Brokers May Have to Change

“A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest.  Advisers always have those duties, but brokers often don’t.  The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.” – Jason Zweig.

If you are confused by the difference among these titles: Financial Planner, Stockbroker, and Registered Investment Advisor, you are not alone.  The “Name Game” in the financial services industry is downright confusing.  How does your financial advisor operate?  How does she get paid?  What are the advantages and disadvantages of each arrangement?

Many people believe that they are getting financial planning from a stockbroker, when in fact financial planning is usually only an incidental part of what a stockbroker does.  Similarly, many people are not aware that a stockbroker does not have to act in the client’s best interests.

A June 19th Wall Street Journal article Big Change in Store for Brokers in Obama’s Oversight Overhaul brings home this point.

According to the article, stockbrokers might have to change the way they do business; they might have to act in their client’s best interests, the way a Registered Investment Advisor already does.

Wow!  What a concept.

Here are the relevant quotes:

Buried in President Obama’s proposed regulatory overhaul is a change that could upend Wall Street: Brokers would be held to a higher “fiduciary” standard that would compel them to place their client’s interests ahead of their own.

Currently, brokers are only required to offer investments that are “suitable,” which means they can’t put clients in inappropriate investments, such as a highly risky stock for an 80-year-old grandmother. The move could change the way products are sold and marketed and even how brokers are compensated.

Many investors don’t even know the difference between the two standards, believing their brokers already are acting in their best interests.

But requiring brokers to operate under a fiduciary standard could force them to offer products that are less costly and more tax-efficient. They will have to disclose any potential conflicts of interest, such as any fees they may get for favoring one product over another. That could mean clients will be offered fewer proprietary products if the broker can find a lower-cost option elsewhere.

For example, a broker couldn’t put you in a mutual fund with higher fees — or one he gets a bigger commission for selling — if he could get a comparable fund with lower fees elsewhere, says Tamar Frankel, an expert on fiduciary law at Boston University School of Law. (Emphasis added.)

The article implies that some stockbrokers sometimes put their interests above yours.  Hmm.   This might just be worth investigating.

Luckily, I’ve discussed this topic many times, and in fact I have a series called The Dark Side of Wall Street, which lists all of the relevant posts.  If you start with Choosing a Financial Advisor, Part 1 at the bottom of the page, you can read them in order by following the “To be continued” link at the end of each post.

Avoid Investment Scams, Part 1

“There’s no such thing as a free lunch.” – Milton Friedman.

“Fed up with purported financial advisers preying on unwitting older people, investigators from the Arkansas Securities Department last year staged an undercover sweep of one of the hucksters’ favorite showcases — free lunch seminars.”

That was the lead in today’s Wall Street Journal article Laws Take On Financial Scams Against Seniors.  According to the article, which is about some questionable and possibly illegal practices, “financial scams that target seniors are on the rise, and states are cracking down.”

“Besides Arkansas and Michigan, Idaho also passed a senior-victim law in recent months that will go into effect this year. Six other states, including Maryland, Minnesota, Missouri, New Jersey, Rhode Island and West Virginia, have similar bills pending in their current legislative session.”

Leaving aside whether seniors are in particular need of protection, and whether the site of the crime is only a lunch seminar, let’s take a look at the misleading products offered.  Here are some relevant quotes, with emphasis added.

The Arkansas sweep … uncovered …shady practices — misleading claims, underplayed risk.

The recession has spurred more scams that play off people’s fear of stocks.  Some investments pitched as low-risk could instead be quite complex.

The events are generally pitched as educational events, with a free meal thrown in. But in Arkansas, state agents instead found that the dozens of seminars they attended all featured hard-sell pitches for financial products, many of which weren’t appropriate for elderly investors. Presenters at about half of the seminars made misleading claims about potential investment returns, Arkansas regulators say. And at about a quarter of the events, products being pushed were ill-suited to older people, such as investments heavily exposed to swings in stock prices.

The frequency of scams is increasing in the recession, many financial experts say. Seizing on fear of stock-market turmoil, sales people and fraudsters are hawking investments that claim to be “low-risk,” or a supposedly safe way to invest in the stock market and earn back losses. In fact, the products may be complex and have significant downsides.

Firms that have been cited for violations range from big financial giants to single-person offices.  In October 2007, a unit of Allianz SE, the German financial company, agreed in a settlement with Minnesota’s attorney general to review sales practices and to give refunds to as many as 7,000 Minnesota seniors that the state said may have been sold unsuitable annuities since 2001.  Allianz also agreed to strengthen its process to determine suitability for customers over the age of 65.

There is nothing illegal about financial advisers pitching products at seminars, but under securities and investor-protection laws, there are lines that these salespeople can’t cross.  Brokers must follow “suitability” standards, meaning they can’t sell a product that doesn’t make sense given a person’s age, income, or liquidity needs.  They can’t misrepresent products. S ales materials and oral presentations must show a balanced picture, with both the risks and benefits of investing in the product.  Any statements to investors that an investment is “safe as cash” or that it carries no market or credit risk “would raise serious questions under FINRA’s advertising rules,” according to the regulatory group.

A number of products sold to seniors have triggered investigations in recent months, including reverse mortgages, which can help senior tap equity into the home and be beneficial, but which can also include hidden costs. Also popular are deferred annuities, which promise future payments to the investor but which can lock up money for a decade or more.

Conclusion

I am not surprised that one of the vehicles used by the scam artists are deferred annuities, as I have written about this before. Quite simply, variable annuities pay salespeople very high commissions. Annuities may be suitable for some people, but determining what is best for you should be done by someone who does not gain from the decision. In other words, your best option is to hire a fee-only planner to advise you on whether you really need a deferred annuity. Quite possibly, a fee-only planner will come up with a less expensive solution that achieves the same goals as an annuity.

The article lists several sites which will help you if you think you have been scammed. Of course it may be too late at that point.  Instead, I’d recommend one site that will help you find a fee-only planner, a fiduciary acting in your best interests – the NAPFA website.

As mentioned in the article, salespeople must only follow a “suitability standard” and do not have to tell you about the best option for you.  The difference between a “suitability standard” and a “fiduciary standard” may seem like a technicality, but the effect on your financial wellbeing can be huge.

Read Part 2.

60 Minutes – The 401(k) Recession

Sunday’s 60 Minutes piece on 401(k) retirement plans was rather shallow, and not at all what you would hope (and expect) from CBS’s popular, long-running show. The template for this type of exposé is generally that there is a problem/scandal and some party has been physically hurt or financially injured, and some other party has to bear the blame.

According to the 60 Minutes portrayal (sadly, all true, by the way), people have lost jobs, their portfolios were destroyed and retirement dreams must now be deferred. Steve Kroft interviewed discouraged job seekers at a job fair, which, if nothing else, provided sympathy and some activity to televise. It’s curious (and quite a coincidence!) how the interviewees just happened to have their 401(k) statements with them.

Naturally, he only interviewed older people, and that’s fine; after all, it’s the older folk who are more severely impacted. In my opinion, younger investors will be fine, as long as they continue to contribute to their own 401(k) plans and invest in stocks. In fairness to 60 Minutes, they did spend about a dozen words on this distinction.

According to my analysis of the 60 Minutes template, we must find victims and we must identify villains. Indeed, they found a very sympathetic woman who not only lost a lot of money in her retirement account, but lost her job as well. She cried on camera. And 60 Minutes made a veteran industry spokesman appear unabashedly unsympathetic, though that may have been the result of heavy editing of his comments.

Actually, the 13 minute piece combined two things: (1) people have lost money, and (2) fees are hidden in 401(k) plans and may be excessive. What they downplayed is that more consumer education is needed. Surely, they could have spared a few more sentences than the paltry few they uttered on that particular, very important, issue.

What can we actually learn from the 60 Minutes segment?

People Lost Money

Well, yes. But, what wasn’t said is that that has been true of other investment accounts as well, not just 401(k) plans. Small business owners have also suffered, as have people who have lost their jobs. Why only claim that 401(k)s have let down participants?

Fees

Yes, high fees can hurt investment performance, so 60 Minutes got it right that high (and hidden) fees can be a big problem in retirement plans. But they chose merely to list the types of fees, not quantify them or put them in a useful context. In my experience, some 401(k) plans are quite good. Some are too expensive. On the other hand, many 403(b) plans have very high fees, yet no one is examining them.

Risk

Defined Benefit Plans (pensions) have been in decline for some time. The old pensions were much better for average Americans, because loyal employees knew (more or less) what they would get, and they didn’t have to worry about making investment decisions. But employers were happy to get rid of traditional pensions to help reduce future costs and to reduce the business risk of achieving adequate market returns. Accordingly, employers have emphasized Defined Contribution Plans and largely dropped pensions.

In essence, investment management and investment risk were transferred to employees, and they were not prepared to make wise choices. In a bull market this was not so noticeable.

The Solution

The nature of defined contribution retirement accounts, such as a 401(k) or 403(b) plan, is that, while they provide a tax-deferred avenue to save for retirement, they need to be managed. Someone has to determine an appropriate asset allocation, based on a number of factors. Moreover, if you have other investments, it is ideal to treat all of your investments as one portfolio. And your allocations should probably change over time. As you get closer to retirement age, you generally will need to be somewhat more conservative in your investments.

The fundamental problem is that people thought that they could simply invest in the 401(k) plan without putting too much consideration into the asset allocation. Or it could be that they chose hot funds based entirely on past performance. The show did not go into any details as to why the participants had done so poorly, only that they had.

Clearly, more consumer education is needed. Fortunately, there are efforts currently under way to provide independent, unbiased support that will assist more employees to make informed decisions about their retirement plans.

Suggestion for 60 Minutes

The producers could have done a much better job. Next time, they should compare and contrast two people. One individual who had read a couple of personal finance/investment books or had consulted a financial planner who explained risk and return, asset allocation and the need to become more conservative as one approached retirement. The second individual would be one who did not understand any of these issues and pretty much just winged it with what amounts to a large part of her net worth.

While this comparison would have been useful and very telling, it would, of course, have made for pretty boring TV.

Rolling over to an IRA account

If you have a defined contribution account – 401(k) or 403(b) – from a former employer you can do a tax-deferred transfer to an IRA account. This would give you more control and more choices, but it should be done carefully. To that end, I recommend that you consult a fee-only financial planner. Otherwise, you may end up paying even higher fees than what you are now paying! You might even, heaven forbid, be sold a variable annuity to put in your new IRA.

To be continued.

Avoiding Financial Fraud

Ron Lieber’s New York Times column Even Vigilant Investors May Fall Victim to Fraud was quite disturbing and not a little worrying. It recounts how Matthew Weitzman, a founder and principal at AFW Wealth Advisors, a Registered Investment Advisor, and a fee-only firm, is no longer with AFW. The firm informed its clients of “certain irregularities in a limited number of client accounts.”

You can read Lieber’s article for the details. What is not clear, though, is how much money was involved nor how quickly the irregularities were discovered. Though, from my point of view, they are not the most worrying aspects. What concerns me most is that Mr. Weitzman was a member of the National Association of Personal Financial Advisors (NAPFA).

When a member of the advisory community violates the trust that clients place in him, all clients and advisors suffer. What this country does not need right now is any further deterioration in what little confidence we have left in the banking system, the federal government or our financial advisors.

I have been a fee-only planner since 2003, and whenever possible, I recommend that investors seek out financial planners who are compensated directly by their clients, rather than by commissions. In this way, you will avoid obvious conflicts of interest.

Members of NAPFA all practice a fee-only method of compensation and sign a Fiduciary Oath, which means that they swear to act only in their clients’ best interest. So it is with great discomfort that I heard that not one, but two, former members of NAPFA have been accused of bilking their clients.

What to do? As Ronald Reagan once said, “Trust but verify.” And of course, you should never write checks directly to your advisor, but only to an independent custodian. It is the independent custodian who should be providing you with confirmations of all transactions and trades, and a monthly statement. These are sensible precautions in the age of Madoff.

As Lieber says, “Open your mail. Confirm the accuracy of your trades and fund transfers. Read your account statements. Every month. Every number. Every single word.” I am not sure about reading every number, every word, but I get his drift.

Lieber further recommends that you handle all of your stock transactions yourself. I believe most investors will find this “solution” impracticable, inconvenient and unnecessary. I believe a better solution is for you to sign a limited power of attorney, allowing your advisor to enter transactions on your behalf, but which does not allow him to withdraw your funds. Only you should have the ability to withdraw funds from your account. I am not an attorney, but I believe that this provides adequate protection. (Attorneys, please weigh in.)

My mother always said “A promise is a promise.” Unfortunately, there are always people who will promise one thing and do another. It’s disappointing to have your expectations dashed.

I don’t know about you, but I expect firefighters to be brave, judges to be moral and rabbis and priests to comfort the troubled. Yet, there have been judges who, instead of upholding the law, bend it out of shape for personal gain. And there have been priests and rabbis who have preyed upon our young and betrayed our trust.

Lieber says, “I’ve always believed that advisers in the (NAPFA) association were plenty smart and morally upright, but it’s hard to recommend them now without at least including an asterisk.”

In my experience, NAPFA members have the highest standards in the profession. But like every profession, there may be individuals who choose to violate the trust of clients they serve.

It’s not easy to protect yourself against out and out theft, but you can take some small comfort from the fact that if financial advisors break the law, they are subject to prosecution by the regulatory authorities.

In my opinion, a great majority of investors will lose countless dollars because of the continuance of “Standard Operating Procedures” at Wall Street investment firms. Every day these firms peddle ill-conceived, hard-to-understand, expensive investments, because it is profitable for them to do so. Investors will lose more money in the ordinary course of business than they will ever lose due to outright fraud.

Unfortunately, what is legal on Wall Street is bad enough.

And so, I will continue to heartily recommend NAPFA members, because the fiduciary standard is the right way to do business.

And yes, monitor your accounts. Remember, “Trust but verify.”

Questions to Ask When Picking a Financial Adviser

An article in the April 13, 2009 edition of the Wall Street Journal entitled Seven Questions to Ask When Picking a Financial Adviser largely misses the boat. Granted, it is a challenge to find a “reliable” financial advisor; however, the article did a poor job of advising you on how to go about it. Reading it may leave you with the conclusion that it is impossible to find a financial planner you can trust. There can be nothing further from the truth.

I take exception with the emphasis of the article and several of its points.

How does the adviser get paid?

Mentioning that there are different methods of compensation, as the article does, is not sufficient.

As I’ve said in previous posts, the key issue in choosing a financial advisor is finding one who will act in your interests. To determine that, you must know exactly how and who compensates your chosen advisor. If an advisor is fee-only, you’re off to a good start.

Remember that a stockbroker must act in the employer’s best interests, and that you are not his employer. A Registered Investment Advisor, on the other hand, must act in a fiduciary capacity, i.e. in the clients’ best interests.

Stockbrokers are subject only to a “suitability” standard. They are regulated by FINRA, which (despite their rhetoric) is dedicated to protecting stockbrokers and their employers, not necessarily investors.

What do the adviser’s clients say?

This may or may not be relevant or helpful.

Registered Investment Advisors are governed by the 1940 Investment Advisor Act, which expressly prohibits providing “testimonials,” which client references would fall under. Of course, a client recommendation or testimonial could easily be concocted anyway.

What’s the adviser’s track record?

The WSJ article didn’t even come close to getting this issue right. Choosing an advisor based on his/her supposed investing track record is the wrong approach on several counts!

Even if you did find an advisor with a “superior” track record, we know that it is meaningless, because, as has been stated before, “Past Performance is No Guarantee of Future Results.” If you’ll recall, Bernard Madoff had a superior track record, many testimonials and lots of personal references and endorsements. And we all know what he did.

Key Financial Solutions does not try to “beat the market.” We are not active managers, because studies show that the added costs offset any possible gains of active trading.  Market timing and stock selection do not work.

Since we are not mutual fund managers, we do not have one uniform documented track record. Real financial planners take into account their client’s needs, financial objectives and tax situation before investing their money.

Because our clients have different risk tolerances and time horizons, they naturally have different portfolios and, therefore, different investment performance.

Financial Planning versus Investment Performance

Understand that beating an index is not a financial plan. What a good financial planner will do is give clients the best chance to achieve their goals.  Because the financial plan sets the parameters of the portfolio, a portfolio is simply a tool to realize clients’ goals.

Don’t get me wrong, we are quite proud of our portfolio design, because we use low cost, tax-efficient mutual funds to build globally diversified portfolios.  I am personally fascinated by asset allocation and portfolio strategy.  I use automated reports and individual spreadsheets to monitor a portfolio and to make changes, when appropriate.  Certainly all of these necessary tasks contribute something to investment performance, but not as much as having a plan and sticking to it.

Real Life Returns

Since investor behavior is a very large component of investment returns, we act as coaches so that clients do not make big mistakes.  For example, we manage how clients respond to the euphoria near market tops and to the panic and despair around market bottoms.

Behavioral advice – coaching clients to continue to do the right thing and to avoid doing wrong things – will have a greater impact on investment returns than attempting to choose next year’s hot sector or mutual fund.

Believing in full disclosure and transparency, we report results quarterly so that a client can see exactly how well his or her portfolio is doing. This report is net of all fees, which are clearly stated, rather than being hidden. But I do not recommend giving quarterly results much importance.

Conclusion

When considering whether to retain an adviser for a long-term relationship, avoiding conflicts of interest should be the first consideration. A strict fee-only method of compensation is the best approach for most people. Members of the National Association of Personal Financial Advisors are strictly fee-only planners who sign a Fiduciary Oath.

NAPFA has always maintained that an advisor who is compensated solely through commissions faces immense conflicts of interest. This type of advisor is not paid unless a client buys (or sells) a financial product. A commission-based advisor earns money on each transaction—and thus has a great incentive to encourage transactions that might not be in the interest of the client. Indeed, many commission-based advisors are well-trained and well-intentioned. But the inherent potential conflict is great.

Who Will Guard Your Nest Egg?

“Make no mistake about it, you are engaged in a brutal zero-sum contest with the financial industry — every penny of commissions, fees, and transactional cost they extract is irretrievably lost to you.” – William Bernstein.

Previous posts have discussed the advantages of using a fee-only financial planner and also the possible conflicts of interest that may arise when working with a commission compensated planner.

Certainly, Wall Street investment firms spend a lot of money on advertising, making it seem as though their interests are aligned with yours. So, it is understandable that the majority of consumers are unaware of the difference between a fee-only planner and someone who calls himself/herself a financial planner but who is actually a salesperson.

In Saturday’s Wall Street Journal, Jason Zweig delineates the nature and extent of the confusion.

Brokers must recommend only investments that are “suitable” for clients.

(Registered Investment) Advisers act out of “fiduciary duty,” or the obligation to put their clients’ interests first.

Most investors don’t understand this key distinction. A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest. Advisers always have those duties, but brokers often don’t. The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.

Brokers can sell you any investment they have “reasonable grounds for believing” is suitable for you. Only since 1990 have they been required to base that suitability judgment on your risk tolerance, investing objectives, tax status and financial position.

A key factor still is missing from FINRA’s (Financial Industry Regulatory Authority) suitability requirements: cost. Let’s say you tell your broker that you want to simplify your stock portfolio into an index fund. He then tells you that his firm manages an S&P-500 Index fund that is “suitable’ for you. He is under no obligation to tell you that the annual expenses that his firm charges on the fund are 10 times higher than an essentially identical fund from Vanguard. An adviser acting under fiduciary duty would have to disclose the conflict of interest and tell you that cheaper alternatives are available.

If brokers had to take cost and conflicts of interest into account in order to honor a fiduciary duty to their clients, their firms might hesitate before producing the kind of garbage that has blighted the portfolios of investors over the years. (Emphasis added.)

Conclusion

Panicking and pulling out of the stock market following a steep decline, concentrating your investments within a narrow range of options, and too much trading and too little long term holding are some of the more common mistakes investors make. Any and all of which will likely result in a reduction of your investment returns.

Understand, though, that high costs can absolutely kill your investment returns, whether from the high fees of a variable annuity or 403(b) plan, high (and often hidden) expenses and fees of some mutual funds, or the opaque mark-up on bonds sold to unsuspecting investors. Your best protection is to ask your financial advisor to sign a Fiduciary Oath. To find a fee-only planner near you, view the NAPFA (National Association of Personal Financial Advisors) web site.

It is encouraging that the issue of who is working in your best interests has been brought front and center by Jason Zweig, a respected author and columnist. Now, let’s see if the Securities and Exchange Commission Chairwoman, Mary Schapiro, proposes changes in legislation that will benefit consumers. The stakes are extremely high, as Wall Street firms make billions from unsuspecting customers.

Entrenched interests never give up power or lucrative business practices easily.

Financial Literacy, Part 1

Given the state of the global economy, the need for financial literacy should be self evident. Life is complicated. And in that complicated life, we all must make sometimes difficult choices, based on the best information we can gather and our interpretation of it.

But, according to a column by Robert Shiller in yesterday’s New York Times, that knowledge is sorely lacking. In How About a Stimulus for Financial Advice? Shiller extols the benefits that would be derived if the government subsidized the financial advice and education that the majority of people desperately require.

Shiller discusses several studies which prove that lower-income consumers are no match for the sophistication of financial service providers. Some of the revelations are quite shocking. Take his example of payday loans. You probably get spamvertisements for them in your email box all the time. But did you realize that  “payday loans — advanced to people who run out of cash before their next paycheck — exploit people’s overoptimism and typically succeed in charging annual rates of interest that may amount to more than 7,000 percent.” You read that right, 7,000%.

Shiller focuses on the need for financial education specifically for those less fortunate, because, in his reasoning, wealthy folks already have access to good advice. I, however, would say that we all need more education, sophistication and good advice; case in point, the billions of dollars lost by wealthy “educated” investors in the Madoff scam.

To confirm that you too need objective advice, ask yourself (or check your records) how much money is your financial advisor making from you? I can pretty much guarantee that your financial service provider knows the answer to that question, probably to the penny. See my previous posts on why it is not in his or her best interest for you to know that answer.

Here are some relevant quotes from the Shiller article.

In evaluating the causes of the financial crisis, don’t forget the countless fundamental mistakes made by millions of people who were caught up in the excitement of the real estate bubble, taking on debt they could ill afford.

Many errors in personal finance can be prevented. But first, people need to understand what they ought to do. The government’s various bailout plans need to take this into account — by starting a major program to subsidize personal financial advice for everyone.

A number of government agencies already have begun small-scale financial literacy programs. For example, the Treasury announced the creation of an Office of Financial Education in 2002, and President Bush started an Advisory Council on Financial Literacy a year ago. These initiatives are involved in outreach to schools with suggested curriculums, and online financial tips. But a much more ambitious effort is needed.

The government programs that are already under way are akin to distributing computer manuals. But when something goes wrong with a computer, most people need to talk to a real person who can zero in on the problem. They need an expert to guide them through the repair process, in a way that conveys patience and confidence that the problem can be solved. The same is certainly true for issues of personal finance.

One wishes that all this financial cleverness could be focused a bit more on improving the customers’ welfare!

The theory of capitalism, going back to Adam Smith over 200 years ago, sees an alignment of interest between consumers and businesses. Only those companies that produce what consumers really need will succeed. Those that do not will be beaten in the marketplace as consumers shop elsewhere. This puts pressure on providers to innovate and to better satisfy consumer needs.

This theory assumes, however, that consumers are rational in their choices, and to a large extent they are. But in some areas, notably personal finance, it is important to recognize that a good share of Americans have difficulty figuring things out.

Most people get financial advice only from sales representatives of one sort or another: real estate agents, mortgage brokers, sellers of financial products. Some of these providers could use their sophistication to exploit people’s tendency to behave irrationally, and to manipulate the judgment errors that consumers typically make. And competitive pressures tend to make providers promote products that exploit those errors to the hilt, unless, of course, we offer consumers real financial advice.

Conclusion

Shiller acknowledges that there is no silver bullet to the issue of financial education and risk taking. However, “it’s still likely that advisers who built long-term relationships with their clients, and who pledged to look after their welfare, would have been a helpful influence, suggesting caution to those who were getting over their heads in debt, and warning that adjustable-rate mortgages could be reset upward, just as the fine print said. For these reasons, financial advisers probably would have reduced the severity of the housing bubble.

Professional financial advice is now generally accessible only by the relatively wealthy. Changing this would be an important corrective step. Giving the general public access to trained advisers would be a boon for the nation in this time of doubt and distrust.”

Shiller raises some very good points. He envisions a government subsidy to help pay for one-on-one financial counseling. I personally believe that part of the needed education and counseling could be delivered with a combination of classes and individual consulting, in order to keep costs down. But I am with him entirely when he says that advisers should have long-term relationships with their clients and that advisers should pledge to look after their clients’ welfare.

A previous post discusses the desirability and practicality of working with someone who is a fiduciary, as opposed to a registered representative.

Stockbrokers in the Spotlight

You may recall a series of articles that I wrote not too long ago about the potential perils and pitfalls of working with stockbrokers, also occasionally referred to as “registered representatives.”

An article in the January 13, 2009 edition of The Wall Street Journal, Help Wanted: Wall Street Stockbrokers, No Joking, explains just how well some “high-producing” stockbrokers are compensated. (Note, in this case, the description “high-producing” refers to how much revenue they generate for their employers.)

For a somewhat jaundiced (and funny) post on this particular issue, see Milo Benningfield’s article, Stockbrokering: Who Said Retail Wasn’t Profitable?

Benningfield, by the way, is a fee-only financial advisor located in San Francisco. Here’s a summary of his post.

Now that investment bankers and traders have proven such great disappointments to the large Wall Street houses, they’ve taken renewed interest in their retail brokerage operations. And what lucrative operations they are.

Naturally, Wall Street wants to take care of these golden geese.

As ‘registered representatives’ of the brokerage firm, stockbrokers (as they are informally called) are legally bound to represent the interests of the firm, not the client, in any transaction. (Registered reps/stockbrokers should not be confused with ”registered investment advisers,” who have a statutory duty under the Investment Advisers Act of 1940 to put the client’s interests before their own.)

In other words, stockbrokers are a distribution channel for the brokerage firms, and it makes perfect sense that the firms would want to protect and support that channel by offering brokers huge financial incentives.

But all the largess heaped upon the brokers does raise a question: just how are the Wall Street firms, who apparently need a government bailout just to stay in business, expecting to recoup the “partner awards” and other incentives that they’re currently “doling” out to stockbrokers?

To answer that question, dear customer, all eyes are upon you. Caveat emptor, my friend.

Caveat emptor – buyer beware. As always, that’s very good advice. If you’d like to read more about this subject, read The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein. Pay particular attention to Chapter 9, entitled “Your Broker Is Not Your Buddy.”

Caveat emptor, indeed.

Making Better Financial Choices, Part 2

“Poor asset allocation, ill-considered active management, and perverse market timing lead the list of errors made by individual investors.”- David Swensen.

In my last post, I suggested that a great many investors would benefit from a financial advisor who could help them create and implement a comprehensive financial plan and who can manage their investments. Whether or not you heed my suggestion depends on whether you consider yourself a do-it-yourselfer or a delegator.

To handle your own investments, you must first know yourself. Be honest. Do you have the time, inclination, and emotional fortitude to do this right?  Successful investing takes both knowledge and discipline.

Do you understand risk management, asset allocation and asset location? Are you capable of writing and sticking to an Investment Policy Statement?

Perhaps you’ve shot yourself in the foot one too many times? It happens to a lot of novice (and not-so-novice) investors. Many individual investors tend to be too enthusiastic after market prices have gone up and go into a buying frenzy; conversely, they become overly pessimistic after market prices have fallen and then are anxious to sell.

If you realistically doubt your investment skills, then you are a delegator, someone who will rely on a professional to invest your hard-earned money for you. If that is the case, you should be looking for an investment manager who will listen to your needs and goals and implement an investment strategy that makes sense to you and for you.

In my opinion, and I’ve said this numerous times, you should only work with someone who has your best interests at heart – and that means someone who is a fiduciary.

The most common arrangement in working with a Registered Investment Advisor (RIA) is to pay an annual fee, which is based on a percentage of assets, though some financial advisors do work on a retainer basis.

If you are not clear on what fees you are paying, or if your prospective advisor cannot explain what fees you will be paying, you are most likely working with a stockbroker or insurance agent, i.e. someone who receives a commission. I cannot and do not recommend this approach for two simple reasons: It is not transparent, and there are possible conflicts of interest.

For most individuals, the investment management or retainer fee is well spent, because you will avoid the costly mistakes that most investors make. Since the manager will be both an implementer and a behavioral coach, it is crucial that you understand and accept his or her investment philosophy.

Trusting someone to manage your personal investments is one of the most important decisions you will ever make. Here are two books I recommend that you read in preparation for your search for an investment manager.

Simple Wealth, Inevitable Wealth (3rd Edition) by Nick Murray

Wise Investing Made Simple by Larry Swedroe

Notice that both books have the word “simple” in the title, but don’t let that mislead you, investing is not a slam dunk. As Warren Buffet is quoted as saying, “Investing is simple, but not easy.”

Choosing a Financial Advisor, Part 3

“Fiduciary – A Financial Advisor held to a Fiduciary Standard occupies a position of special trust and confidence when working with a client.  As a fiduciary, the Financial Advisor is required to act with undivided loyalty to the client.  This includes disclosure of how the Financial Advisor is to be compensated and any corresponding conflicts of interest.” – Focus on Fiduciary.

In a previous post, I said that, when looking for a financial advisor, you want someone who puts your interests first, i.e. a fiduciary.  This merits further discussion.  By way of example, lawyers, trustees or doctors are considered fiduciaries. On the other hand, stock brokers, insurance agents and registered representatives are not.

According to the National Association of Personal Financial Advisors (NAPFA) web site, Focus on Fiduciary:

Federal and state law requires that Registered Investment Advisors are held to a Fiduciary Standard.  This law requires that an advisor act solely in the best interest of the client, even if that interest is in conflict with the advisor’s financial interest. Investment Advisors must disclose any conflict, or potential conflict, to the client prior to and throughout a business engagement.  Investment Advisors must adopt a Code of Ethics and fully disclose how they are compensated.

Because broker-dealers are not necessarily acting in your best interest, the SEC requires them to add the following disclosure to your client agreement.  Read this disclosure, and decide if this is the type of relationship you want to dictate your financial security:

“Your account is a brokerage account and not an advisory account.  Our interests may not always be the same as yours.  Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest.  We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”

If you see this disclaimer in your contract, you have been warned that you are not working with a fiduciary.  My question to you is, “Why would you even consider working with someone who has issued you this warning?”

After all, you engage a financial advisor to look after your interests. In my opinion, having a trusted relationship is not possible after you have read the warning quoted above.  Since commissioned representatives receive incentives for selling one investment over another, how do you ever know why someone recommends one investment product to you over another? How do you know what it is actually costing you?

I wholeheartedly agree with NAPFA’s conclusion:

NAPFA has always maintained that an advisor who is compensated solely through commissions faces immense conflicts of interest.  This type of advisor is not paid unless a client buys (or sells) a financial product.  A commission-based advisor earns money on each transaction—and thus has a great incentive to encourage transactions that might not be in the interest of the client.  Indeed, many commission-based advisors are well-trained and well-intentioned. But the inherent potential conflict is great.

I believe that a strict fee-only approach is the best way of working with clients.  I want my clients to consider me as a trusted advisor and true partner, not a salesperson.

To be continued.

photo credit: Rui Almeida (Portugal)

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