It is important for investors to understand what your investment professional stands to gain for a particular recommendation or strategy. It is hard to imagine that an investor needs to be so vigilant, but considering how many different ways investment professionals take advantage of investors, investors need to understand the motivation for a particular recommendation.
The most obvious area for misconduct is when an investment professional recommends an active trading strategy where the investor relies upon the investment professional’s stock picks. Despite countless studies that demonstrate that passive investment styles such as indexing outperform active trading strategies, certain investment professionals still recommend active stock picking. Most reputable brokerage firms have compliance procedures in place to prevent your broker from churning your account, however, smaller broker dealers tend to have less supervisory safeguards. The most prudent step to take if an investment professional recommends an active trading, commission based strategy is to find a new investment professional. However, you can also ask that your account be converted to a fee-based account, otherwise known as a wrap account.
Wrap accounts have grown over the last decade because brokerage firms have been subjected to substantial arbitrations filed by investors who suffered significant losses due to excessive commissions. Investors in wrap accounts tend to pay a flat 1% fee for unlimited trades. If a broker that is recommending an active trading strategy is unwilling to execute the trades through a wrap account, then the motivation is certainly the commissions. Wrap fee misconduct, however, is usually the opposite of churning, where an investment professional does very little managing to justify the 1% fee. Retirees with large balances are the most susceptible to such misconduct. Retirees are much less likely to enter a significant amount of trades, so the 1% fee may actually be over charging them for what they receive. Having an in-depth understanding of what your investment professional will provide for the 1% fee each year is important. This lets the investment professional know that you are paying close attention to your savings.
Investors should also beware when an investment professional tells you there is no fee or commission associated with the transaction. This should be a huge red flag that the payout is built into the price. Private placements, structured products, REITs, reverse convertibles, IPO’s, new issue preferred stocks, variable annuities, and even bonds are likely to have a fee to the investment professional packaged with the deal. This doesn’t mean that you investment professional shouldn’t get paid for his advice, but it is important to understand the motivation behind the recommendation. The best investment for the client is very likely something with low fees or commissions added to or built into the price. Conversely, a REIT that pays your investment professional 5% of the investment is likely not what is best for you.
It is imperative for you to have an investment plan with your advisor with documented goals, periodic meetings to adjust according to any changes in your life, or the markets, and a full understanding of what you will be paying as far as fees and commissions.