The Devil's Financial Dictionary

AA

AAA, adj. Traditionally pronounced “triple-A”—but, more recently, “AAAAAAAAAAAAAAAAAAAAGH!”

AAA is a grade assigned to a SECURITY by a RATING AGENCY such as Standard & Poor’s, Moody’s, or Fitch, indicating that it is “highest quality” and has “the lowest expectation of DEFAULT risk.” Even so, in 2007–2009, thousands of securities rated AAA turned out to be lowest quality with the highest default risk. In the first three quarters of 2008, more than 11,000 issues of AAA-rated mortgage-related securities had their ratings abruptly downgraded. The prices of many fell 70 percent or more; investors lost hundreds of billions of dollars.

See also CREDIT RATING.

ACCOUNT, n. The money you have at a brokerage, investment advisor, bank, or other firm, subject to continuous and sudden change from income, profits, losses, and fees. The firm will use a monthly or quarterly ACCOUNT STATEMENT to call maximum attention to the income or profits while minimizing or disguising the losses and fees.

The word has several alternate meanings. “To account” is to tell a story, particularly in order to justify one’s actions. “To call to account” or “bring to account” means to make a steward responsible for what has happened, especially if the outcome was harmful. “The final account” is God’s ultimate rendering of justice on the Day of Judgment.

The first of those alternate meanings is retained in the modern financial usage of “account.” The others have conveniently been forgotten.

“Account” is also a slang term for CLIENT:

“This gentleman is my best account,” said Moe DiNero, a wealth manager at the brokerage firm of Blitz, Baum & Newcombe in Eureka, California, pointing to a name on his computer screen. “I earn more fees off him than I do off anybody else.”

ACCOUNT STATEMENT, n. A document from a bank, brokerage, or investment firm that is designed to be incomprehensible to CLIENTS, thereby preventing them from asking impertinent questions like “Who set my money on fire?” You might be able to recognize your balances and recent transactions on an account statement, although that will be easier if you earn a PhD in cryptography first.

ACCUMULATE, v.; ACCUMULATION, n. A term often used by ANALYSTs to recommend a stock without uttering the word “buy,” thereby enabling them to duck at least some blame if the stock later collapses.

“Why did you recommend buying Vertiginous Corp. at its all-time high?” asked an angry client. “I lost 88 percent in a week!”

Kent B. Thoreau, a senior analyst at the brokerage firm Schmutz, Garbisch, Dreck & Pugh, responded calmly, “I didn’t recommend buying it, I recommended accumulating it.”

ACQUISITION, n. A transaction in which one company pays too much to buy another.

As Warren Buffett wrote, “If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked.”

ACT, v. What a financial market supposedly does, as if it were a living creature with a sense of self and volition. Traders and market analysts will say “the market isn’t acting right,” or “the market is acting like it wants to go up no matter what,” or “the market is acting nervous.” Research led by Michael Morris, a social psychologist at Columbia University, shows that investors are more likely to expect a market trend to continue when stock-price changes are likened to physical actions.

Such active images as “the Dow fought its way upward today” or “the market broke free and climbed higher” impart a power of their own. People are inherently excited by motion—especially when it is described in terms familiar from our social interactions. Depicting a financial market as an athlete sprinting, leaping, and cliff diving makes news coverage much more exciting than a droning flux of numbers.

And the belief that markets “act” is centuries old. In seventeenth-century Amsterdam, stocks were called actie, or “actions,” and a trader was known as an actionist; in France, traders were called actionnaires.

That doesn’t make the belief valid, however. A market that is “leaping up 20 points” might seem more likely to keep going up than a market that “has gone up 20 points,” but it isn’t. Millions of traders are squaring off, and no one can sell unless someone else is buying. The stock market isn’t a unified force and doesn’t act in unison; it is a mechanism that enables people with opposing opinions to put a price on their differences. Investors should therefore ignore any verbs used to describe how the market is “acting.” Instead, ask how large the price change is in percentages. Chances are, a leaping or surging or racing or plunging or collapsing or diving market has barely moved by even 1 percent.

ACTIVE, adj. A stock is active when trading is high—typically generating wealth for the brokers who execute the trades and destroying it for the people who request the trades.

PORTFOLIO MANAGERs are active when they seek to beat the market by identifying the best investments and avoiding the worst. To do so, the managers study the investments so exhaustively that by the time they understand them, the information has become outdated and they have to sell them. That takes most managers approximately one year and costs investors 1 percent to 2 percent of their wealth annually.

Several studies have shown that if active managers did nothing all year, they would increase their performance by approximately 1 percentage point. Thus, fund managers would likely improve their performance if they went on a yearlong vacation on January 1 or replaced themselves with potted ficus trees. But it isn’t easy to market yourself that way, so active managers persist in destroying wealth instead of creating it—at least for their clients.

See also FEE; PORTFOLIO TURNOVER; RESEARCH.

ACTIVIST, n. Known as “holdup artists” in the 1920s and “corporate raiders” in the 1980s, these agitators seek to profit by shaking up an underperforming company, typically by buying a large block of shares and then demanding that DIVIDENDs be raised, assets sold, or MANAGEMENT fired. Now that pension funds and other SOPHISTICATED INVESTORs back their efforts with billions of dollars, these dealmakers go by the more dignified name of “activists.”

AFFINITY FRAUD, n. A financial crime committed by someone with an affinity for doing terrible things to his friends, as when a crook promotes a bogus investment to members of his church, social club, ethnic group, or other close-knit community. They trust him because they know him so well. In return, he trusts them not to notice that he is stealing their money.

ALGO, n. Short for ALGORITHMIC TRADER or ALGORITHMIC TRADING, in which computers substitute the risks of mechanical, electronic error for the risks of human, emotional error. Much of the time, that is an improvement, but when it goes wrong it can lead to a FLASH CRASH. Using the tools of HIGH-FREQUENCY TRADING, algos buy and sell automatically, at high speed and often in tiny increments, roving from market to market, moment to moment, to sniff out the best price. An order to sell 10,000 shares, for instance, might slice that block into tiny pieces, selling 47 shares at the New York Stock Exchange at 10:01:52 A.M. for $37.88, 56 shares at the NASDAQ exchange at 10:01:53 A.M. for $37.89, and so on. The algo will continue the instruction to sell until all the shares have been liquidated, which could take anywhere from a few seconds to a few days. If all the algos sell at once, however, trillions of dollars may be torched in a matter of seconds.

ALLIGATOR SPREAD, n. A trade in the OPTIONs market that generates such carnivorous commissions that the person who places the trade stands no chance of making a profit. (Related terms are Acapulco spread, Midas spread, and Cadillac spread, all nicknamed for their ability to fund lavish spending by the broker who earns them from clients.)

ALPHA, n. Luck.

Technically, alpha is the excess return over a market INDEX, adjusted for the risk that the PORTFOLIO MANAGER incurred to achieve it. Used as a synonym for skill, alpha is in fact nearly always the result of random chance:

“We bought Mongolian mortgage-backed securities when other investors had decided that the market for yurts would collapse,” said Ivana Butler, an analyst at the investment-management firm Bosch, Tosh & Mullarkey in Boston. “But an outbreak of botulism among camels and yaks sent the yurt market higher, driving up the price of our bonds. This is only the latest example of the alpha-generating research process that enables us to outperform.”

AMORTIZE, v. To liquidate or eliminate a debt through periodic payments; also, to spread an expense evenly across a period of time until it goes to zero. Rooted in the Latin mortuus, meaning “dead,” to amortize means literally to kill. Even brain cells can be amortized when the effects of time on money are described:

“Yes, 5.75 percent might seem like a lot to pay up front for a mutual fund,” said Hannah Dover, a financial advisor at the Chicago-based brokerage firm Stoneham, Black & Blue. “But when you amortize that over the next twenty-five years, it’s only 0.23 percent per year, which is a bargain price for access to my advice for the next quarter of a century.”

Detail from a thirteenth-century English illuminated manuscript. THE BRITISH LIBRARY

AMPHIVENA, n. Also: AMPHISBAENA, n. An obscure mythical creature long believed to exist only in ancient and medieval bestiaries, the amphivena has one head at the end of a long neck and another at the end of a long tail. Far from being imaginary or extinct, the amphivena has materialized, in the modern era, as those “on-the-one-hand-on-the-other-hand” creatures known as ECONOMISTs and MARKET STRATEGISTs.

The amphivena is traditionally described as being able to move both forward and backward, or to rock back and forth on its round stomach. Fortunately, the amphivena most often strikes out at itself. The creature was often portrayed with one head gnawing away at the other, or with neck and tail entangled in dubious battle with each other—postures familiar today to anyone who has watched an economist or market strategist being interviewed on television.

ANALYST, n. A purported expert on a company who in theory estimates its value by breaking it down into its constituent parts but in practice functions as a salesperson and cheerleader.

“We think CyberSushi will earn $1.43 per share this quarter,” said Rosie C. Nareo, an analyst at Merck, Mudd, Marsh & Meyer, a brokerage firm in Muscle Shoals, Alabama, who follows the fast-growing company, which distributes raw fish over tablet computers. “I talk almost every day with management, and I’ve never heard them so optimistic.”

ANCHORING, n. A mental shortcut, or HEURISTIC, that automatically seizes upon a readily available number, no matter how irrelevant, as the basis for estimating a value or probability, thus stopping the human mind from wandering too far in search of new evidence. In one common form of anchoring, analysts often set “price targets” far above or below the market price of a security. The numbers then lodge in the mind of any investor who encounters them, serving as anchors to drag expectations toward them, regardless of how ridiculous they are.

In an appearance yesterday on the financial television network CNBS, analyst Gilda Lilly of the Atlanta investment bank Fuller Bologna said, “We think SnapAppCapp could be worth $1,000 a share six months from now.” SnapAppCapp Corp., the company that enables teenagers to send and receive text messages through their baseball caps, recently traded around $150. “You’d have to be crazy to think it could go up that much,” said Roland E. Dice, an individual investor in St. Louis, Missouri, who says he “plays” the market. “I mean, sure, maybe it could, like, double from here. That’d be only $300. But $1,000? That’s absurd.”

ANNUAL MEETING, n. A yearly gathering at a hotel serving bad food and stale coffee, somewhere near an airport, at which the company’s management gilds its results and pretends to listen to the wishes and grievances of the people who own the company.

ANNUAL REPORT, n. A yearly embellishment of a company’s financial condition, featuring glossy pictures of smiling employees and customers, burnished images of the company’s goods and services, and many pages of financial information presented to be as opaque and confusing as possible. The detailed version of an annual report, the 10-K, is more useful: its footnotes often explain how a company is trying to hide its accounting shenanigans.

As Peter Lynch, the renowned manager of the Fidelity Magellan Fund, wrote, “It’s no surprise why so many annual reports end up in the garbage can. The text on the glossy pages is the understandable part, and that’s generally useless, and the numbers in the back are incomprehensible, and that’s supposed to be important.”

In the nineteenth century, corporate bylaws often forbade outsiders from even examining the financial statements of the companies they invested in. Not until 1933 did the New York Stock Exchange require listed companies to have their annual financial statements prepared by an independent auditor. The history of companies hiding or cloaking the facts is much longer than the history of them disclosing it, so no investor should be surprised at the opacity of any annual report.

ANNUITY, n. From the Latin annuus, or yearly; an investment that often provides a regular annual income for its buyers but always does for its sellers.

ANOMALY, n. An investing strategy or valuation technique that generates a higher return than the market without obviously higher risk and thus cannot be explained in the context of EFFICIENT MARKET HYPOTHESIS. The JANUARY EFFECT is one example. Every year, several new anomalies are trumpeted in articles published in academic journals. Soon after the results of their past outperformance are published, anomalies tend to begin underperforming—partly because of REGRESSION TO THE MEAN, partly because new money rushes into the approach and eliminates any remaining potential for extra return, partly because flesh-and-blood investors incur taxes and trading costs that a professor’s spreadsheets never have to pay, and partly because the results might have been nothing but a statistical fluke.

As the Nobel Prize–winning economist Merton Miller put it, “Above-normal profits, wherever they are found, inevitably carry with them the seeds of their own decay.”

Anomaly derives from the ancient Greek for “irregular” or “uneven”; investors should bear that original meaning in mind whenever they consider investing on the basis of an anomaly.

APOLOGY, n. In the real world, an admission of culpability and remorse for an action that harmed someone else, typically followed by an attempt to right the wrong and a commitment not to repeat it; on Wall Street, a declaration that other people did something wrong and that any resulting harm was caused by circumstances beyond the bank’s control. A Wall Street apology always purports to take responsibility, but usually omits contrition, shame, a desire to make good on what went bad, or the willingness to make sure the same behavior never happens again.

In testimony at congressional hearings today, Manuel B. Schacht, chief executive of Bellow, Blair, Howell, Huff & Bragg, the investment bank, apologized for the $794 billion in losses his firm incurred on securities backed by the value of beachfront property in the Central African Republic. “I accept full responsibility for what happened, and as a firm we deeply regret the inconvenience that investors and taxpayers have experienced,” said Mr. Schacht.

He added: “The worst of the suffering, however, will be borne by our own employees, who must forgo their future bonuses and search for work elsewhere while bearing the stigma now so unfairly attached to our firm. It is important for policymakers and the public to recognize that, while mistakes were made, these losses were triggered by events beyond our control.”

ARM’S LENGTH, adj. Purportedly executed on the same terms that would have applied if the two sides in a negotiation or deal had no affiliation with each other. For example, a company may hire one of its retired executives to do consulting work in an “arm’s-length transaction.” Whether the terms are fair depends largely on whose arm is longer.

ASSET ALLOCATION, n. The art—and purported science—of choosing how much money to divide among which ASSET CLASSes. Assets with low CORRELATION tend to offer divergent patterns of risk and return, so an intelligent asset allocation consists of holdings that go up and down at different times and rates. You should welcome owning assets that lose money some of the time, because they are likely to end up making money when your other holdings go down.

Asset allocation accounts for the vast majority of the differences in results among investors, dwarfing other factors such as exactly which securities they buy, or when they buy or sell. However, instead of using math or logic to determine a recommended asset allocation, many financial advisors use guesswork or promote whatever has been hottest lately.

Almost no advisors recommended an allocation to gold in 1999, when the precious metal had lost money for two decades. By 2011, when gold had tripled over the previous five years, many put at least 10 percent of their clients’ assets in it—right before it collapsed.

Similarly, a presentation to the prestigious Institute of Chartered Financial Analysts in 1986 recommended that a “conservative investor” with $100,000 allocate as much as 15 percent to limited partnerships. Why? Data full of BACKFILL bias and SURVIVORSHIP BIAS showed that real-estate partnerships had earned an average of 13.2 percent annually over the previous fifteen years, twice the return on stocks. Over the ensuing decade, however, most limited partnerships ceased to exist.

Whenever you consider a recommended asset allocation, ask which of the asset classes have low historical returns. If none of them do, you aren’t being assigned an asset allocation. You’re being invited to chase whatever is hot—most likely right before it’s not.

ASSET CLASS, n. A category of investment offering its own distinctive risks and rewards, with low CORRELATION to other investments. Bonds, for instance, tend to do well when stocks do poorly, and vice versa. Commodities also tend to zig when stocks or bonds zag.

Not all asset classes are always worth owning, however, and not everything proclaimed to be an asset class is sufficiently distinctive to be one (see HEDGE FUND). If a “new” or “alternative” asset class costs a lot more to own than traditional categories like stocks and bonds, it probably won’t turn out to have durable value.

ASSET GATHERING, n. How brokers, financial advisors, and portfolio managers describe what they do when no one else is listening. In plain English it means: “grabbing all the money we can with both hands from as many customers as possible so we can earn more fees for less work.”

AUDITOR, n. In Latin, “one who hears”; in English, also one who obeys. All too often, accountants approve a company’s financial statements exactly as the company’s management wishes them to be presented.

“It’s our job as auditors to do whatever we can to ensure that a company’s financial statements are presented fairly and accurately,” said Seymour Billings, a partner in the Chicago office of the accounting firm of Tinker Hyde Alter & Berry, on a recent visit to one of his largest clients, a retail chain. “We’re not policemen or fraud detectors,” Mr. Billings added, while in the adjacent building, employees of the retailer loaded filing cabinets full of financial records into a garbage truck.

AVAILABILITY, n. A mental shortcut, or HEURISTIC, that leads people to judge the frequency or probability of events by how easily examples spring to mind. The vividness of rare events can make them seem more common and likely to recur than they are. Flying is among the safest ways to travel, but on the rare occasions when an airplane does crash, the fireball on the runway is broadcast worldwide and burned into the brain of everyone who sees it.

Market crashes are rare, too, but the spectacular damage they cause is also seared into the collective unconscious. That leads many investors to miss out on the gains stocks can generate during the surprisingly long periods between crashes.

The vast majority of initial public offerings (see IPOs) fail to outperform the market, but it takes only a few spectacular successes like Google to create the illusion that investing in IPOs is the road to riches. The vividness of huge gains on one stock makes such profits seem more probable than they are. See also NEXT.

AVERAGING DOWN, v. To buy a stock or other asset as its price keeps dropping—an action widely ridiculed, often by speculators who bought the same asset at twice the price and have already lost their shirts. However, assuming you have calculated a MARGIN OF SAFETY, you should be willing to buy more as the asset falls in price; it is, after all, getting cheaper.

AXE, n. The Wall Street analyst whose opinions hold the greatest sway over the price of a stock—until his or her hot streak runs out, at which point a new “axe” takes a whack at it. This bizarre cycle continues for decades without most investors ever noticing that the blade is never swung by the same person for long enough to be meaningful.

BB

BACKFILL, v. To inflate the average return of HEDGE FUNDs by as much as 4 percentage points annually. Fund managers are not required to report their returns and may launch as many funds as they wish; thus, they can wait to see which fund turns out to do well before deciding whether to report its existence to the data services that calculate returns. The performance history of the INDEX that tracks the returns of hedge funds is then backfilled by the data service to include the performance of the fund back to its inception. The return of a fund that turns out to do poorly, meanwhile, may not get reported to the database at all. With good returns added back into the index over time and bad ones often excluded, the average performance of the index looks better, after the fact, than the returns of the hedge funds themselves were in real time.

If a CONSULTANT or FINANCIAL ADVISOR tells you that the average hedge fund in a particular category has earned an annual average of X percent, ask: “Is that number free of backfill bias?” If your advisor doesn’t know what you’re talking about, get a new one.

See also SURVIVORSHIP BIAS.

BACKTEST, v. and n. To comb through financial databases to determine which investing or trading techniques would have worked the best if anyone had known about them at the time. Many asset managers then use the back-tests as a way to extract money from clients in the present—and disappoint them in the future.

Backtesting can be legitimate; just as you wouldn’t buy a car without test-driving it or a house without going inside, you shouldn’t manage your money without knowing how that investment approach performed in the past. All too often, however, backtesting is “overfitted,” or designed to find any technique, no matter how obscure or absurd, that beat the market over some period, no matter how unusual the circumstances.