Investment Risk in Stock Market Securities

Investment Risk in Stock Market Securities

Introduction:

Stories of people making fortunes from the securities market have enticed many others into risky investments. Congress created the Securities & Exchange Commission (SEC) to protect investors. Many corporation managers became greedy and made self-serving decisions that created the principle-agent problems. The solutions for these problems lead to more unethical behavior from management. The creative use of financial statements even tricked analysts and brokers. Public trust began to erode with unethical corporation behavior. Analyst’s suspicions of some corporations cooking the books were confirmed with an announcement from WorldCom. The public’s distrust started to mount while accusing brokers of hyping stocks. People began to invest without brokers’ advice. With numerous risks rising for individual investors, Congress passed the Sarbanes-Oxley Act and the SEC responded by passing the Reg AC act.

Ordinary Investors Enter the Market:

Golden opportunities lie ahead for those who invest well in stock market securities. “The stock market, which was once the province of the very rich, is now easily accessible to millions of ordinary investors.” (Ethical Issues in Financial Services). Ordinary investors have flooded stock market securities with money in hopes of striking it rich. Many people were told by investment brokers the stock market securities are safer than it used to be. They were informed the Security and Exchange Commission (SEC), and the National Association of Securities Dealers (NASD) are the watchdog for the small investor.

Congress Acts to Protect Investors:

Congress created the SEC shortly after the 1929 stock market crash in order to protect investors. Their goal was to restore investor confidence and faith in the financial sector, which was notorious for fraudulent activities, easy credit, and hazardous investments. (Investopedia). The NASD is the largest self-regulatory organization (SRO) in the securities industry in the United States. An SRO is a membership-based organization that creates and enforces rules for members based on the federal securities laws. SROs, which are overseen by the SEC, are the front line in regulating broker-dealers. (Investopedia). In addition to federal regulations most states have created blue-sky laws to protect investors from fraudulent security offerings. (Finance). Even with these safe guards many companies have participated in fraudulent financial activities such as off-balance-sheet reporting and fooled many brokers and analysts.

Shareholders and Corporation Management Conflicts:

In the mid to late 1990s many shareholders of corporations were discovering management and executives were making self-serving decisions. Dishonest managers were increasing their expanses with corporate owned vacations villas, high salaries and excessive perks for themselves. These unethical practices were harming shareholders and corporate profits. As an incentive to align management interests with shareholders many managers were offered stock options. This allowed managers to purchase and sell stock of the company when they desired. If the stock rose, so did the profit of the managers.

The Incentive Lead to Unexpected Side Effects:

The solution of aligning interests between management and shareholders lead to unexpected side effects. Several managers started to hide corporate costs, overstating revenues, and engaging in deceptive transactions in order to exaggerate profits and boost the stock prices. (Finance). As the stock price soars under these perceived profits the managers would sell off their stock options and make fortunes. These managers used their financial statements to fool brokers and analysts as well as the public.

The Publics Trust is Eroded:

People placed their trust and money with investment brokers and analyst recommendations. Many brokers and analysts claimed that Enron, WorldCom, and others were financially sound and stable. Brokers and analysts promoted these companies as good investments with nominal risks. When analysts became suspicious of the accounting practices of several companies, they began to use cash-flow statements in addition to the other financial statements. The reasoning for this was because they were losing faith in corporations accrual-accounting based income numbers. Even with these suspicions they failed to inform the public of their concerns.

The Suspicions of Analysts Confirmed:

In 2002 WorldCom, Inc. disclosed that it had improperly capitalized expenses: It moved $3.8 billion of cash outflows from the “Cash from operating