SOURCE: Disciplined Growth Investors
MINNEAPOLIS, MN--(Marketwired - Aug 30, 2013) - If you're under the impression that your broker's top priority is to make you money, you need to take a closer look inside the mind of your investment manager, according to author Frederick K. Martin of Disciplined Growth Investors.
In his book, "Benjamin Graham and the Power of Growth Stocks" (McGraw-Hill), Martin explains that the financial institutions operate with three primary goals in mind:
1. To gather assets
2. To induce transactions
3. To improve the client's net worth
"Unfortunately," writes Martin, "the goal of improving the client's net worth is a distant third on this list and is subordinated to the first two goals. An individual who wants to develop and manage a successful investment program must recognize that financial institutions are not concerned about his situation."
Instead, brokers are more interested in generating transactions to pay their salary and institutions are concerned primarily with gather as many as assets as possible in order to collect as many fees as possible from their clients. "The best interest of their clients -- including the implementation of any new strategy that could improve the long-term returns for those clients -- often takes a backseat to their own priorities," adds Martin.
After all, the investment industry tends to attract people who are lured by the high wages and hefty commissions. Brokers earn their money by motivating their clients to make trades. Their clients' investment returns are often secondary to their own desire to generate commissions. In fact, at most brokerage houses, a broker's job is often contingent on his or her ability to generate trades.
Even the basic training for brokers typically revolves more around sales tactics than it does investment management. Brokers spend very little time learning to analyze stocks or research the market. Their company typically supplies them with a list of recommended stocks that they are expected to present to their clients. Their job is to persuade their clients to buy stocks from that list -- and later sell them to buy different stocks and generate more trades and more commissions.
"Taking a buy-and-hold approach and patiently waiting for the perfect time to invest in a stock contradicts the institutional imperative that inactivity is a bad thing," explains Martin. "Your clients think you're not working for them if you're not making any trades. They want to know, 'Why should I pay you for doing nothing?'In fact, that call to action is music to the ears of the transaction-based brokers. They can't earn if they don't churn. Trades are the lifeblood of their business."
A better choice for most investors who prefer using a professional to manage their money would be to find an experienced Registered Investment Advisor (RIA). RIAs typically assess their clients an annual fee in the range of 1 percent of assets under management to compensate them for their services. Their income is not tied to transactions so they are not driven to make pointless buys and sells to pad their revenue. Instead, it is in their best interest to see their clients' assets increase since their income is based on a share of assets under management.
The retail brokers are not the only ones who may put their own interests ahead of their clients. The managers of the big investment firms have also been known to push their inventory of unwanted investments on their unsuspecting clients.
"In the days leading up to the global financial meltdown of 2008, there were reports that some Wall Street firms were instructing their brokers to ramp up the sale of mortgage-backed securities," says Martin. "But they weren't pushing the sale of those securities because they believed that this was in the best interest of their clients. They were pushing them because the mortgage market was on the verge of collapse and they had a vast inventory of highly leveraged mortgage-backed securities that they needed to unload. They were trying to minimize their losses and save their businesses by dumping those securities onto their unsuspecting clients before the bottom fell out of the market."
Mutual funds are the other big player in the battle for assets of the retail investor. The more assets they can gather, the greater revenue they will generate through various fees. Martin contends that mutual fund investors don't always get their money's worth.
He points out that the Fidelity Magellan Fund earned an average annual return of just 1.09 percent for the 10-year period from 2001 to 2011. It assessed an expense ratio of 0.75 percent. Although that fee is fairly low by mutual fund standards, it was still no bargain for the investors. With a 0.75 percent fee, investors in the fund received about 60 percent of the return from Magellan during that period, while the mutual fund company received nearly 40 percent. "This does not seem like much of a deal to me," said Martin.
Certainly many investors have enjoyed investment success with mutual funds and retail investors, but it's important to understand the motives of the people who are selling you investments -- and those motives are geared more to making them money than making you money. If you're dealing with a broker or a mutual fund company, the best advice is to maintain a healthy degree of skepticism and keep both eyes wide open.