John Bogle on Liquidity

speed of light giant transactions in complex financial instruments that would have been inconceivable in an earlier age, and operating at volume levels undreamed of in an earlier era. For example, shares of U.S. stocks (NASDAQ and NYSE combined) turned over at 135% last year, three and one-half times the 40% rate of two decades earlier. Importantly, without electronic systems and the dispersal of market activity and back-up communications networks that they facilitated, the rapid reopening of our financial markets after the September 11 terrorist attacks would have been impossible. What is more, money managers today have seemingly infinite information at their fingertips. Corporations observe the rules of full disclosure, and a vast community of investment professionals analyze each firm’s financial statements in intimate detail. Soaring transaction volumes, liquidity and information availability—spread among market participants almost simultaneously—have made the markets even more efficient, arguably making it more difficult for skilled managers to ply their trade. Money managers can—and do—compare their portfolio holdings with those of their peers, and their weightings with those of the stock market indexes which the marketplace uses to evaluate them, and fiduciaries can—and do—regularly evaluate their managers on the same basis.

Let me now turn from the miracles of what Vanguard’s IT group has accomplished to the miracles that technology has brought to the mutual fund industry. These four stand out:  The emergence of a financial system that has enabled the professional money managers of funds to offer a whole new variety of investment products, to provide remarkable liquidity for transactions, and to transact business around the globe at the speed of light.  The provision of an up-to-date information network that provides data about mutual fund portfolios and performance so vast as to be beyond the ability of the human mind to absorb.  The development of websites that not only provide fund shareholders with real-time account valuations, but also financial planning advice, including recommendations on saving for retirement and on the allocation of investment assets.  The availability of a communications network so efficient that investors can purchase and redeem fund shares instantaneously (albeit so far with the transactions executed no more frequently than hourly), without ever moving from their desktop computers. But, with all of this extraordinary technology available to investors, I ask you tonight: To what avail? Yes, computer technology has played a major role in the growth of the mutual fund industry, adding a whole new order of magnitude to the growth fostered by the 18-year bull market in stocks.

Reliance on the fundamentals of investing means investing in corporate businesses for the long run. Reliance on speculation, and gambling on changes in the price-earnings ratio, means investing in stock certificates-pieces ofpaper-for the short run. Sadly, most mutual funds preach the long run, but practice the short run, turning over their portfolios at a costly and grotesquely tax-inefficient rate of some 90% per year. I urge you to ignore the practices mutual funds follow ... and attend to the practices they preach. For the long term investor who wants to stay the course, reliance on a sensible balance of stocks and bonds is essential-more important today, I believe, than for as far back in market history as most of you here can remember. (I'm older!) Such a course will mitigate emotion in investing and emphasize reason and common sense. Simplicity, then, above all: Balance. Markets Fluctuate. Invest for the Long-Term. Stay the Course. Simplicity also gives us a surprising rule for measuring investment success. The central task of investing is to realize the highest possible portion of the return earned in the financial asset class in which you invest-realizing, and accepting, that that portion will be less than 100%. Why? Because of cost. To state the obvious, we know intuitively that our cash reserves will inevitably earn less than the going short-term market rate.

Mutual fund directors are responsible for none of these decisions. Rather, in the industry’s own parlance, they are “watchdogs” for each of the 100-300 funds usually managed by the large fund complexes, approving (and rarely, if ever, disapproving) each fund’s advisory and distribution contracts, custodian agreements, and pricing and valuation procedures; and monitoring investments and portfolio quality and liquidity—part of a seemingly imposing list of 40 duties set out by the industry, but duties that, in the real world, are largely perfunctory. None of these duties, moreover, relates to a fund’s mission and its obligation to create economic value by earning the cost of its capital. Further, those approvals and that monitoring take place under the direction of the fund’s chairman—a chairman who is, almost without exception, also the chairman (or a high official) of the fund’s management company. The chairman controls the agenda; the staff reports are made by his subordinates; the responsibilities for management are theirs alone. It’s simply not reasonable to attribute the vastly higher fees paid to these independent fund directors to their having assumed vastly higher responsibilities than their management company counterparts. That leaves us with at least the possibility that such high fees are there to subtly encourage directors to act at the manager’s behest.

Cash Flows – The Investment Essential To explain what happened, we can again rely on Dickens’ words, for we have returned from the epoch of incredulity to the epoch of belief. As I stressed in my year-ago speech, despite the dichotomy that appeared to exist between two U.S. economies—the Old Economy of Industrial America and the New Economy of the Information Age (a difference that is quite nicely captured, as it happens, between the stocks listed on the NYSE and those traded on the NASDAQ over-the-counter market), the mathematics of the market ultimately come down to the theory that is universally taught in undergraduate finance classes and graduate business schools: In the long-run, the rewards of investing must be based on future cash flows. For the purpose of the stock market, simply put, is to provide liquidity for stocks in return for the promise of future cash flows, enabling investors to immediately realize the present value of a future stream of income. If investors didn’t simply ignore this inevitable truth, they anticipated future streams of income that lost touch with reality, projecting that the earnings of the New Economy stocks would grow at unprecedented rates in order to justify price-to-earnings ratios that ranged from 50 times earnings, to 150 times, all the way to infinity. (Infinity is reached when there are no earnings, so the price-to-sales ratio is substituted, often itself reaching hundreds of times.)

They should be measured against the market segment (or segments) in which they choose to participate. Weighted indexes combining appropriate levels of large cap and small cap, value and growth, and international surely make sense. That said, however, blame the client if he selects a small-cap strategy and the adviser outperforms the small-cap universe yet fails to outpace the total market over the long term. But blame the adviser if he overweights small-cap in the hope of beating the total market over the long term but fails to do so. Further, consider the role of bonds and cash reserves in the asset mix of the target index. Stock indexes (and index funds), to state the obvious, hold neither. A balanced fund should be measured against a balanced mix of stocks, bonds, and reserves. And it would not necessarily be foolish for an adviser to an equity fund which holds a fairly consistent 5% to 15% position in cash reserves to use a similarly adjusted stock/reserve benchmark.dampen

, related “specialized investment vehicles (SIVs) have also created havoc. To sell these instruments, our giant banks increasingly issued “liquidity puts” to buyers, guaranteeing to repurchase them on demand at face value. Citigroup, it turns out, was not only holding $55 billion of CDOs on its books, but also some $25 billion of SIVs that have been “put” back to the bank, a fact not publicly disclosed by Citi until last November. Astonishingly, former Treasury Secretary Robert Rubin, chairman of Citi’s Executive Committee (and a man, one might say, of not inconsiderable financial acumen) has stated that until last summer he had never even heard of liquidity puts. (Not quite as embarrassing as former chairman Charles Prince’s earlier comment: “As long as the music is playing you have to keep dancing. We’re still dancing.”) The peculiar characteristics of financial innovation are not limited to fixed-income investments underwritten by our investment banks. The mutual fund sector too has much to answer for. For example, in the late 1990s, innovation in the mutual fund sector was designed to capitalize on the so-called “New Economy.investors

The managed fund then provides an ever more index-like portfolio, until it becomes a virtual index fund—but without the added value provided by low operating and advisory expenses, microscopic portfolio turnover and commensurately lower taxes, and a fully invested participation in equities. In short, today’s chance of victory, as small as it demonstrably is, will become tomorrow’s certainty of defeat if managers offer tacit index funds with high fees, high portfolio turnover, and a significant position in cash reserves. And it is the mutual fund shareholder who will pay the price. Relativism suggests that managers are becoming more similar to the enemy—“if you can’t beat ‘em, join ‘em.” But in the long-term, it is being different that gives an individual manager at least a fighting chance to win the battle for extra market return. Surely holding to a clearly differentiated strategy—and, for mercy’s sake, keeping a tight lid on fees and other costs—to cope with the realities of index competition is better than just standing there and hoping, again in Mr. Micawber’s words, that “something will turn up.” I acknowledge that not all fund managers subscribe to the new relativism. Indeed, some of the better managers in the field find it repugnant.magazine

The characteristics of those who do so will be individuality, training, experience, savvy, determination, contrarianism (or sheer iconoclasm), and hard work. The Puritan Ethic is not all bad! Importantly, they will limit the assets of the funds they manage relative to the market cap of the asset class in which they utilize their expertise, and relative to their proclivity to actively trade the portfolio rather than analyze, buy, and hold. Some successful managers, rather than being concerned with short-term relative risks, will run fully invested equity positions to capitalize on the fundamental long-term opportunities of equity investing. Others will succeed simply by investing with the courage of their convictions, rather than slavishly relying on short-term standards, and holding cash reserves when they judge market risk as excessive. Both groups will manage their funds at reasonable costs, allocating their fee revenues toward human talent and investment productivity, rather than engaging in marketing profligacy designed not to improve investment returns for fund shareholders, but solely to advance the manager’s own profitability.

A New Idea, Sixty Years Old With all of the high-priced creative and imaginative talent in this industry, I find myself wondering why someone, somewhere, hasn't dreamed up a still better way to enhance after-tax mutual fund returns. Surely the opportunities abound. Let me describe my own idea. I start with a fund that simply buys a large sampling of high quality blue-chip growth stocks, and holds them unless fundamental circumstances change radically. Where, you ask, do we fmd the budding Warren Buffett to manage it? Honestly, I don't know. So, I shift gears. Why not a fund that buys, say the 50 largest stocks in the Standard & Poor's Growth Index universe? (That's nearly 30% of the capitalization of the entire stock market.) Simply hold them "forever" and don't rebalance as prices change. If there is a merger, keep the merged company; if a company is bought for cash, reinvest the proceeds, either in the next largest company or in the fund's other holdings (it probably won't matter which you do); ifit fails and goes out of business, well, just realize that can happen. Then, run the fund at an expense ratio of 20 basis points, just incurring bare-bones operating costs. Minimize exposure to shareholder redemptions with a stiff redemption fee and/or strong limitations on daily liquidity (i.e., open the fund for redemption only, say, on the last day of each quarter). These latter steps will, of course, make it difficult to attract quick-triggered opportunists. That's good!it

It takes only a moment’s contemplation to imagine what might happen in the financial markets if, say, half of that number responded to a major earthshaking (literally or figuratively) news event. The industry’s old gatekeeper—a busy signal on the telephone—is retiring, for better or worse. Perhaps busy Internet service provider numbers, or even an Internet crash, will “protect” us if the dark day comes, but perhaps not. Honestly, it’s sort of scary. The Report Card Let’s grade each aspect of the technologies currently used in mutual fund investing:  Investment technology: Innovative financial instruments, A+; liquidity, A+; cornucopia of funds, A+; soundness of new funds, C; investment behavior of mangers, D.knowledge,

transaction costs to a bare minimum; produced greater liquidity, and improved (perhaps only slightly) price discovery and greater market efficiency for professional investors. That’s all to the good. But the huge risks of a technology breakdown in our increasingly computerized stock market remains hidden out there, beyond the horizon. In our data-intensive, speed-driven society, yes, HFT is here to stay. ETF Toys I find it both astonishing and deeply discouraging that index funds have become one more example of the apparently irresistible impulse of investors to speculate. Imagine! In 1975, Vanguard created the world’s first index mutual fund, following this elemental strategy: (1) buy and hold all of the stocks in the Standard & Poor’s 500 Index; (2) operate at rock-bottom cost; and (3) attract long-term investors who wish to hold the stock market portfolio, well, forever. Those original sensible strategies of indexing have reshaped investing in a highly positive way for long-term investors. But the exchange-traded index fund (ETF) is the antithesis of that third key to index success—holding the market forever. Formed in 1991,6 the first ETF was also based on the S&P 500, but with the added “feature”—embodied in its advertising slogan—that its shares could be “traded all day long, in real time.” (I’m not making this up!) With $160 billion of assets, the so-called “SPY” is now the world’s largest ETF.

(In the 20-years ended in 2000, venture capital funds slightly lagged the index despite the substantially higher risks involved.) This experienced expert’s conclusion: “suppliers of funds to the venture capital industry generally realize poor risk-adjusted returns.” It is no secret that in the years before the bull market peaked in 2007, many of the larger endowment funds made substantial advance commitments to private equity deals, and in the ensuing crash were pressed to maintain sufficient liquidity to complete those transactions. In recent years, a market has emerged to relieve the endowments of some of those commitments, but at nothing like 100 cents on the dollar. (Perhaps 50 cents would be more like it.) In any event, the whole issue of market valuations vs. book values (usually the cost basis of the commitments) raises complex questions regarding the precision of reported endowment fund returns. My conclusion: use private equity only if you have the staff, skill, and the skepticism about future projections to do so, and don’t over commit. You may come to find that liquidity can become priceless (no pun intended!) Summing Up Yes, alternatives have provided a solid plus for many endowment funds, especially the largest funds, but remember that the past is not necessarily prologue. Remember reversion to the mean.

For as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted, these enormous costs seriously undermine the odds in favor of success for our citizens who are accumulating savings for retirement. Alas, the investor feeds at the bottom of the costly food chain of investing. This is not to say that our financial system creates only costs. It also creates substantial value for our society. It facilitates the optimal allocation of capital among a variety of users; it enables buyers and sellers to meet efficiently; it provides remarkable liquidity; it enhances the ability of investors to capitalize on the discounted value of future cash flows, and of other investors to acquire the right to those cash flows; it creates complex financial instruments that enable investors to divest themselves of risks they prefer not to assume by transferring them to others who are willing to bear them. No, it is not that the system fails to create benefits. The question is whether, on the whole, the costs of our financial sector have reached a level that overwhelms its benefits.

They are not improved by my second significant error, the prediction that “institutional markets— pension, endowment, corporate, foundation—should become extremely important to our industry’s future growth.” Perhaps a “D” will reflect the actuality—that, according to Investment Company Institute data, the portion of our Industry’s assets represented by these institutional accounts eased only slightly upward during the past decade, from 12 percent to 14 percent. Put another way, mutual funds currently represent something like 2 percent of the assets of all corporate pension plans, by far the dominant institutional market. So, my supposition that mutual funds could penetrate these markets in an important fashion was just plain wrong. Nonetheless, it is at least possible that the proverbial “jury is still out” on this issue. I believe that the recent trend from the traditional defined benefit pension plans toward defined contribution plans, and the related growth of 401(k) employee savings plans, will open vast new markets for mutual funds. It continues to seem to me that there is no investment vehicle providing benefits comparable to those offered by mutual funds: “simplicity, efficiency, liquidity, and flexibility: (the words I used a decade ago). Indeed, “flexible pricing” has made it the norm for funds of all types—not merely no-load funds— to offer their shares in this giant market without sales commissions.

Well, four years later, that “big market event” is upon us. The innovation of derivatives has enriched the financial sector (and the rating agencies) with enormous fees, and these over-rated, as it were, CDOs have wreaked havoc on the balance sheets of those who purchased them, including the banks and brokers themselves. They too bought them, and in the end, with many of them still on their books, were left holding the bag,. What is more (if we need more!), the SIVs have also created havoc. For it turns out that to sell these instruments, our banks increasingly issued “liquidity puts” to buyers, guaranteeing to repurchase them on demand at face value.its

books, but also some $25 billion of SIVs that have been “put” back to the bank, a fact not publicly disclosed by Citi until November 5. Astonishingly, Robert Rubin, chairman of Citi’s Executive Committee (and a man, one might say, of not inconsiderable financial acumen) has stated that until last summer he had never even heard of liquidity puts. (Not quite as embarrassing as former chairman Charles Prince’s earlier comment: “As long as the music is playing you have to keep dancing. We’re still dancing.”) Innovation in the Mutual Fund Industry If innovation has again gone too far in the banking sector, that sector is hardly alone. Innovation has also gone too far in the mutual fund industry. When I entered this industry way back in 1951, it was overwhelmingly dominated by equity funds holding a diversified list of blue chip stocks; investing for the long-term (15 percent portfolio turnover); operated at modest expense ratios (averaging about 75 basis points); and pretty much closely tracking (before costs, of course) the returns of the stock market itself. We were an industry that sold what we made, and we valued management over marketing, stewardship over salesmanship. And then we decided to innovate. It was the mid-1960s when the mutual fund sector began to stray from its commonsense charter that had served investors with reasonable—if not quite optimal— effectiveness.

considerable assurance—that America itself will continue to have a population that is growing in age, education, professional status, real income, and asset accumulation—the same five areas in which no-load funds have found their greatest relative strength. I wish I had more time today to deal with the institutional markets of the 1980’s, and their relationship to pricing and product strategy. Let me simply state my conclusion that these markets—pension, endowment, corporate, foundation—should become extremely important to our industry’s future growth. Why? Because a mutual fund group—especially one with a nominal or no sales charge, and with a low expense ratio—offers extraordinary opportunity to such institutions, from the largest to the smallest, in terms of simplicity, efficiency, liquidity, and flexibility—to say nothing of investment performance. One of the great canards of recent years is that mutual funds are somehow “second class citizens” when it comes to performance results. I would like to take a moment to put that ridiculous apprehension to rest right now, because as we approach the 1980’s the information explosion will mean that institutional investors will be even more informed—if that is possible— about relative performance than they are today. And the simple fact is that mutual funds have a significantly better record than any type of adviser to corporate pension accounts.

the outside looking in, and they are a small minority.) Their shared goal: To increase the price of a firm’s stock, the better to please “the Street,” to raise the value of its currency for acquisitions, to enhance the profits executives realize when they exercise their stock options, to entice employees to own stock in its thrift plan, and to make the shareholders happy. How to accomplish the objective? Aim for high long- term earnings growth, offer regular guidance to the financial community as to your short-term progress, and never fall short of the expectations you’ve established, whether by fair means or foul. What’s wrong with that? What’s wrong, as I said in my 1999 remarks, is that when we “take for granted that fluctuating earnings are steady and ever growing . . . somewhere down the road there lies a day of reckoning that will not be pleasant.” I was warning, of course, about the aftermath of the classic “new economy” bubble that had developed, where stock prices were wildly-inflated by unrealistic expectations and, well, irrational exuberance. Finally, the eternal truth re-emerges: The value of a corporation’s stock is the discounted value of its future cash flow. All over again, we learn that the purpose of the stock market is simply to provide liquidity for stocks in return for the promise of future cash flows, enabling investors to realize the present value of a future stream of income at any time. Corporations, we again came to realize, must earn real money.

0% 5% 10% 15% 20% 25% 30% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Financial Sector’s Share of S&P 500 Earnings, 1980 – 2007 7. Source: Standard & Poor’s Corporation Was Minsky right? Has a new element of uncertainty been introduced into our economy? I’m inclined to agree. Indeed, I express the secular changes in the economy in a way quite similar to Minsky. Over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and to what is now predominantly a financial economy, and a global one at that. But the costs that we incur in our financial economy, by definition, subtract from the value created by our productive businesses. Think about it. When investors—individual and institutional alike—engage in far more trading— inevitably with one another—than is necessary for market efficiency and ample liquidity, they become, collectively, their own worst enemies. While the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market—for all of us as a group—is a zero-sum game before those costs are deducted. After intermediation costs are deducted, beating the market becomes, by definition, a loser’s game.

It facilitates the optimal allocation of capital among a variety of users; it enables buyers and sellers to meet efficiently; it provides remarkable liquidity; it enhances the ability of investors who wish to capitalize on the discounted value of future cash flows (stock sellers), and other investors who wish to acquire the right to those cash flows (stock buyers); it creates financial instruments (so-called “derivatives,” albeit often of mind-boggling complexity) that enable investors to divest themselves of a variety of risks by transferring those risks to others. No, it is not that the system fails to create benefits. The question is whether, on the whole, the costs of obtaining those benefits have reached a level that overwhelms them. Once a profession in which business was subservient, the field of money management has largely become a business in which the profession is subservient. Harvard Business School Professor Rakesh Khurana was right when he defined the standard of conduct for a true professional with these words: “I will create value for society, rather than extract it.” And yet money management, by definition, extracts value from the returns earned by our business enterprises. The Dominance of Finance over Business I now turn to the rise to dominance of our financial economy over our production economy, just as Minsky predicted.

It is, I think, these two factors—competitive zeal and moral values—that have been central to my career-long quest to make the things that I have touched during my long life better than I found them. Hence, the title I’ve chosen for my remarks this evening—“Aspiring to Build a Better Financial World.”1 I’ll talk first about the causes of today’s financial crisis, then set out an eminently sensible—if provocative—solution, and close with some reflections on how many, well, “Princeton coincidences” have punctuated my career, and on how the values and character of my Princeton education contributed to my mission. Causes of the Financial Crisis Why is it important to build a better world in finance? Because finance provides credit and fosters liquidity, it is the oil that lubricates the machinery of corporate capitalism, an essential element of a flourishing society. But our financial sector has failed us, and bears the overwhelming responsibility for the current economic crisis. The proximate causes of this crisis 1 I’m mindful of the fact that the theme of Princeton’s present capital campaign is “Aspire,” in the sense of “ambition to achieve a higher goal.” One citation in the Oxford English Dictionary defines aspire in especially beautiful terms: “an immense instinct in man’s nature (that) points upward, like a spire of flame.”

How can that be? Of course credit is central to our economy. Liquidity—enabling one person to acquire the stream of future income generated in a business, by using his capital to purchase shares from another person who wishes to withdraw his capital and relinquish his claim—is vital. And the efficient pricing of shares traded in our financial markets is essential to their functioning. But the principal function of the financial sector is to act as the middleman in a trade between a buyer and a seller, a trade that pits one investor against another, a trade that inevitably constitutes a zero-sum game (one side wins, the other side loses). But once the costs of the middlemen—the brokers, the bankers, the money managers, all those croupiers of finance— are extracted, speculation in stocks, becomes a loser’s game, a subtractor from social value. An old English saying puts it well:3 Some men wrest a living from nature and with their hands; this is called work. Some men wrest a living from those who wrest a living from nature and with their hands; this is called trade. Some men wrest a living from those who wrest a living from those who wrest a living from nature and with their hands; this is called finance. So, yes, I confess to you who will actually do the world’s work, making your living “from the earth and with your hands,” that your commencement speaker has earned his own living, not in that kind of real work, but in finance.

While some of this activity is necessary to provide the liquidity that has been the hallmark of U.S. financial markets, it has grown into an orgy of speculation that pits one manager against another, and one investor (or speculator) against another—a “paper economy” that, as Minsky warned, can devastate the real economy where our citizens save and invest. It must be obvious that our present economic crisis was, by and large, foisted on Main Street by Wall Street—the mostly innocent public taken to the cleaners, as it were, by the mostly greedy financiers. The economist Henry Kaufman warned about this very problem in his book, On Money and Markets, published in 2000: 1 Using the valuation model developed by Dr. Robert Shiller of Yale, the valuations were even more extreme. In October 2007, stocks sold at prices equal to 27 times earnings during the prior ten years, compared to the long-term multiple of 16 times. Result (if you agree with his premise): at the market peak, phantom wealth totaled nearly $7 trillion.

dancing.” (Rubin never heard of the “liquidity put.” Yet, as 2007 ended, Citigroup would write- down an astonishing $22 billion for expected future losses on CDOs and consumer loans). For Merrill Lynch, the write-down was $22 billion. Following a long age of cheap credit and rife credit availability and borrowers with high confidence and low collateral, we are beginning to pay the price, even as our economy itself faces a whole plethora of other risks created by our financial system. The key question is the extent to which these problems in our financial system will infect our economic system. The long boom in the real estate market has now turned down, with home prices in retreat, even as the same thing happened in the stock market early in 2000, and stock prices are now below the levels they reached eight long years ago. As I see it, our policy makers are running scared, with the Federal Reserve making credit available to banks (a good, and necessary step) and driving short-term interest rates down (great for borrowers but terrible for lenders and savers, and probably terrible for the dollar). I’m not at all sure that this is sound policy-making, for it increases the likelihood that inflation will rear its ugly head later on. Maybe, just maybe, we should not intervene and just let the markets clear.

For as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted, these enormous costs seriously undermine the odds in favor of success for our citizens who are accumulating savings for retirement. Alas, the investor feeds at the bottom of the costly food chain of investing. This is not to say that our financial system creates only costs. It creates substantial value for our society. It facilitates the optimal allocation of capital among a variety of users; it enables buyers and sellers to meet efficiently; it provides remarkable liquidity; it enhances the ability of investors who wish to capitalize on the discounted value of future cash flows, and other investors who wish to acquire the right to those cash flows; it creates financial instruments (so-called “derivatives,” albeit often of mind-boggling complexity) that enable investors to divest themselves of a variety of risks by transferring those risks to others. No, it is not that the system fails to create benefits. The question is whether, on the whole, the costs of obtaining those benefits have reached a level that overwhelms those benefits.

Whatever the benefits, the tremendous drain on investment returns represented by the costs of our investment system raises serious questions about the efficient functioning not only of that investment system, but of our entire society. Over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and now to what is predominantly a financial economy. But the costs that we incur in our financial economy, by definition, subtract from the value created by our productive businesses. Think about it. When investors—individual and institutional alike—engage in far more trading—inevitably with one another—than is necessary for market efficiency and ample liquidity, they become, collectively, their own worst enemies. To reiterate: while the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market before those costs—for all of us as a group—is a zero-sum game. And after intermediation costs are deducted, beating the market becomes a loser’s game. The rise of the financial sector is one of the seldom-told tales of the recent era.