This is a guest post from Bob Richards, the publisher of The Retirement Income Blog.
Your broker may seem like he wants to help you make money and odds are he does. Unfortunately, he works in a system that decreases the possibility he can help you.
Your Broker Does Not Give You the Best Advice
Your broker has positioned himself as your advisor, someone acting in your interest. However, this is not always so. If he works for a large firm, that firm issues his paycheck and he is beholden to that firm. Say he works for ABC Financial. Notice that he often recommends the mutual funds or annuities created by ABC Financial. This allows his firm to not only get a commission when you buy the fund but also fees for managing the fund. So even though there may be better-performing funds he can recommend, he is under no obligation to do so. His legal obligation is only to sell you what is suitable, not what is best. And he often recommends “packaged products” such as mutual funds, annuities, or wrap accounts rather than individual stocks and bonds. It is much easier for his firm to bury high fees in a packaged product.
You Broker May Not be Competent
In order to become a broker (now called financial advisors at many firms), one must take a test. The exam is like most exams—you memorize a bunch of information and then regurgitate it. The test is multiple-choice. Any intelligent 12-year-old can pass the exam. In fact, many brokers attend a 40-hour cram course the week prior to the exam as their only preparation. Furthermore, the exam tests knowledge about rules and regulations and almost nothing about what it takes to help you make money. From my experience as a former branch manager for a major brokerage firm, about 80% of the brokers know very little about the market or the investments they sell. The other 20% may have actually taken investment management, economics and finance classes in school but this is not a prerequisite for becoming a broker. Alternatively, the 20% who are knowledgeable may have educated themselves.
Your broker sells you offerings he may not understand. Investments come with a prospectus. I have never met a broker who read the prospectus of the investments sold. The way he often learns about the investments is by attending a luncheon given by a wholesaler (a sales person to sales people) who provides the sales talking points for the broker to incorporate in his pitch. Because the broker cannot distinguish between a “good” and “bad” investment, he generally sells what his firm recommends.
A Better Investment Professional
Very few investors realize that there are two types of professionals in the investment business. I have described so far a registered representative, the technical term for a stockbroker who sells investments and earns commission. There is another type of investment professional called a registered investment advisor. This person has obtained a license that permits him to give investment advice for a fee. He won’t sell you something and earn a commission (though some brokers and registered reps are both sales people and registered investment advisors via their firms). He will give you advice in return for payment. He is also legally responsible to you as a fiduciary. The definition of fiduciary duty:
“A fiduciary duty is the highest standard of care at either equity or law. A fiduciary (abbreviation fid) is expected to be extremely loyal to the person to whom he owes the duty (the “principal”): he must not put his personal interests before the duty, and must not profit from his position as a fiduciary, unless the principal consents.”
The way that most registered investment advisors work is that they manage your investment portfolio for a percentage of the assets for which they are providing advice (e.g. 1% of the portfolio value would be $1,000 annually on a $100,000 portfolio). Because of the way they are compensated, they have no motivation to sell you this stock, that stock, that mutual fund or this bond. Their motivation is to retain you as a client and to make your account grow. Only in this way can they make more money from you by helping you grow a larger investment nest egg from which they can collect their 1%. Yet others simply work hourly much like an accountant or an attorney or via a fixed retainer. Again, they have no incentive to sell you the product-du-jour as does a broker.
Advice for Selecting an Investment Professional
So here’s the advice I’d like to give every investor.
- Do not buy packaged products because unless you read the 80 page prospectus, you are likely being ripped off in terms of high fees.
- Buy individual stocks and bonds and no load mutual funds which you must buy on your own because commission brokers don’t sell them.
- Either deal with a registered investment advisor who will charge you fees and not commissions or you’ll need to learn enough about investing to do it yourself.
This is a guest post from Bob Richards, the publisher of The Retirement Income Blog.
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