Author Michael Lewis’ skepticism of all things Wall Street has made him millions in royalties over the years and brought him hundreds of thousands of readers and fans. And yet his recent claim — in his latest book, Flash Boys, and in a now-infamous 60 Minutes interview a couple of months ago — that the U.S. stock market is “rigged” is both very wrong and very right.

The gist of his claim is that the stock markets are rigged in favor of high-speed traders who pay for preferential access to the NYSE and Nasdaq computers that match buyers and sellers. They get quicker trading opportunities because of their fiber optic cable feeds into the servers and because their trading servers are housed, in some cases, in the same room as the exchange’s own computers.

First, the wrong: The individuals who are being fleeced by flash trading are not, typically, long-term investors. The money comes directly out of the pockets of the person who believes he can make money by actively trading through a discount brokerage account, as well as professional traders whose firms can’t afford the fiber optic cable feeds, and the handful of mutual funds and institutional investors who haven’t already switched their trading activities to exchanges that don’t permit flash trading.

But that doesn’t mean he isn’t right about something else — because I think his book offers a good opportunity for everybody to consider how far our society has drifted from some of the basic purposes of our capital markets.

The stock market was created for a very specific reason: to pool the capital of many individuals to create a complex, expensive enterprise with the capital to operate and grow. On the one side, it is a way of creating economies of scale for innovation and enterprise in our society. On the other, it allows ordinary individuals who don’t have a lot of financial resources to participate in the value growth of these larger enterprises.

The key here is the connection between the individual investor and the enterprise he or she is investing in. If you lose confidence in the company, if you no longer believe it will create long-term value, you can sell your investment to others in a liquid market. Indeed, knowing that the liquid market exists makes you more likely to invest in the first place. That, of course, is the important service that the exchanges provide to our society.

Meanwhile, the companies that were made possible by these pooled investments ought to be managed for the benefit of those shareholders who made them possible in the first place.

I know you know this, but laying it out shows just how far we, as a society, have drifted away from these basic principles. All of us — not just regulators but also planners and members of the investment community — should start thinking about the implications of this drift, and come up with ways to halt it and, perhaps, move investing back toward its basic purpose.

WHO’S TRADING NOW?

Let’s look at some components of this drift more closely. Start with trading.

Ben Hunt, of asset management firm Salient Partners, noted in a recent blog post that 70% of all trading activity in the markets today is machines talking to machines, which automatically seize on arbitrage opportunities in which the shares might be owned for less than 30 seconds. A significant percentage of the rest is investment banks moving in and out of the markets for their own accounts, using traders armed with fiber optic cable feeds directly into the same room as the trading servers.

Mutual funds, meanwhile, turn over more than 50% of their portfolios each year, according to the Investment Company Institute. Over the past decade, Hunt noted, institutional ownership of equities has grown from 54% to 81% — up from 5% from the 1920s through the 1950s — meaning fewer individuals own company shares directly.

Rather than picking stocks, financial advisors now spend an increasing amount of their time on dynamic asset allocation, repositioning portfolio asset classes to tack into the market winds.

Many of the high-speed traders are employed by large investment banks, which have drifted from the purpose they are chartered for — providing lending capital to individuals and businesses — into the more profitable creation of increasingly exotic gambling instruments posing as investments and hedging devices. In some cases, they have created confusing products at the behest of someone who wanted to bet against them, and then sold them to others, at a nice profit, as “investment opportunities” — while betting against them for their own accounts.

All of this is entirely legal. But does any of it serve any important public purpose for our society and economy?

Investing advice, meanwhile, has drifted from the “honest advisor” clearly specified by Congress in the Investment Advisers Act of 1940, to the point where a majority of people calling themselves advisors don’t even fall under the Act’s provisions at all. They are really brokers with “vice president of investing” on their business cards, giving advice that benefits their company more than the consumer. Study after study shows that consumers, understandably, have trouble telling the difference. Isn’t that exactly what the brokerage firms intended all along?

There also appears to be a dramatic move away from the idea that companies are managed for the benefit of their shareholder investors. In the 1950s, the average American chief executive was paid about 20 times as much as the typical employee of the firm. Today, at Fortune 500 companies, the pay ratio has drifted to more than 200 to one — diluting the returns of the shareholders who theoretically own the company — and many CEOs do even better through generous (some would say careless) grants of stock options or outright stock grants.
Shareholders are powerless to stop CEOs, and a handful of their compensation committee cronies, from looting the coffers of the companies.

Meanwhile, our IPO market bears little resemblance to the original idea of pooling capital. Today, an IPO usually suggests that founders and early investors are cashing out, not raising money to expand.

REVERSE THE TREND

It seems to me that society has tolerated this drift for far too long, to our detriment, and it is time to think about how these pernicious trends can be reversed. We would do our best thinking on this subject by returning again to the basic societal purpose of our investment markets.

In the planning arena, I would recommend a new emphasis on helping clients connect portfolios with the prospects of the underlying companies they are invested in. Are they good companies? Profitable? Are they set to grow and prosper? This is one way to get people to move away from a horizon measured in milliseconds.

State and federal regulators should consider whether bank charters permit organizations to indulge in a lot of vastly profitable activities that are clearly predatory. When you slip in ahead of somebody’s buy order, buy that stock and then resell it to the putative buyer at a higher price instants later, I would argue that you are not fulfilling a beneficial role in our economic society.

I think it is highly problematic that brokerage firms are allowed to buy and sell stocks in their own portfolios, and at the same time pose as impartial advisors who give stock tips to retail investors. The SEC is extremely vigilant about requiring financial planners to have strict trading policies in place that ensure that advisors aren’t front-running the trades they make on behalf of their clients. So why are brokerage firms allowed to unload a dog stock in their own portfolios by having brokers tout it to customers as a great “investment opportunity”?

I would also hope that regulators will consider whether the exchanges are fulfilling their highest societal function when they allow certain high-speed traders to buy access to information not available to all and, for a price, let some traders co-locate trading servers in the same room as the computer that matches buy and sell orders.

Unchecked, I expect the U.S. financial system to continue its unhealthy drift away from the core values and purposes of our investment institutions. Lewis showed us a small piece of a much larger, more worrisome trend — and all of us who care for the welfare of our society and our clients have an obligation to stop and reverse it.

Bob Veres, a Financial Planning columnist in San Diego, is publisher of Inside Information, an information service for financial advisors. Follow him on Twitter at @BobVeresPost comments below or email them to bob@bobveres.com

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