Speech by SEC Chairman:
Common Sense Investing in the 21st Century Marketplace

by Chairman Arthur Levitt

U.S. Securities & Exchange Commission

at the Los Angeles Times 3rd Annual Investment Strategies Conference,
Los Angeles, California

May 23, 1999

Thank you very much. It’s a pleasure to be here today with all of you. This is a remarkable time to be an investor. Any way you measure it, our markets have been enjoying record-setting growth. We’ve seen new highs, record volumes and a greater number of new investors than ever before in our country’s history.

Amidst this growth, technology continues to revolutionize how people invest, how brokers do business and how markets function. Because of new technologies and years of nothing but "up" markets, we are living in a time when the stock market is more a part of the American consciousness than ever before. Today’s gathering is a pretty compelling example.

Turn on the T.V. and you’ll get a constant ticker of stock prices. Surf the Web and you’ll find over 10,000 web sites dedicated to investing. The other day, I was driving behind a bus that advertised a financial web site. I remember when buses used to advertise the local newspaper.

More and more people are tapping into web sites to get stock quotes, historical price and volume information, company press releases, quarterly and annual reports, earnings reports, analyst reports and a host of other financial data. Never before in the history of our markets has so much information been available so readily to so many people.

The breadth and pace of change prompted by the Internet are almost bewildering. But, we shouldn’t get manic about the mania. The massive movement into our stock markets has provided new opportunities. But it has also increased the risks. There’s a lot of euphoria among investors. Some of today’s optimism is justified -- but some is not.

As cliché as it may be, fundamentals still apply. The ease and speed of the Internet have made trading -- not investing, but trading -- easier than ever before. Yet, in no way does it absolve investors of their basic responsibilities to invest in a way that is consistent with their goals and risk level.

Today, I want to focus on three things: First, at the SEC, we have noticed some common misconceptions that investors have about on-line trading. I want to review those with you. Second, whether you invest on-line or through a traditional brokerage, today’s technology provides unprecedented access to information that every investor should be taking advantage of. I’m going to talk about where you can get the information you need to help make informed investing decisions. And, third, I want to discuss how you can spot some of the obvious danger signs of fraud whether they are perpetrated in-person, over the phone or on the Internet.

Let’s start with on-line trading. How many people by a show of hands invest over the Internet? As recently as 1994, not one person traded over the Internet. In the next few years, the number of on-line brokerage accounts will roughly equal the metropolitan populations of Seattle, San Francisco, Boston, Dallas, Denver, Miami, Atlanta and Chicago, combined.

It is absolutely crucial that every on-line investor realize that the opportunity to make trading decisions comes with the responsibility to take the time to understand the implications of those decisions. We have noticed four common misconceptions that investors have about on-line trading.

The first is that although the Internet makes it seem as if you have a direct connection to the securities markets, you don’t. When you push that enter key, your order is sent to your broker, who then sends it to a market to be executed. This process is usually seamless and electronic; it is not, however, guaranteed. Lines may clog; systems may break; orders may back-up.

Even when automated systems can handle a lot of investors who want to buy or sell the same stock at the same time, a line often forms. Price quotes are only for a limited number of shares; some investors may not receive the currently quoted price. And, as you would expect, the price of that stock will then go up if there are more buyers and down if there are more sellers. By the time you get to the front of the line, the price of the stock could be very different.

So, how do you protect yourself from a rapid change in the price of a stock? Part of the answer is considering the use of a limit order. That’s the second thing every on-line investor needs to know. A limit order buys or sells a security at a specific price. In other words, the order can be executed only if the market price has not moved past a certain level. On the other hand, a market order buys or sells the stock at whatever price the security is at the time the order reaches the market. So, if you place a market order to buy an IPO stock at $9, you could end up paying $90 by the time your order is executed.

This isn’t theoretical. More than a few investors have lost most of their savings -- thousands and thousands of dollars -- because they failed to limit their price. Now, sometimes limit orders may not get executed in a fast moving market and some firms may charge more for them. But, at the very least, I’d rather not own a stock or pay a little more upfront than be totally unprepared or incapable of paying a whole lot more later. My goals as an investor may be different from yours, but considering the costs and benefits of a limit order is part of responsible investing in today’s market.

The third misconception is that an order is canceled when you hit the "cancel" button. But, the fact is it’s canceled only when the market receives the cancellation. You may get an electronic confirmation, but that may only mean your request to cancel was received -- not that your order was actually canceled. Recently, one major brokerage wasn’t able to process 20 percent of the cancellation orders on a fast moving IPO. One investor placed an on-line order for 2,000 shares of the stock -- thought she canceled it -- and then placed another order for 1,000 shares.

After realizing that she had two orders outstanding, she tried to cancel both. Instead, she owed her broker over a quarter-million dollars for 3,000 shares after wanting to invest roughly $18,000. Most cases may not be this exceptional, but I urge you to contact your firms to see how they can ensure a cancellation order actually worked.

Fourth, if you plan to borrow money to buy a stock, you also need to know the terms of the loan your broker gave you. This is called margin. When you buy on margin, the stock you purchase is collateral for that loan. In volatile markets, investors who put up an initial margin payment for a stock may find themselves required to provide additional cash if the price of the stock falls.

But, some investors have been shocked to find out that the brokerage firm has the right to sell their securities -- without any notification and potentially at a substantial loss to the investor. It’s clear that if an investor fails to understand the use and consequences of a margin account, he does so at his own peril.

Now, obviously, many investors don’t invest over the Internet and do so through a broker. Regardless of how you invest, if you are not asking questions and reading the right information, you are doing a disservice to yourself and to your long-term investment goals. In this day and age, there simply is no excuse for not being an informed investor. And, that’s my second point today.

Today’s access to timely information was virtually unthinkable just a few years ago. But, I’m surprised when I ask investors who and what they consult before buying a stock. I’ve found that very few people read the company’s annual report or mutual fund prospectus or do independent research. As far as I’m concerned, there is no more valuable time spent than getting the information straight from the horse’s mouth. That way you drastically reduce the chances that you’ll be taken on a wild and dangerous ride.

Raise your hand if you are familiar with the term EDGAR? EDGAR is the SEC’s electronic database of filings by most public companies. Type in a company’s name and you can retrieve every report they have filed with the SEC in the past five years. You can look up a specific filing or the most recent filing.

In doing so, you can find out if a company has made money or lost money. You can learn if the outside accountants think there are problems at the company or whether there are disagreements over accounting between those accountants and company management. You can find out who is on the Board and how many shares they own. You can determine if company insiders are buying or selling shares. As an investor, this is information I would dream about getting. And, it’s all free and available at the click of button at WWW. SEC.GOV.

Now, not all public companies file reports with the SEC. Smaller companies only have to file if they have $10 million or more in assets and 500 or more shareholders, or if they list their securities on an exchange or Nasdaq. That can make it extremely difficult to find information about small "microcap" companies.

But it’s not impossible. We’ve developed a fact sheet that tells you how to get information about companies. You’ll find it in our brochure "Microcap Stock" on our web site. You can also order a copy of "Microcap Stock" by calling our toll-free publications line at 800-732-0330.

You can also log on to a specific company’s web site to get an earnings report or any other report the same day they release it. If you don’t have access to the Internet, call the company and ask for it or go to your local library for Internet access.

Recently, the Internet has spawned an array of other investing tools. A growing number of sites allow you to type in a company’s name and find out if it has ever been a target of an SEC action or other government investigation. Some cites tell you if the company has ever made outrageous claims or if its stock price has experienced tremendous volatility.

Now, some may ask, "Why go through the trouble of reading this material or searching out a company on the Internet? I trust my friends. I trust the Wall Street analyst on T.V. or in the newspaper. I trust my instincts." Well, the answer can be found in something Folksinger Pete Seeger once said when explaining the difference between education and experience. "Education," he said, "is when you read the fine print; experience is what you get when you don’t."

So far, I’ve talked about information about investments. But there are other important questions that have to do with the people recommending investments.

Here’s a very important question if you have a broker: Have you ever asked precisely how he or she gets paid? Commissions reward a broker for the quantity of the trades, not necessarily the quality. There are other ways to do it. Some firms offer such alternatives as a flat fee, or a percentage of the assets under management.

Brokers are sometimes paid more for selling mutual funds, for example, rather than stocks -- or paid more for selling the in-house brand of mutual rather funds than another. And any item that comes out of a firm's own holdings may have an extra incentive attached to it.

Ask your broker: Do you make more if I buy this stock, or bond, or fund, than if I buy another? If you weren't making extra money, would your recommendation still be the same?

How many of you have seen analysts from Wall Street firms on television talking about a specific company? I’m willing to bet that not many of you have thought twice about that person’s recommendation to buy or sell a particular stock. But, you should.

The vast majority of analysts speaking to the public today work for firms that have relationships with the companies the analysts follow. When you see an analyst on television you should be aware that the analyst’s employer could have a business relationship with the issuer that may be directly affected by that commentary. And, you should know that the firm that is paying an analyst to talk about a particular company could be the same firm that was paid to handle the issuance of that company’s stock. This all could put financial pressure on that analyst to sugar coat the news about a company’s prospects.

Today as investors, you are confronted with a dizzying number of choices and opportunities. And those options can easily overwhelm and intimidate the most financially savvy person. In this day and age, there simply is no substitute for a person’s awareness and wariness.

Don’t fall for the illusion of easy money. And don’t be pressured by an aggressive salesman or enticed by a fancy web site promising that you’ll make a fortune with one quick gamble.

That leads to the third of my themes today: how to be alert to some of the dangerous practices in the marketplace.

While the scams we have seen on the Internet are the same basic frauds that have always accompanied the flow of money, the Internet’s speed, low cost and relative anonymity give con artists access to an unprecedented number of innocent investors.

Every once in a while, we get news of some outlandish sales pitch that -- incredibly -- some people fall for.

Just recently, the SEC took action against an individual who told investors through his web site that a tax-free island would emerge from the sea floor of the Caribbean. He sold so-called New Utopia "government" bonds promising returns of 200 percent. Sounds crazy doesn’t it? Guess how many hits his web site received. More than 100,000.

Remember the cardinal rule of investing: If it sounds too good to be true, it probably isn’t true. Let me add another one here today. If it sounds crazy, it almost definitely is.

The classic warning sign of fraud is a high-pressure sales pitch, where the salesman may pretend that he has inside information about a small company that, he says, "just can’t miss." The scam puts pressure on you to send money right away, before you’ve had much time to think. And it almost always promises quick, easy, astronomical profits.

You’ll often see a lot of fantastic claims in chat rooms. Chat rooms increasingly have become a source of information and mis-information for many investors. They have been compared to a high-tech version of morning gossip or advice at the company water cooler. But, at least you knew your co-workers at the water cooler. That just isn’t true on the Internet. And, I hope everyone recognizes that.

I wonder how many chat room participants realize that if someone is waxing poetic about a certain stock, that person could well be paid to do it. I encourage all of you to take what you see over chat rooms -- not with a grain of salt -- but with a rock of salt. By doing so, you protect yourself and you protect the Internet.

We’ve covered a lot of ground today. We discussed what you need to be aware of if you invest over the Internet. We discussed how to ask well-informed questions by using the wealth of information that exists to better inform your investing decisions. And, we discussed how to protect yourself in the marketplace.

Too often these days, we get caught up with the day-to-day numbers—how many points the Dow soared or plummeted or how many millions the latest IPO netted. With so much focus on what’s sizzling and what’s fizzling, important information about saving and investing gets lost. And that information can change people’s lives.

All over this country and this city and in this very room, there are important stories. Not necessarily stories that make the evening news or the newspaper headlines. But stories of people who work day in and day out for a better life and a better future. And many of these important but untold stories are as profoundly simple as sending a daughter to college, buying a first home, taking care of a sick parent, or helping a sibling through a tough financial spot.

And yet there are other stories that for lack of a better word are tragic; a mother and a father who struggle through their retirement; a middle-aged couple who desperately want to adopt, but can’t afford it; a college student who recklessly invests the fruit of his grandfather’s life-long labor in a matter of weeks.

With so much at stake, all of us must do our part to realize the promise of our markets, and more importantly, the promise of our lives. All of you have the power and means to be the most informed generation of investors in the history of our capital markets. The ease of today’s technology isn’t an excuse to do less. It’s an opportunity and a mandate to do more; to learn more; to be aware of more; to be informed of more and to achieve more -- as individuals and as a country.

Thank you very much.

http://www.sec.gov/news/speech/speecharchive/1999/spch280.htm