From Alexander Efros, a list of 7 things your broker would rather not tell you:
“1. Brokers can legally put their interests ahead of yours. Most brokers operate under what is called the “suitability standard”, which simply means that the securities they recommend must be appropriate for you given your financial profile. However, many of the securities that can be considered “suitable” may be far from the best investment options available at a particular time.
You may be surprised to learn that brokers working under the suitability standard are not legally obligated to find the best prices or the best investments to help you accomplish your goals. As a result, your broker may offer you securities that provide lower returns and carry more significant risks than other alternatives as this can be more profitable for the broker. The suitability standard can apply to brokers that sell insurance, annuities, stocks, or other investment types.
2. Brokers can make money whether you succeed in the market or not. This is because of the commissions-based compensation model used by many brokerage firms. Let’s say your broker convinces you buy into ABC Corp. at $100 per share. If the price subsequently increases to $120, your broker may call and advise you to buy more of the same security because of the 20% appreciation in price. This transaction would then generate a commission for your broker.
On the other hand, let’s say the same $100 investment in ABC instead dropped to $80 per share. In this case, the same broker might still tell you to buy more of ABC because it is now less expensive than it was at the time of the initial investment, and therefore it should be considered a bargain. This transaction would also generate a commission. So as you can see, your broker’s success can have little relation to your own. This represents a misalignment of interests which may cause your broker to benefit at your expense.
3. Brokers may choose to offer you only those investments which pay the highest commissions. To illustrate this point, let’s consider another example. Let’s say Investment A is the best investment for you, but it offers no commissions to your broker. Investment B, on the other hand, is a worse investment which offers a 5% commission. Under the suitability standard, the broker is not obligated to offer you Investment A, and may instead sell you Investment B in order to collect the commission on the transaction. This conflict of interest is permitted under the suitability standard which is currently applicable to many brokerage firms.
4. The investments your broker sells may be illiquid or highly risky. It is often the case that brokers are associated with a particular issuer of securities or a certain investment company. These brokers may be limited to offering only the proprietary products sold by their affiliates, even though other more attractive investment options may be available in the market. They may be also be limited to a particular list of securities and may be paid more to offer one security over another at any particular time.
The fact is that investors have time and time again been sold products which are illiquid, non-marketable, highly risky, and lacking in transparency and disclosure. This manner of investing can often result in significant downside exposure which often leads to disappointing investment results.
5. Brokerage commissions may significantly erode your returns over time. If your broker charges commissions on a per-trade basis, then you may be paying more to your broker than you might expect. If you are charged a per-trade commission of 2%, then making just 3 trades per year could cause you to pay 6% of your total investment portfolio in commissions annually. This amount can significantly exceed the 1-2% annual management fees typically charged by Registered Investment Advisers.
6. Brokers may use deceptive titles to give you the wrong impression about their compensation model and/or qualifications.
The abundance of professional designations used by professionals within the financial services industry (e.g. ‘broker’, ‘financial planner’, ‘financial adviser’, ‘financial consultant’) is often confusing even to the most experienced investors. Nevertheless, having an understanding of the differences between these various titles could have a dramatic effect on your long-term results and overall satisfaction.
As an example, the term ‘financial adviser’ is one of the most commonly used terms in the business. However, many of the individuals using this title are salespeople working to meet quotas by selling financial products. They may, in some cases, sell non-marketable securities which require long-term commitments, excessive fees, and a high level of risk.
There are also ‘fee-based advisers’ who earn income both from management fees paid by clients and commissions earned from the sale of certain financial instruments, such as insurance or annuities. This blended compensation model may influence advisers to sell investments which generate high commissions but may not be most advantageous for their clients.
7. There are investment firms other than broker/dealers that may be better suited to your needs. With a broker, you are working with a salesperson who may or may not have your best interests in mind. On the other hand, Registered Investment Advisers (RIAs) are firms which operate under the fiduciary standard, meaning that they are legally obligated to put their clients’ interests first.
There are also firms known as Fee-Only RIAs, which operate under the same fiduciary standard, but differ in that they only accept compensation directly from their clients in the form of management fees. This helps to ensure that Fee-Only RIAs provide unbiased and objective investment advice without third-party incentives of any kind. For more information regarding a particular RIA’s compensation model, you may consult the firm’s brochure (also called the Form ADV Part II) which is typically available on the firm’s website or upon request.
What can investors do to ensure that their financial professional has their best interests in mind?
When choosing an investment adviser, investors should consider whether the professional they are dealing with is acting in a fiduciary capacity. If not, the adviser may be influenced by third-party incentives which can lead to disappointing investment results.
If choosing to work with a Registered Investment Adviser, investors can consult the brochure (also known as the Form ADV Part 2) to find out more about a particular firm’s compensation model, management, investment style, and any relevant disciplinary disclosures. The Form ADV can provide valuable information which can make it easier to compare different RIAs and choose the one best suited to your needs.
Furthermore, investors may seek out “Fee-Only” Registered Investment Advisers. Fee-Only firms typically receive no third-party compensation of any kind. As they are compensated only by their clients, these firms are able to provide reliable, objective, and unbiased investment advice.”