I have a little secret for you.
Your broker might not have your best interest in mind when they make recommendations to you.
In fact, brokers can legally put their interests ahead of yours.
Did you catch that?
Translated that means that your broker can get a speeding ticket for going 75 mph on the interstate, but won’t get punished for selling you a crap investment that makes them a bunch of money.
This is because most brokers operate under what’s called the suitability standard, which simply means 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.
How do you like them apples?
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 investment options available at a particular time. As a result, your broker may offer you securities that provide lower returns and carry more significant risks than other alternatives as this may be more profitable for the broker. The suitability standard can apply to brokers that sell insurance, stocks, annuities, or other investment types.
1. Brokers Make Money Even if You Don’t.
This is because of the commissions-based compensation model presently used by many brokerage firms. Let’s say your broker convinces you to buy into XYZ stock at $50 per share. If the price subsequently increases to $60, than your broker may call you 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 that the same investment in XYZ stock instead dropped to $40 per share. In this case the same broker might call you and still tell you to buy more of the same security because it is now less expensive than it once was and should therefore be considered a bargain. This transaction would also generate a commission for your broker.
Great for them. Not so much for you.
As you can see your broker’s success can have little relation to your own. This represents a misalignment of interests that may cause your broker to benefit at your expense.
2. High commissions are a good thing right?
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 that investment 1 is the best investment for you, but it offers no commissions to your broker.
On the other hand investment 2 is a worse investment, which pays 5% commission. Under the suitability standard your broker is not obligated to offer you investment 1 and may instead sell you investment 2 in order to collect the commission on the transaction. This conflict of interest is currently permitted under the suitability standard, which is applicable to many brokerage firms.
Isn’t that special?
3. Looks good on paper.
Your broker may sell you an investments that is illiquid or highly risky. This is due to the fact that brokers are often associated with particular issuers of securities or certain investment companies.
As a result they 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 also be restricted to particular list of securities and may be compensated to offer one investment over another at any time.
One of the worst examples that I witnessed this was with a portfolio of a friends mom. Her broker had sold her what he called a “safe investment” which was a limited partnership. While some limited partnerships could be considered good investments, this particular one was Medical Capital Holdings.
What’s the big deal about that? Well, this particular limited partnership ended up being a fraud and most investors lost everything that they invested into it. What makes the story even worse, is that this particular broker thought it was “suitable” to put over 1/3 of her portfolio into it.
4. Their commissions can eat away your returns.
If you’re paying commissions on a per-trade basis, you may be spending more than you might expect.
For example, if you’re charged 2% per trade, then making just three trades per year could result in you paying 6% of your overall portfolio in commissions annually.
5. Alphabet jumbo soup.
Brokers may be using deceptive titles to give you the wrong impression about their compensation model and qualifications. Currently, the shear abundance of professional designations being used within the financial services industry is confusing even to the most experienced investors. However, understanding the differences between these titles could have a dramatic effect on your long-term investment results and overall satisfaction.
As an example, the term financial advisor is one of the most used terms in the industry; however, many of the individuals using this title are sales people looking to meet quotas by selling financial products. They may in some cases sell non-marketable securities, which include long-term commitments, excessive fees, and a high level of risk.
Titles with the word “senior” — Certified Senior Advisor (CSA) and Certified Senior Consultant (CSC), for instance — have come under a great deal of scrutiny. I get offers in the mail all the time to buy designations. Don’t let the alphabet soup impress you. The only one that should in the financial planning profession is the CFP® designation. Other notables are the CFA and CPA designation.
6. I have a sales quota.
I love when I get a statement from a competitor that is sponsored by a mutual fund or insurance company. The broker claims to them that they have their clients best interest at heart and can utilize all types of investment choices, except that they only investments I see are from that companies proprietary products.
Hmmm……now whose best interest is first? I assure you not the client.
7. My records clean….kind of
Your broker is not obligated to tell you if there’s anything on his or her record. And why they should they? It’s reported that 70% of prospective clients do not do a background check on the broker before hiring them.
Want to make sure that your broker doesn’t have a record like Bernie Madoff? Head over to FINRA BrokerCheck to see what’s on your brokers record.
8. It could be better somewhere else.
With a broker you’re dealing with a sales person who may or may not have your best interest in mind. On the other hand, registered investment advisors, also known as RIAs are firms which operate under the fiduciary standard, which means that they are legally obligated to put their client’s interests first at all times.
As an independent registered investment advisor, Alliance Wealth Management, LLC was founded as a welcome alternative to the traditional brokerage model so many investors have become accustom to. We are compensated only by management fees paid directly by our clients.
How do you pay you broker? If you don’t know, maybe it’s time to find out.