Image: Charles Schwab
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The period since early 2008 "is the worst time since I began the company," says Charles Schwab, the father of the modern American individual investor.
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updated 5/30/2010 10:48:54 AM ET 2010-05-30T14:48:54

In 12 years as a retail financial consultant for Charles Schwab, George Pennock thought he had seen every kind of market. Then, on May 6, he and his 250 clients lived through something new. Pennock was in Schwab's office in Englewood, Colo., just outside of Denver, talking by phone with a retiree who moved his money to Schwab last year because he says he felt suckered by his old broker. While they spoke, Pennock kept an eye on his computer screen and saw the Dow drop 250 points, bounce sideways, then go into free fall — 300, 400, 900 points down. His client was watching the same thing on CNBC.

"What's going on, George?" the retiree asked. "Do you have any explanation for this?" Pennock didn't. He was thinking he should end the call and contact clients who had pulled out of equities after getting clobbered in 2008 and 2009. Some left at the bottom, then sat on the sidelines while the market raced up 80 percent. Maybe they would see this as a buying opportunity.

He never got the chance. In minutes, the market anomaly was over and the Dow was heading back up. It wasn't until the next day that Pennock, 37, began to appreciate its impact on investor psychology. He arrived at his office the morning after to find 22 phone messages. By day's end he had 50 — one-fifth of his client base. "A lot of the calls were nervous," he recalls. "It was, 'George, this is testing my risk tolerance.' They have deep-seated concerns that [the correction] will go on for a while and nobody knows how long or how bad it will be."

It took Pennock two weeks to catch up on all the calls. "These conversations are lengthy," he says. "They take a lot of hand-holding." Some clients wanted to retreat; he reminded them why they had made financial plans in the first place. A retired airline pilot wanted to know if the 30 percent of his assets invested in equities was too high. (Pennock assured him it wasn't.) Another investor, who had waited five months to get back into the market, worried he had missed his chance. Most simply wanted reassurance. The May 6 crash may have been a freak occurrence, but it felt like one more sign that the deck was stacked against the little guy. "They got burned very badly before," Pennock says, "and they don't ever want to be in that situation again."

Many small investors had only begun to tiptoe back into equities when the May 6 crash and the European credit crisis rocked the markets, completing a particularly cruel cycle. In the year prior — while the S&P 500 was rebounding 69 percent from its Mar. 9, 2009, bottom — individual investors withdrew a total of $11.5 billion from U.S. equity mutual funds and poured $506 billion into lower-yielding bond funds, according to TrimTabs Investment Research. By late spring, they had just begun to reverse course, venturing back into equities by channeling $13.9 billion into domestic mutual and ETF funds in March and $6.9 billion in April. By the third week of May, they'd withdrawn $29.3 million from U.S. equity mutual funds and poured an additional $8.2 billion into bonds. An American Association of Individual Investors survey taken the week of the May crash showed investor sentiment jumped to 36 percent "bearish," from 28 percent the week before. As of May 10, according to the Federal Reserve, money on the sidelines in bank and money market accounts had reached $9.36 trillion, compared to $7.44 trillion in May 2007.

The period since early 2008 "is the worst time since I began the company," says Charles Schwab, the father of the modern American individual investor. "These are the most violent markets. Most people are still in a state of fear. I'd say 98 percent are still very concerned. And for a lot of good reasons. Look at the headlines. You've got these scoundrels doing all this stuff. People wonder, 'Who can I trust?' "

Schwab is sitting in his San Francisco office — which has always been spare but these days seems downright Spartan — looking out the window at the Bay Bridge and mulling the tortured psychology of the American investor. "Where are they?" he asks, then pauses and lets out a sigh. "This is the most violent period I've ever seen," he says finally. "It was the end of capitalism as we knew it. The whole definition of safety and soundness — what does it really mean any more?"

As chairman of the $4.2 billion company he founded in 1975, Schwab has reason to be worried about his customers. The success of his company depends in some measure on his financial advisers' ability to keep their clients engaged in the markets. Last year, almost a quarter of the company's revenue came from trading commissions; another 45 percent came from asset management fees. That's the tension at the heart of Schwab's enterprise. He has become the de facto therapist to the individual investor, but he is not a disinterested observer. His job—like Pennock and his other 6,868 licensed brokers—is to keep America invested. Schwab says that staying broadly diversified and firmly in the game remains the key to long-term financial security. Given what's going on in the world, should anyone believe him?

Schwab, now 72, and Vanguard Funds founder Jack Bogle are the old lions of the retail investment industry. Both played key roles in launching the golden age of individual investing — the period between August 1982 and March 2000 when the S&P 500 climbed from 102 to 1,527 and buy-and-hold seemed the surest path to security. Bogle was the pioneer of mutual funds and Schwab opened the door to equity trades for small investors. When Congress deregulated brokerage fees in 1975, some brokerage houses responded by raising fees; Schwab slashed his, making investing affordable for the middle class and becoming broker to the masses. His company's revenues grew from $387 million in 1990 to $5.8 billion in 2000. By then, it was offering round-the-clock trading, sophisticated investment analysis, and a mutual fund supermarket. Long before Starbucks, Schwab's branches were gathering places for market enthusiasts — office workers, day traders, and loiterers who stopped by to check stock quotes, mull their next move, brag about their big scores, and indulge in a group fantasy about a spectacular new way to get rich.

As individual investing became a way of life, Schwab inevitably drew competitors — rival discount brokers (and, later, discount online brokers) such as Ameritrade and E*Trade, and full-service houses such as Fidelity. Schwab's company rode the late-1990s tech boom but was battered by the steep drop in trading following the 2000 crash. Schwab himself moved out of the top job in 2003, only to move back in a year later, renewing the company's commitment to the small investor. (Today the chief executive officer is Walt Bettinger.) During the financial panic of 2008, Schwab attracted investors fleeing Merrill Lynch, Wachovia, E*Trade, and other battered firms. That new business helped boost Schwab's assets under management 25 percent to $1.4 trillion last year from the prior year (compared with $1.5 trillion at Fidelity, $350 billion at TD Ameritrade, and $162 billion at E*Trade) but Schwab's revenue fell 19 percent under pressure from low interest rates. The company's stock was trading around $16 last week, down $3 from one month before.

Since 1986, Schwab has written four books on investing. He is an optimist by nature, one who has always preached asset allocation, diversification, and investing for the long term. By empowering individual investors at the start of the bull market, he and Bogle and Fidelity's marquee investor Peter Lynch inadvertently created a monster. As playing the market became a national pastime, investing turned into a synonym for stock picking. Equities were thought of as savings. Today, legions of investors are torn between a newfound desire for safety and the allure of old, bad habits.

Worse, as Americans became do-it-yourselfers and sometimes day traders, their success — especially during the inflating of the dot-com and real estate bubbles — masked a profound shift in the balance of power. Wealth was migrating to institutions, hedge funds, and investment banks like Goldman Sachs, which had created proprietary desks to trade ever more esoteric instruments for their own accounts. Institutional investors now own about 70 percent of American corporations, up from 35 percent in 1975, according to Bogle. As trading algorithms grew more complex and computers sped up, every advantage went to the big guys.

The Yale School of Management has conducted a "buy on dips" survey since 1989, a confidence index that measures investors' willingness to buy after market drops of 3 percent or more. Institutional and individual investor sentiment tracked closely until 2007. At the height of the Dow Jones industrial average, in October 2007, 61 percent of each group said they would buy on dips. Since then they have diverged. By March 2010, 71.6 percent of institutional investors were willing to buy on dips compared to only 57.5 percent of individuals.

In other words, small investors need more help than ever. "Before, nobody needed advice — most just called me up to place their trades," says Robinson Martin, a financial consultant in Schwab's Cobb County (Ga.) office, on the outskirts of Atlanta. Now Martin and others are no longer cheerleaders and trade executors; they are psychologists, trauma experts, counselors, empathizers. It's a delicate balance. In pre-crash days, the company's clients were mostly avid investors. Rarely did Schwab have to coax them into the market. But that's what the company has to do now to prop up the assets it oversees. It's what it has to do to juice its own adviser business. It's what Charles Schwab has preached from the beginning—asset allocation over time. And it's what he does, as well. In August 2007, near the very top, he invested the more than $10 million he'd received from the company's sale of its U.S. Trust unit in a portfolio divided between 50 asset classes. Then he left it. After losing about 30 percent of its value at its lowest point, it is now down about 12 percent, he says. "I follow my own advice," he says. "I'm not running for the hills. Yes, those investments might be somewhat down from '07, but they will be at higher values next year or the year after. I don't know exactly when, but I believe it because of my confidence in the American economic system. If you don't have that confidence, then you definitely should not be a client of Schwab."

Atlanta is a buy-and-hold town, loyal to local favorites Coke, SunTrust Bank, Delta Air Lines, and Home Depot, says Martin, 38, as he prepares to conduct a client seminar on a sunny weekday at Schwab's Cobb branch. The old rules don't work anymore, he says. You can't buy and hold anything with confidence, and that's rattling even those who didn't follow the rules during the bull market.

Martin's conference room, inside a tall, glass-and-steel building in a suburban office park, feels like a relic of more prosperous times as a dozen strangers unwrap turkey and ham sandwiches and start talking about the markets. Most are retirees; three are doctors, one a former restaurant owner. They have come to get a market outlook that turns out to be cautiously optimistic. No matter. For nearly two hours, the conversation ricochets from one fear to another — mostly about what could blindside them next. Fannie and Freddie? Inflation? Government spending debasing currencies? "I look at what's happening in Greece, and I see us. I think that could happen here," says James Wood, an Atlanta neurosurgeon.

No one at the conference table knows what to believe anymore, and with good reason. "I had absolutely no idea how deeply the subprime mortgages had penetrated into the financial markets." says Dyckman Poland, a retired engineer. How are investors supposed to make informed decisions when they can't trust what's printed on corporate balance sheets, asks Dr. Wood. How much of the market is ruled by computer-generated trading anyway, another asks, "while you and I are just putting in our dribs and drabs? How do we individuals fit into all this?" Bob Bonacci, the vice-president of a business-services firm in nearby Kennesaw, looks around the table. "I think the majority of us are at or near retirement," he says. "We've taken a hit once, and now it looks like we're on the brink of another situation where it could all be taken away from us. For us, these mistakes are really going to count."

As the stock market fell toward the bottom in March 2009, Schwab distributed videos to its clients in which the founder tried to strike a reassuring tone. Just hang on, he urged. "We told them," Schwab says, "the world was not coming to an end." Yet just as they had after every market crash since 1987, investors fled to safety at the wrong moment, trading equities for cash and fixed income. "It is too darned bad," Schwab says. "So many people held on and held on and held on through 2008, and finally, by early 2009, they'd had enough. Then just at the wrong moment, they got to the pitch of emotion and they said, 'I've had enough.' And chucked it in and sold. Fear took over in the most extreme way." To steady their nerves, the company puts out books, seminars, articles, and the famous "Talk to Chuck" ads. "One of our chief roles is to try to help people through this thing," he says. "But we can't help people overcome the power of fear. Or the power of greed. Those are too much a part of human instinct. We are not psychiatrists."

Now, Schwab says, his biggest worry is that investors will miss out again. They have $2.98 trillion stashed in money market funds, according to TrimTabs, and lots more in CDs and savings accounts. "If you're not an investor, you get no return on your savings and you have this very difficult situation coming up in the next three to five years of inflation that will just take away whatever you might get in some kind of yield. My fear is that inflation will come back and people will throw up their hands and say: 'Jeez, I wish I'd done something to protect myself.' "

That may sound self-serving. Except that, barring a return to a raging bull market, Schwab stands to benefit more, at least in the short-term, if its clients stay paralyzed. If interest rates take off, as the company expects they will by next year, its earnings will soar. That's because Schwab began to change its business mix a decade ago. Foreseeing an end to the bull market and with it, a decline in trading volume, it reduced its dependence on trading to 24 percent of total revenue last year from about 40 percent in 2000. It increased its asset management business and added the Charles Schwab Bank, offering retail banking and mortgage services—thus turning itself into more of a discount investor-services firm than a mere brokerage. It derives much more of its revenue from fees for managing and administering assets (45 percent last year, vs. 27 percent in 2000) and net interest revenue from the cash in its bank and money market funds (29 percent last year, vs. 22 percent in 2000).

If Schwab had not waived the fees it charged on money market funds last year — a move Schwab ordered because their interest yield was so low — trading would have accounted for just 20 percent of last year's revenue and interest would have accounted for 32 percent. And if interest rates do head higher, a report by JPMorgan Chase analyst Kenneth B. Worthington said this month, Schwab's earnings will react like a "coiled spring." As rates rise from 2010 to 2012, he predicts, Schwab's net income will more than double.

"We make little bits of money on everything, for the most part," says Schwab. "We are completely neutral about what you do. We would probably make more money on money that sits in a money market fund than on a stock you buy and hold. But we don't have an agenda. We really don't."

Yet the Schwab brand is not about making a killing by collecting interest on the money that clients have sitting in their accounts. The brand lives and dies by "Ask Chuck," as a place where befuddled investors go to not get screwed. And Schwab can't continue to be the "Trusted Advisor" if the client assets of its advisory business aren't growing. It's got to show that it's helping investors, and that means guiding them into vehicles that show growth, not stagnation. "Individual investors must understand asset allocation," says Schwab. "With just a few thousand dollars, you can get a little slice of this and a little slice of that — large caps, small caps, emerging markets, and then build on it," he says. The point is not to get in on the ground floor of the next Google and ride a juggernaut. "You're going to get maybe 5 to 10 percent per annum over 5 to 20 years — maybe 30. That's still pretty good."

The day after the Schwab seminar in Atlanta, one of its attendees, Gene Perkins, 66, returned to Robinson Martin's office. Though he has done his own investing since he sold his restaurant business three years ago, Perkins is now enlisting Schwab so he doesn't get burned, as he did in the 2008 crash when his investments lost 28 percent of their value. He and Martin are working on an asset allocation plan, and it's pretty tough going. Perkins' approach to investing is practically bipolar. At first, he presses Martin about the safest assets. "So what if you just buy treasuries and CDs?" Perkins asks. "Would it kill me to lose a little ground [to inflation] if it lets me sleep at night? It's all relative."

Within minutes, Perkins is trying to elicit a little stock picking from Martin. That hybrid approach was a big winner during the long bull market. Even disciplined investors could dip in now and then, roll the dice and maybe make a windfall. "You're going to be mad at me for bringing this up," Perkins says. "But if the market tanks, there's going to be some good buys. ... Let's say the market closes down 80 ... I may be wrong, dead wrong, and I hope I am. But I got eight or nine stocks here. ..." He gestures to a hand-scrawled list: McDonald's, BP, Altria, Citi. He's got good arguments for each. "McDonald's is at $68 — that's my business. If I can get it at $65, that's a good deal. And Citi ... I can wait it out. If Citi is still at $4 a share four years from today, well then I deserve to lose money on that account."

Martin listens patiently and then shakes his head. "Gene, that's too much risk," he says. What will Perkins do with the gains? "Keep it in cash?" Perkins ventures. "Or wait till the market tanks again and buy some more deals?" Responds Martin: "Gene, that's head fakes. When the market tanks again, you will pull everything out. You are playing Vegas odds."

Perkins slumps back in his chair. "I just have a lot to make up. I can't afford to take another hit."

Martin continues calmly: "You said McDonald's and Citi, Gene, and that may well be. But what you're missing is a hedge. Asset allocation is your hedge. You started this conversation with capital preservation, and what capital preservation has to be is a balance between risk and growth. Ultimately what we're trying to do is get out of the guessing game."

Martin keeps trying, his bedside manner patient but firm. Once Perkins has a plan in place, his assets will be invested broadly across asset classes to mitigate his risk. What he has to decide is the balance between risk and reward. With a financial plan working for him, "it's all math at that point," explains Martin. The hard part for so many investors is having to constantly recalibrate the portfolio to keep the asset classes in line with each other. That means scaling back on — not rushing into — sectors that are growing fast. To individual investors who came of age in a bull market, it's all painfully counterintuitive.

Perkins has heard it all before. "Asset allocation is the opposite of market timing, I do understand that," he sighs. "You all have made that crystal clear." And then he gets to the heart of the matter, the reason these investing decisions are causing him so much agony. He has no heirs. He will begin drawing on his retirement funds at 70. "If I live to be 90 ... if I start drawing at 70, will there be enough?" The subprime crash was a huge setback, and now he doesn't know. "I don't need to have anything left over. I'd like to be broke when I'm dead. I don't even need a casket. As long as I have enough. I just don't want to run out before I die."

Copyright © 2012 Bloomberg L.P.All rights reserved.

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