3030: 8 Secrets Your Broker Won't Tell You (and Why You Need to Know Them) by Jeff Rose of Good Financial Cents

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[00:00:51] This is Optimal Finance Daily. 8 Secrets Your Broker Won't Tell You and Why You Need to Know Them by Jeff Rose of Good Financial Cents.com. I have a little secret for you. Your broker might not have your best interests 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 your best interests ahead of yours.

[00:01:19] You can't get a speeding ticket for going 75 miles per hour 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.

[00:01:40] 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.

[00:02:03] As a result, your broker may offer you securities that provide lower returns and carry more significant risk 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. Number one, brokers make money even if you don't. This is because of the commissions-based compensation model presently used by many brokerage firms.

[00:02:33] Let's say your broker convinces you to buy into XYZ stock at $50 per share. If the price subsequently increases to $60, then 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 that same investment in XYZ stock instead dropped to $40 per share.

[00:03:01] In this case, the same broker might call you and still tell you to buy more of this same security because it's 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.

[00:03:26] This represents a misalignment of interest that might cause your broker to benefit at your expense. Number two, 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 one is the best investment for you, but it offers no commissions to your broker.

[00:03:51] On the other hand, investment two is a worse investment which pays 5% commission. Under the suitability standard, your broker is not obligated to offer you investment one and may instead sell you investment two 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?

[00:04:19] Number three, looks good on paper. Your broker may sell you an investment 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.

[00:04:46] They may also be restricted to a 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 was with a portfolio of a friend's 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?

[00:05:15] 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 a third of her portfolio into it. Number four, their commissions can eat away at 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,

[00:05:45] then making just three trades per year could result in you paying 6% of your overall portfolio in commissions annually. Number five, alphabet jumbo soup. Brokers may be using deceptive titles to give you the wrong impression about their compensation model and qualifications. Currently, the sheer abundance of professional designations being used within the financial services industry is confusing even to the most experienced investors.

[00:06:14] 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 salespeople looking to meet quotas by selling financial products. They may in some cases sell non-marketable securities,

[00:06:39] which include long-term commitments, excessive fees, and a high level of risk. Titles with the word senior, like certified senior advisor or 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.

[00:07:05] The only one that should in the financial planning profession is the CFP designation. Other notables are the CFA and CPA designation. Number six, I have a sales quota. I love when I get a statement from a competitor that's sponsored by a mutual fund or insurance company. The broker claims in them that they have their client's best interest at heart and can utilize all types of investment choices,

[00:07:32] except that the only investments I see are from that company's proprietary products. Hmm, now whose best interest is first? I assure you, not the client. Number seven, my record's clean, kind of. Your broker is not obligated to tell you if there's anything on his or her record. And why should they? It's reported that 70% of prospective clients do not do a background check on the broker before hiring them.

[00:08:00] And number eight, it could be better somewhere else. With a broker, you're dealing with a salesperson who may or may not have your best interests 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 clients' interests first at all times. You just listened to the post titled,

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[00:10:54] Rocketmoney.com slash OFD. While I really do enjoy articles warning about the downsides to working with brokers and financial advisors, I've also come to realize that not everyone has an interest in managing their own investments. And it can be intimidating to come up with your own financial plan. I know it was for me once upon a time. I don't personally work with a financial advisor because I enjoy reading about this stuff and doing it myself. But if that's not you, it's okay.

[00:11:24] You can still take control over your finances and work with someone else without paying high assets under management fees or commissions. There are really helpful robo-advisors out there like Betterment, M1 Finance and Wealthfront that can provide similar assurances as a financial advisor at a much lower cost. And if you decide that you'd prefer to work with a human, I highly recommend that you consider a flat fee advisor.

[00:11:53] This is different from fee-based, fee-only, or commission-based advisors because most of the time they don't manage your investments for you. They're also really hard to find because only 3% of all financial advisors offer a flat fee model for compensation. They basically work with you on the financial plan and show you how to implement that plan yourself. And you're paying them a flat fee for their time and their knowledge.

[00:12:22] I'm likely going to use a flat fee advisor to double-check my drawdown strategy from my portfolio as I approach early retirement. And that should do it for today. Have a happy rest of your day and I'll see you on the Thursday show tomorrow, where your optimal life awaits.