest in which the firm placed its own interest above that of its clients.

The individual brokers are hardly blameless. Carried away with the day's investment fads, they chose nothing but big, high-tech stocks, like Cisco and JDS Uniphase. Diversification to various asset classes and to the stocks of different industries was thrown to the wind.

Another, much bigger party must also share the blame. Sixty-eight years ago, the federal government, with the best of intentions, created the Securities and Exchange Commission. Citizens were thought to be too stupid and disinterested to attend to investment risks. Government was supposedly necessary to protect them from being bamboozled by investment professionals. Nice try. It didn't work for Teeples.

As a result, investors do not focus on the brokerage firm's reliability; they go for growth. Those who consider themselves ill-informed nevertheless hand over their financial futures to immoral companies like Morgan Stanley, because they feel, in part, that their interests are being looked after by the government.

But let's say there were no Securities and Exchange Commission. And let's say that Mr. Teeples could find no court in which he might file suit to recover his funds. Except for fraud (in which Morgan Stanley did not engage), imagine that all courts held to the precept of buyer beware.

Under these circumstances, I doubt that Mr. Teeples would have been so trusting. He would have known that margin borrowing increases risks more than returns. He would have known that diversification to various asset classes and many industries is essential.

There is nothing wrong with regulation. It's government regulation that raises costs and protects the interests of the bigger companies. After checking the audits of various investment houses prepared by private, for-profit regulators, Mr. Teeples would have selected a company that places the interests of its customers first.