Weekend Open Thread: How SHOULD a “Sophisticated Investor” Be Defined?

9 Jul

Securities laws define an “accredited investor” like this.  There are so many problems with these definitions I don’t even really know where to start, but firstly, I think the most glaring problem with the existing definition of a “sophisticated investor” is the wealth aspect.  Wealth does not equal, approximate, or even remotely correlate with financial sophistication.

What else needs to be changed?  Should we require at least a Bachelor’s degree in Finance?  Masters?  PhD?  X years of professional experience?  Lets talk this out and draft what we think it should really be.  GO!


61 Responses to “Weekend Open Thread: How SHOULD a “Sophisticated Investor” Be Defined?”

  1. pentheus July 9, 2010 at 7:39 pm #

    five years brokerage statements showing purchases of every trend at its highest possible price.

    letter from CPA assuring that a minimum amount of “googling” will be performed as due diligence.

  2. Anal_yst July 9, 2010 at 7:42 pm #

    I’d like to see the net worth/income thresholds completely abolished. I make (damn TARP employer) below $200m a year these days and certainly don’t have a LWN of >$1mm, but I have a BS in Finance and several years experience in the field. Yet my Dr Dad can buy all sorts of private placements despite knowing very little about Finance (although he’s quite bright so he’s not completely retarded, but that’s besides the point).

  3. Downtown Josh Brown July 9, 2010 at 7:44 pm #

    No, where this discussion needs to begin and possibly end is with the question “When did we decide in this country that adults shouldn’t be responsible for their own decisions anymore?”

    Why does everything have to come with 15 pages of warnings and disclosures, 12 different agencies overlooking every sneeze and blink and the implied promise of an automatic absolving of loss every time someone just makes a bad choice?

    Grown ups have been treated like children for years and as a result, they don’t concern themselves with anything, knowing that SROs and government officials will babysit for them. That’s why each new generation is dumber and more oblivious than the last. That’s why 20 million psychotic, unpayable mortgages were taken out.

    Accredited or not, there are signatures of ADULTS on every account form, every loan doc and every power of attorney. But the only thing is, THESE adults have been coddled for too long and as such, have gone through a sort of devolution and the strip-mining of their own street smarts.

    People need to relearn that they are responsible for themselves.

    • Anal_yst July 9, 2010 at 7:50 pm #

      I couldn’t agree more, and have been arguing since High School that the downfall of this country is the complete and utter failure of Adults to take responsibility for, and to consider, the consequences of their own actions.

      The problem is that its politically convenient to impose rules, regulations, laws, agencies and other BS to “protect” investors, which, as you said, unsurprisingly had lead them to routinely fail to do the diligence they should because if shit hits the fan, its seldom the buyer’s fault.

      Especially in this political climate, I don’t see any meaningful progress to fix this insane dynamic, any ideas?

      • Downtown Josh Brown July 9, 2010 at 7:56 pm #

        Every memorable mistake I’ve made over the years can be traced back to not having read the directions or thought through a few moves ahead like I should have.

        And I still don’t do these things sometimes, out of either stubbornness, arrogance or laziness.

        But I have no one to cry to or to demand a do-over from, and so the result is I keep getting smarter and rarely fuck the same thing up twice.

        • Anal_yst July 9, 2010 at 8:02 pm #

          Alas, but people like us are largely the exception, not the rule, even among finance professionals…

          • eradke July 11, 2010 at 4:31 pm #

            We have become a participation ribbon society

  4. Caligula July 9, 2010 at 7:47 pm #

    I don’t see how a degree in finance is going to equate to sophistication. My “wealth advisor” has a finance degree and he is a moron.

    • Anal_yst July 9, 2010 at 7:55 pm #

      With few exceptions (e.g. Josh Brown) I haven’t encountered many “financial advisors” or whatever you want to call retail brokers who know preferred stock from livestock, let alone do their own research/analysis. Instead, they’re mostly salespeople, pumping out whatever new deal the b/d is trying to unload or whatever meets (or can be argued to meet) suitability requirements with the highest fees.

      I have a friend who graduated with me with a BS in Finance, now doing an MBA, who’d asked me for some help on some of her papers last semester. I was appalled by the ignorance, like ARE YOU FUCKING KIDDING ME HOW DO YOU NOT KNOW THIS appalled. Point is, a bachelor’s degree in finance doesn’t always guarantee financial sophistication, but I’d argue its a far-better requirement than the current definition, no?

  5. geedubb July 9, 2010 at 7:50 pm #

    there is no such thing. it’s a term created by a-holes in nyc to sucker retail and institutional clients out of even more money.

    it boils down to risk preference: if you invest in treasuries you’re called “unsophisticated”. if you use complex mathematical formuls to speculate in highly leveraged derivative instruments and happen to win, you’re god.

    for examples, read the big short. all those people are in the tail. finance is a joke.

    • Anal_yst July 9, 2010 at 7:56 pm #

      I dont think I’m as cynical as you, but you’re starting to touch on a good point. Its all about lobbying by Brokers/Ibanks to keep the security distribution (i.e. fee-generation) machine running smoothly.

  6. BankrChick July 9, 2010 at 8:02 pm #

    Downtown Josh Brown got me thinking. Young children can be quit sophisticated investors. Is this sort of a biological vs. learned question? Because let’s face it, when your 2 years old your already evolving into an investor. For as long as your making choices about how your spending your scarce time, like playing vs. sleeping/running vs walking etc… and making these sorts of trade-offs, your “investing” at least time. Now to what degree, depends on your ability to identify risk factors. The more sensitive to said risk-reward earlier on in life would explain your level of sophistication. So, young children could be extremely sophisticated investors…or whatever

    • BankrChick July 9, 2010 at 8:04 pm #

      See *update* Marshmallow Experiment Video here: http://www.youtube.com/watch?v=6EjJsPylEOY

    • Anal_yst July 9, 2010 at 8:10 pm #

      If you wanna start from square 1, upbringing definitely matters. My ‘rents, especially my dad always drilled it into my head to look both ways before crossing the road, test the water before jumping in, and all those other pearls of wisdom that I’m sure many people with less smart/educated/committed parents didn’t get.

  7. professorpinch July 9, 2010 at 8:07 pm #

    I’m going to start off with an observation. There’s an old saying/question: if you’re so smart then why aren’t you rich? And vice versa: if you’re so rich, why aren’t you smart? Old sayings don’t get to be old sayings by not having some level of truth. This one has a lot in it.

    As for what a sophisticated investor should “look like” I think it’s a combination of things. First, there has to be a way to assess whether or not they have a baseline amount of knowledge. Something like a CFA or a series license, but it doesn’t have to be those necessarily.

    You’d also want to see if they have a multi-year track record, so you could see how well they’ve done, or see how much risk they take on. Excessive risk-taking isn’t a sophisticated investor in my mind, but someone who likes to gamble. As an investor you have to take risks, but someone who is always “reaching” for returns is a warning sign.

    Look forward to what others have to say on this.

    • Downtown Josh Brown July 9, 2010 at 8:10 pm #

      Hey Pinch!

      You’re saying “the investor” should have a CFA or a Series license? or did you mean the person bringing the product should have to have one…confused.

      • professorpinch July 9, 2010 at 8:31 pm #

        Hey Brownie,

        If we’re talking about “sophisticated” investors – who won’t shed tears or cry about dogs eating their homework – maybe it should be both sides.

        How many pension plans are being run by guys who are just clueless beyond clueless about investing (and/or their analysts), but they do the job anyway? I’m not one to play favorites or choose sides in this fight, but it seems folks on the sell side could have an edge on information about a trade/investment etc. and you have folks on the buy-side that don’t even know what rocks to look under and do proper due diligence.

        I’m all for what you said: accountability and learning from your mistakes. But when one side has a knife and the other has a Gatling gun, that seems like a problem to me.

        Hope I cleared things up. And now, my son is waiting me to join him in watching that critically acclaimed movie classic: Caddyshack.

        • Anal_yst July 9, 2010 at 9:30 pm #

          The problem with Pension & other institutional investors is that esp with the former, alot of those guys DO have MBA’s, CFA’s, or even PhD’s, but the problem is that the investment guidelines/charters/governing documents have language in them that basically incentivize pension managers to buy the highest yielding position that meets the minimum rating threshold from the fund documents. Why buy a AAA vanilla HY bond at 7.5% when you can buy a structured product (or whatever) with the same rating and get another 50 or 100bps? Its pretty simple: best case, it works out and you look like a genius, worse case it goes to shit and you can fall-back on “well I just did what I was supposed to do, its not my fault the rating agencies fucked up!”

          • professorpinch July 9, 2010 at 10:31 pm #

            That’s really sad because not all AAAs are created equally, but to get to the point of recognition you have to be willing to dig into the securities you’re buying. Something that obviously wasn’t being done.

            What a crock. Using the investment charter as a shield from responsibility…

    • Anal_yst July 9, 2010 at 8:38 pm #

      I think a minimum standard of experience/knowledge is a good idea, but using an exam or a degree won’t work (see my previous comments on this, and how much of a joke the Series 7 is).

      Currently, to pick an example, for retail clients to trade options they have to answer all sorts of questions about their experience investing in a variety of securities/asset classes, income, risk tolerance, etc. While certainly not perfect, I think an approach like that to identify accredited investors would work.

      1. Do you have a degree in Finance (etc)? If so, what level?

      2. Do you have relevant work experience? If so, what, and for how long?

      that, possibly combined with a short test to prove understanding of complex securities/strategies/concepts might work, but I doubt it’ll ever happen, sigh…

      • pentheus July 9, 2010 at 9:31 pm #

        You assume that the series 7 license (or CPA or CFA or law. Degree) is meant to signal competence rather than just exclude people (and drive up wages of holders of the badge).

        But I agree. We definately need poll testing and literacy requirements for black voters Accredited investors.

        Wait, what?

    • eradke July 11, 2010 at 4:48 pm #

      I should have stopped reading after the first part of your comment but you lured me in like a traffic accident. You realize those were conflicting statements right?

      A CFA or series license? If they had the time to get a CFA, min. of 5 years I think they would take or have the time to invest their own money. That is like saying in order to buy band-aids you should be a doctor.

      You can make some inferences about a manager based on their previous record but like the disclosure says “past performance..”. Also, there are very few businesses that close or almost close after being in business for many years. Oh wait, disregard that statement.

      The only correlation with profits is risk, so despite how much I may hate myself in the morning, I have to agree with you on that one.

  8. Dvolatility July 9, 2010 at 9:18 pm #

    Everything mentioned on this thread basically confirms the fact that the “sophisticated investor” (or is it accredited”) label is BS, as well as the “professional investment advisor” designation. Not in all cases, but you know what I mean.

    First w/ accredited investors: http://www.sec.gov/answers/accred.htm, it’s fully based on who has enough money to play with (accredited investors = banks, insurance co’s, hedge funds and Brittany spears and to close off the market for them to deal and f* up the whole market (Banks, Goldman, Paulson, AIG, IKB, ACA, AIG etc etc ) AND then feed securities down to to series 7/63/65 guy in wealth mgmt department to sell an AAA MBS mutual funds or ETFs (created by Morgan Keegan for example see http://blogs.wsj.com/law/2007/12/13/investors-sue-morgan-keegan-over-bond-losses/) to retirees who trust him/her w/ their hard earned retirement money? Uhh Beavis? The model is broken in my opinion and the existing infrastructure needs to be bombed out (changed) so we can start over. But that will be hard to do, unless there’s an incentive for big $ to make more $. But I like what Covestor, Second Market, Prosper, Stocktwits and fin blogs are doing though.

    • Dvolatility July 9, 2010 at 9:45 pm #

      Is there no edit button? Damn you!

      • Anal_yst July 9, 2010 at 10:03 pm #

        I can edit your comments, not sure if you can, email me with changes and I’ll replace.

    • Anal_yst July 9, 2010 at 10:02 pm #

      The Financial Blogs are (i.e. the ones on our blogroll & others) routinely do much better work (and – gasp – our own analysis instead of parroting BS fed from money managers/execs talking their own books) than most MSM. Unfortunately, the majority of us don’t have the distribution/readership that the NYT gets, a problem for which I have no solution.

  9. perrymecium July 9, 2010 at 9:18 pm #

    “Accredited investors” should be certified as such: Brock Lesnar slaps you across the face as hard as he can and screams CAVEAT EMPTOR.

    They might as well admit what they really what and just ban losses on investments.

    • Anal_yst July 9, 2010 at 9:32 pm #

      Pretty sure stocks on Pakistan’s market can’t go down, i.e. no downtick rule…

      • perrymecium July 9, 2010 at 10:15 pm #

        I feel like this is a market issue, and firms that leveraged themselves have been shut down and cut off. Could banks, investors, and regulators have done a better job managing the good times? Sure. But that’s why we have market issues like this, to get rid of the dead weight.

        I think all this talk and uncertainty with government overhauling Wall Street is impeding progress.

  10. fbonacci July 9, 2010 at 10:11 pm #

    In the movie The Sting Redford & Newman recreate a betting parlor to lure in an unsuspecting BIG FISH. Rigged markets have been playing “sophisticated” investors for years. Definitions mean nothing in the land of Wink & Nod. Markets can be regulated to the nines, and be effectively “unregulated”.
    Slow execution of a watered down FinReg will act to keep sophisticated cash on the sidelines. Trust is key & still in short supply.

  11. David Merkel July 9, 2010 at 10:37 pm #

    I’ve been on many sides of this. AS a young man, with enough knowledge to use sophisticated investments and denied the opportunity. In middle age, being offered them as an institutional investor, and turning them down, mostly.

    There are many risky products that we let unaccredited investors buy: California and Illinois Munis, pink-sheet stocks, various preferred stocks that offer the worst of all worlds, promissory notes, structured notes that offer an enhanced yield subject to adjustment at the worst possible moment, homes in hot markets, and more. We let them invest in all manner of fads, and those that are less wise tend to lose. This should include their choices for those that advise them; they don’t choose well there either.

    Howard Simons once said at RealMoney something to the effect of, “On Wall Street, we sell the products that intelligent investors can use to destroy themselves.” LTCM did not lack for bright people; they did lack management, discipline, and a real understanding of risk control.

    There are three questions in front of us: First, do we constrain people’s ability to invest? Second, if we do restrict, what are the criteria? Financial ability to take a loss? Knowledge of the investments undertaken? Ability to not get greedy or panic, buying and selling at the wrong times? Third, what products do we restrict? What criteria would we use to restrict products? Volatility? Credit rating? Leverage? Analyses of prior loss experience, if any?

    This is one those sets of questions that doesn’t admit a sharp answer. Personal ideology affects the answer to a high degree. I would favor no restrictions, because I know that fools will destroy themselves with the tools we do let them have.

    Political realities say otherwise, because the political landscape is “We must protect little guys from predators.” It applies to insurance, so it probably applies to investments. If politics is the art of the possible, then we have to start here and tweak this. We are back to my questions 2 and 3.

    Here are some ideas:

    Have the SEC commission a book on losing money in investing. Require those that want to buy accredited investments to read it, and then make them take a 20-question test (have a 1000 question bank), with a 80% passing score. (Prometric will be overjoyed at the testing revenue.) Accreditation would have to be renewed every five years for new investments. Beyond that, require that accredited investments can be no more than x% of liquid net assets, where x goes up as one gets wealthier.

    As for what investments to restrict, I guess leave that alone for now. More restrictions would fall on those that can handle it, as well as those that can’t.

    Perhaps a shift needs to be made in presenting risk factors to investors in plain English (Flesch-tested), in the same typeface as the benefits are presented. Perhaps some sort of “cooling off” period before the transaction is final. Finally, if an insurance agent deceives, he can be sued, as can his company. At present, in the securities industry, we have arbitration, and slaps on the wrist from FINRA. We need something better there, perhaps the same lack of protection that the insurance industry has; it might make broker-dealers more careful.

    That’s all. Thoughts welcome.

    • Anal_yst July 9, 2010 at 10:48 pm #

      I generally support your approach/ideas, however, you and I (and probably every else here) knows that will NEVER.HAPPEN. The B/D lobbyists will destroy any such proposal immediately. They’ll say “WHAT?! How are firms going to raise $ if investors have to jump through these ridiculous hoops just to buy a damn equity IPO?!?!” or something to that effect.

      Thus, the direction I’d like to take the conversation is into how we can achieve the goal of reforming the definition of “Accredited Investor” (and what one of them is able to do) given the political realities with which we’re faced. That, unfortunately, is not my strong suit, but I’m convinced with enough smart people we can figure out a way to at least make the existing definition less retarded.

      • Kid Dynamite July 10, 2010 at 11:19 am #

        a lot of it also comes down to transparency of disclosures. I really shouldn’t have to read a 180 page prospectus before buying a stock or ETF. there should be a few pages on the things you NEED to know – like how if you buy SDS, that DAILY COMPOUNDING is not the same as LONG TERM COMPOUNDING. etc.

        i mean, on the one hand, i’m relying on efficient markets – that SOMEONE has read the Tesla IPO docs, and if, on page 189, on the bottom, in 6pt font, it says “by the way, we’re just going to take all of your money and spend it on hookers and blow” – that SOMEONE has found that, not that I have to find it… know what i mean?

        but back to the issue: wealth is very much NOT sophistication, although as DM noted, one issue is ABILITY TO WITHSTAND A LOSS, which wealth gives you… i disagree with Prof Pinch’s comment that you should have a track record. I can be a very sophisticated investor and still have a terrible track record.

  12. Kid Dynamite July 10, 2010 at 11:40 am #

    one other thing – the brokerage industry (retail, mostly, i think) needs to be consistent. If you’re going to let Joe SixPack buy 1000 shares of BUD, you should let him sell 10 naked puts instead. LESS risky – not MORE risky – because he takes in premium from the put sale. yet, somehow, they define selling puts as riskier. same thing with shorting stock vs selling naked calls.

    • Byrne July 10, 2010 at 4:33 pm #

      Selling the puts might be more risky, because the delta of put-selling is close to the delta of stock-buying, but the number on the monthly statement is a lot smaller. If you ask SixPack how much exposure to BUD his naked puts represent, he’s more likely to answer with the market value of the puts, not the market value of 1000 shares of BUD.

      • Kid Dynamite July 10, 2010 at 5:22 pm #

        good point. again – if JoeSixpack has the margin to buy 1000 shares of BUD, though, he should also be allowed to sell 10 puts. but you’re right – it should be made clear that he has more exposure than the put notional.

  13. goodbushel July 10, 2010 at 1:41 pm #

    Instead of replacing the rule, just keep adding definitions of Accredited Investor so that more people can invest. If you want to invest in a hedge fund, pass a test (Question 1: If a fund has smooth returns, self-administers, and is audited by the PM’s cousin, you should A) invest all your money in this risk-free investment, or B) not.)

    Anal_yst is right that the lobbyists would kill these things on the spot, though. Nobody looks out for the small sophisticated investors. The SEC is the SEC, and the MFA caters to the biggest funds, who would prefer more restrictions and more regulation, not less. It’s much easier to hire a full-time compliance staff when you can raise $100MM chunks from Calpers.

    Plus, since all the evidence shows that hedge funds largely offer high-priced alternative beta, any attempt to demystify the industry will be fought bitterly by the big funds.

  14. _phlox July 10, 2010 at 1:50 pm #

    I don’t know what a sophisticated investor is, but for the right price, I will defend your right to be considered one.

    My only serious comment is it shouldn’t be based on Degrees. There are (good) derivatives lawyers without any formal finance training, while there are people with Finance BAs who have no idea what they’re doing.

    If anything, there should be a required reading and multiple choice test about the various investments. FINRA suggests getting informed, written consent before buying warrants from a broker. There’s no punishment per se for not doing so, but it’s evidence of unsuitability and failure to supervise in later investor lawsuits. I don’t think B/Ds would fight what amounts to a “licensing” requirement for investors if it also eliminated some of their liability. If, say, licensing took away unsuitability claims because the investor assumed the risk of the investment, the B/D and individual broker would only be liable for outright fraud or commissions-based offenses. Also, if the B/D actually instituted a robust licensing system that they actually watched, the B/D would probably protect themselves from any failure to supervise claims as they did “as much as they could” to reasonably regulate their employees. Like how boards of directors are protected from company wrongdoing (absent “red flags”) if they have adequate reporting and compliance systems in place.

    I don’t LIKE the government interference in contracts, and I generally say caveat emptor. But it seems to me so many investor losses could be avoid with an hour-long test. Even just the existence of a “test” would, I guarantee, make many people re-think investing in these things in the first place. There’s just no need for most people to be in these instruments at all. And it doesn’t even have to be the SEC, it could be instituted by FINRA as long as the SEC added a rule that said compliance with the FINRA investor-regulation scheme would be prima facie evidence of reasonable care.

    • Anal_yst July 11, 2010 at 2:09 pm #

      I like your suggestion(s) but there’s at least one major problem: B/D’s currently have all sort of suitability (etc) questionaires clients/brokers must complete, however, the internal controls and scrutiny that these questionaires receive is, well, not very impressive. I’ve heard of clients with tens of millions of dollars in brokerage accounts for entities like “ABC Import/Export” based in Medellin with a PO Box in Miami that claim they make $100m/year and are only worth $800m. Its insane, firms internal systems don’t automatically pick-up the clear red flag, and alot of the supervisory principals don’t give a fuck either, because they don’t have the time to properly scrutinize every last account; they’re too busy getting everyone selling.

  15. gaius marius July 10, 2010 at 1:52 pm #

    i work for a small qualified purchaser and have interaction with others. without a doubt, capital is for the most part heavily littered with the lucky who have no special (or often enough any) knowledge w/r/t investing — most hugely overestimate their expertise and indeed their own role in acquiring their fortune. IMO, if you tried to test for intellect and/or expertise in capital, you’d end up excluding a large bit of it — and that isn’t going to happen.

    FWIW, it seems to me that this discourse may be looking at the accreditation from the wrong perspective. is its role really to protect the investor from products whose risk is difficult to ascertain? whatever its prima facie justification, i sincerely doubt it. in my estimation, the true purpose is to identify for the sell-side who the marks are — people who can buy in size with capital enough to exhibit patience (or tolerate lockups) and absorb losses without abject panic when they come.

    as to the idea that accredited investors should be folks won’t cry when they lose and internalize all responsibility reflexively, i’m not sure how to address that, so distant from human nature in my experience is that view. getting the lawyers out of capital is, i would suggest, a more futile endeavor than getting them out of politics — and is a self-serving sell-side argument in any case. if you want people who won’t sue when they may have been sold a bill of goods that their due diligence was too shoddy to detect, you should be targeting retail as they generally either can’t afford the recourse or are too intimidated to seek it. and i might add it has been ever so, and is not a product of our times, which is why complaints about lawyers can probably be found etched into the hieroglyphs of egyptian tombs.

    anyway, just my thoughts — but trying to make capital management the province of the financial intellectual is simply not going to fly because it contravenes human nature to do so.

  16. Steve Waldman July 10, 2010 at 4:08 pm #

    i think this is easy in theory (although of course difficult in politics and in practice).

    “accredited investor” should not be a binary category. people should be free to lose what they can afford to lose, and they can afford to lose what we are willing to let them lose without intervening.

    in effect one should be accredited, as KD put it, up to one’s “ABILITY TO WITHSTAND A LOSS”. it is not who you are, but your ability to lose without adversely impacting the interests’ of others that should form the basis of accreditation.

    pension funds should not be “accredited investors” any more than your grandmother on a fixed income should. they often cannot afford losses at all, often cannot afford to miss outsized gains, before compelling the rest of us to bail their beneficiaries out. an underfunded pension fund is and should be a ward of the state, a pension fund fully-funded under conservative assumptions has no reason to take unusual investments, since the beneficial owners of the fund see no upside from that, only corrupt sponsors and manager do.

    for the most part, institutions SHOULD NOT be accredited investors, if that implies an unrestricted investment menu. institutions are run by agents, managing money their beneficiaries often cannot afford to lose. endowments, insurance companies, etc need to be heavily regulated in how they invest, because it is almost impossible to align the incentives of managers (who have only their jobs to lose and convex incentives to gamble, in both their compensation and their reputation) with those of beneficiaries. the principals of institutions (either directly, or via choosing a form of institution and relying upon state regulation) should restrict the scope of agents’ investment activity, and the state should enforce those restrictions tightly (we’ve erred since the 1970s in using portfolio theory as a pretext to loosen institutional restrictions). since very many institutions are ultimately backstopped by the state (e.g. there are universities as well as banks that are too big to fail), the state may restrict the mandate of such institutions beyond what their private principals would allow. broadly speaking, institutions should be the market for sleepy, conservative investments, not the sexy stuff.

    rich individuals trading on their own account should be able to do anything they wish, provided they shelter enough to provide middle-class lives to their families. we could literally make them segregate wealth into front companies that could lose everything while bothering no one, and let them play. hooray!

    hedge funds, to the degree that they are UNLEVERED vehicles by which rich individuals invest, should also be free to do what they want. as soon as they start borrowing from banks or prime brokers, however, they are playing with institutional capital and should be subject to nasty institutional restrictions. (if rich individuals or other hedge funds funded only by rich individuals want to lend to them, more power to ’em.)

    basically, there is a “fruit if the poisoned tree” sort of logic here. as long as the root of the tree is money that can be lost traded on an individuals’ account, institutions built on top of that should be able to do what they want. but if institutions accept money from pension funds, universities, insurace companies, banks all of a sudden they should have to trade subject to the restrictions of those institutions. leakages between the “wild west” of free individuals and the stultifying safety of the regulated sector should be carefully policed and mercilessly punished. people should be much too afraid to try to build “bridge entities” that accept regulated money and invest in lumber or worm farms. for example, trying to rebrand a leveraged speculation on home prices as a AAA bond suitable for conservative institutions should get raters and deal arrangers quickly thrown into jail.

    the tricky group is middle class investors with families. fundamentally, middle class investors with families can afford to lose very little without impairing, potentially seriously, the interests of a vulnerable party. at the same time, denying access outright to risky investment to the broad middle class is a greater restriction on economic freedom than i’m comfortable with. i think we do need to have the sort of wishy-washy/nudgey-nudgey regime that we do have for middle class investors, where it’s pretty easy to get a low-dollar cash stock account to play in, then a little bit harder with a few more formalities to get margin trading going, annoying disclosures and warnings before trading options and futures, etc. i do think middle class individuals, investing on their own or their families’ accounts, should be able to invest in even very exotic investments, but perhaps via a kind of vehicle into which they could deposit, say, exactly as much income as they net-deposit into low-risk savings instruments. the speculative vehicles would be the same sort of personal hedge funds described above for rich individuals, and just as free. that strikes me as a decent compromise between paternalism and freedom for ordinary families: you can gamble, or perhaps exploit your superior talents and information, but only to the degree that you are also able to conservatively set aside some wealth. (the high-risk vehicles would be nonrecourse; leverage providers — again not banks — would have to deal with that, or not.) once a “middle class” family achieves a certain level of safe wealth, the restriction gets lifted, they can deposit as much as they’d like into their speculative account, and they are as free as John Paulson.

    one thing i think accreditation shouldn’t be based on is any sort of finance or investment credential. finance, as a profession, is subject to fads and collective delusions; it frequently persuades itself that mathematical complexity implies wisdom or invincibility; it is organized into institutions that are deeply corruptible and frequently corrupt in fact. this is not something we could fix with better schools or credentialing programs. it is inherent in the subject matter: finance is fundamentally the art of making decisions in the real world that cannot be known to be right or wrong until they are tried. we either build the rocket ship or we don’t. it could make a killing, could crash and burn. wanna invest? a CFA can’t help you make that choice, and though a lot of useful common sense and accounting skills are taught in the CFA program and formal finance courses, the most important part of investing well is the substantive evaluation of real investments or real economic events. that cannot reliably be taught, what works today may not work tomorrow, the best we can do is force people to put their own rather than other peoples’ money on the line when they take their risks. although i think it is helpful for investors to learn “the basics” of financial statements analysis and investment valuation, the correlation between finance credentials and the much-more-important real-world insight is far too weak to restrict investment to the “educated”.

    a last point: “accreditation” of any sort is no excuse for tolerating nondisclosure of material facts, conflicts of interest, etc. we want risk-tolerant investors to be evaluating actual business propositions. that is the informational work they perform for the economy. inevitably, they will have to spend some fraction of their intellectual and research energy policing fraud, but that’s ultimately a waste of their talent and attention. we want even John Paulson to be able to trust that, when he chooses an investment, his money will be used for the purpose described, he will reap returns under the agreed conditions, and the arranger of the investment has not withheld anything, ANYTHING, she knows that the investor would want to know. our investment infrastructure should not be about refereeing which BSD gets paid-off in some zero-sum game, but about choosing real enterprises wisely.

    there are important tensions between the bureaucracy and cost of disclosure requirements and fraud protection, and we need to take those seriously. (i think it should be much easier to offer public securities than it currently is. i think that the corner pub should be selling public securities.) but the fundamental principal, at any level of accreditation, should be that the offerer of securities is an open book to investors. the economics of a good offering are a simple exchange: the offerer thinks something is a good project, but lacks the money or is uncomfortable with the risk of going it alone. she tries to persuade you of what she believes, that this is a good idea, so you will invest side-by-side, with interests aligned.

    (note that an offerer of securities and a market-maker are very different roles, despite some banks’ attempt to blur the distinction. i’m talking about parties initiate, offer, market, and place positions, not parties who respond to unsolicited requests to take positions.)

    FD: i’m a hypocrite — if the policy i advocate above (w.r.t. middle class families) were in place, i’d be probably be restricted from behaving as i currently do. (i don’t — yet — have children, but when i do i may still be speculating aggressively.)

    • Anal_yst July 12, 2010 at 5:16 pm #

      Whoa that’s a pretty awesome response, thanks! I think you’ve pretty much made all sound arguments except that I’d like to see much more (or at least some damn enforcement) of fiduciary responsibility for institutional/entity managers, regardless of whether they’re actively making the investment decisions or farming it out to others. If a pension or endowment manager (or those they’ve farmed the task out to) want to invest in some cockamamie opaque, illiquid derivative on Morroccan street fair rug trade, they should be able to, and they should be able to get fleeced on it if they failed to do their diligence/hedge/ensure they weren’t taking inappropriate risks. But, if/when they screw up, they should be held to account, up to and possibly including jail time. Fear is a great motivator of cautious behavior, especially to balance out the already silly asymmetric incentive structure inherent in such arrangements.

      Another thing I don’t agree with you on, though, is current retail brokerage standards of “sophistication” or what-have-you. My dad makes several times what I do and is worth god knows how much more, and thus, would under common “risk management” and “suibility” schemes, be allowed to trade pretty much whatever he wanted. Now Dr Dad is a very smart man, and a diligent one, so I do not doubt if he had the time and inclination, he couldn’t understand all sorts of derivatives trading strategies (or whatever), but the fact of the matter is that he doesn’t have the time, doesn’t have the education, and doesn’t have the experience. Yet he could, were he not as smart (or perhaps more desperate) of a man, bet the farm on a highly levered directional unhedged derivative trade on some opaque emerging-market security. I, however, despite a BS in Finance, several years of experience investing on my own and professionally analyzing companies and markets, probably wouldn’t meet most B/D’s thresholds to trade uncovered equity options. This, sense does not make.

  17. Byrne July 10, 2010 at 4:30 pm #

    A more Law & Economics-oriented view:

    Accrediting investors is not about deciding who can effectively evaluate risk. It’s a way to ensure that complex investment products are only sold to people, or entities, that can cost-effectively sue someone for misleading them. Thus, accreditation should be based on assets. If you’re poor, you should only be able to buy stuff that’s easy to understand. The more money you have, the more complex an asset you can buy. That way, if your broker fooled you, it will be worth it to pay a lawyer’s hourly fee to extract a settlement.

    This version solves a couple problems:

    1. It replaces an intractable issue (how much judgment is necessary to understand Product X, and how do you measure this judgment?) with a tractable one (for Product X, what is 10th percentile of the net worth of people who sue their broker after buying it?).
    2. It leads to optimal behavior from brokers and customers.
    3. There’s an easy opt-out mechanism: you sign a piece of paper stating that you know that if you bought this product, and you didn’t understand it, you can’t sue /anyone/. For the purpose of calculating your net worth, you’re required to value the product at a huge discount to cost.

    Oh, and best of all: banks and brokers could actually lobby in favor of this entirely sane standard, since it minimizes their liability by minimizing their opportunities to do something that they could be sued over. This reduces the cost of compliance, too, by making it also more in-line with what a practical, self-interested company would do.

    Oh, and it invalidates this argument: http://www.washingtonpost.com/wp-dyn/content/article/2010/05/01/AR2010050100205.html . IKB may have low net-worth owners. But IKB itself is big enough to cost-effectively seek legal redress for dumb mistakes. Which means that it’s incumbent on IKB to avoid making those mistakes in the first place, since (Exepected value: (settlement – fees)) < (Expected Value: (loss from investment)) .

    • Anal_yst July 12, 2010 at 5:24 pm #

      While I appreciate the reply and you’ve made some valid points (specifically relating to IKB who I think has only themselves to blame, but let’s not get back into that here), I’m not sure sure I agree with others.

      Firstly, the premise of your argument(s) is(are) based, as far as I can tell, on situations where brokers mislead (or whatever word you want to use) their clients. This fails to consider situations where – as I mentioned in my reply to Steve Waldman’s comment above – clients have only themselves to blame i.e. unsolicited orders. In these cases sure there could be arbitration but there are generally few circumstances where a burned client could successfully sue the broker, at least as far as I’ve seen.

  18. forextraderforums July 12, 2010 at 6:12 am #

    What type of degree do I need to pursue to become a real estate investor?

    • Anal_yst July 12, 2010 at 5:18 pm #

      A BS in Finance/economics plus several years in the business would be a good start, in my opinion.

  19. Danny Black July 17, 2010 at 4:47 pm #

    I think there should no such distinction. Basically there should be two intermediaries out there:

    Investment manager – you give this guy money and he has a fiduciary responsibility to look after it. The difficulty is defining the parameters of “looking after it” – does losing it count? Does sitting out a major bull market count?

    Market makers – these guys should have exactly one responsibility and that is to accurately describe the economic inputs and outputs. Does the guy on the other side think this product is going to fail, maybe, maybe not, but Mr MM has zero responsibility to tell you. His sole responsibility is to say that these are the payouts under these circumstances. It would be YOUR job to work out the value of the product and whether it fits your investment needs.

    The later is easy to define and I think it is key to bring back fiduciary responsibilty for the buy-side. It is a disgrace that a bunch of shaved chimps at IKB can roll the dice and get feted when it come up 6s and get reimbursed in full when it rolls snake eyes.

    Finally anyone whose response to losing money is “Oh but you should have told me X could happen” or “The guy told me it was risk-free” should been banned for life from ever holding an asset except cash.

  20. gakUtenteejax August 6, 2010 at 9:04 am #

    Boston, MA – Boston Red Sox first baseman Kevin Youkilis commitment misapprehend the rest of the 2010 seasonable with a torn abductor muscle in his right thumb.

    He last wishes as endure surgery at the Cleveland Clinic on Friday to renew the rare injury. His thumb will be immobilized in the service of the next six weeks.

    Youkilis was injured in the second inning of Monday’s game against the Indians after hitting a Fausto Carmona pitch. He stayed in the field initially, but was pulled in the third.

    He finishes the 2010 season with a .307 batting commonplace, 19 homers and 62 RBI to run with a .411 on-base share in 102 games.

  21. Rena Parara August 7, 2010 at 9:32 am #

    It is an top article, but I was wondering Were can I found your feed?

  22. makeup brushes October 21, 2010 at 12:08 am #

    Great to find out you back. And again by having an interesting post.

  23. mantomarantina November 3, 2010 at 4:56 pm #


    it’s my first topic here
    i hope to be happy with you

    thank you

  24. a5njmlu November 6, 2010 at 7:56 am #

    Hello Everyone!I am new to stonestreetadvisors.com

  25. Nikon Camera Bag January 28, 2011 at 7:51 pm #

    `-, I am very thankful to this topic because it really gives up to date information ;:’

  26. zxmanulh1 March 29, 2011 at 7:12 am #

    Formidable matin à tous,

    Pour commencer , permettez-moi de vous montrer ma gratitude pour chacune des très “à propos” connaissances que j’ai lues sur cet fantastique site internet .

    Je ne suis pas convaincue d’être au bon section mais je n’en ai pas trouvé de meilleur.

    J’habite à Port plaisance, ca . J’ai 34 ans et j’ai 2 très gentils enfants qui sont tous âgés entre 7 et 11 années (1 est adopté). J’aime énormément beaucoup les animaux de compagnie et je fais de mon mieux de leur présenter les accessoires qui leur rendent la vie plus à l’aise .

    Merci d’avance pour toutes les excellentes débats à venir et je vous remercie surtout de votre compréhension pour mon français moins qu’idéal : ma langue maternelle est l’arabe et je fais de mon mieux d’apprendre mais c’est très ardu !

    A plus tard


  27. Tiobpauu July 4, 2011 at 6:36 am #

    kid robot watch,


  1. Evening Hot Links: Monkey Terrorists The Reformed Broker - July 11, 2010

    […] This weekend's big discussion was at Stone Street Advisors, an epic thread on what constitutes a "Sophisticated Investor".  (StoneStreet) […]

  2. International Expansion Strategies – OTC Bulletin Board – James Scott | SEO and Marketing - July 11, 2010

    […] Weekend Open Thread: How SHOULD a “Sophisticated Investor” Be … […]

  3. Morning Take-Out - DealBook Blog - NYTimes.com - August 2, 2010

    […] How do you define a sophisticated investor? Stone Street has the discussion. (Hint: It’s not how much money they’re prepared to […]

  4. Good, Funny, Other | traderhabits.com - October 4, 2010

    […] Weekend Open Thread: How SHOULD a “Sophisticated Investor” Be Defined? Via stonestreet.com This thread is still pretty active. Comments are really good, well most of them. Add your thoughts. […]

  5. Weekend Must-Reads: Unions, Unemployment, Real Estate, Asset Allocation and Auditors « Stone Street Advisors - April 10, 2011

    […] back in July I asked “How should an Accredited/Sophisticated Investor be defined?” That open thread elicited dozens of comments, many of which seemed to agree that the current […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: