Sadly for investors, Yogi Berra was right: It’s deja vu all over again. Recent problems with so-called derivative investments have just been the latest reminder that stockbrokers sometimes push products most small investors shouldn’t touch.
To be sure, a professional broker can be a valued guide to investment profits. But regrettably, more than a few salespeople put their own moneymaking interests ahead of their clients’.
Indeed, Securities and Exchange Commission Chairman Arthur Levitt Jr. says of the brokerage business: “There’s probably no industry in America that has more conflicts of interest.”
To help you protect your pocketbook, here are several questions that securities regulators and other experts say small investors should get answered by any broker they do business with.
– What’s your educational and professional background? While there’s no magic combination of education and experience, a broker’s answer to this question will help you gauge his or her level of knowledge and trustworthiness.
In the investment business especially, experience is vital. In fact, many industry observers contend that you should invest at most a small portion of your portfolio with a broker who has experienced the ups and downs of the securities business for less than four years. A broker who has been around for 20 years, on the other hand, will have weathered both bull and bear markets.
A broker’s work history also yields clues about competence. Be wary of stockbrokers who bounce from one firm to another every year or so. Bear in mind, however, that even outstanding brokers may jump ship every five years or so, lured by up-front bonuses or sweetened commission schedules.
Finally, call your state securities regulator and request a copy of the broker’s central registration directory file, or CRD. In Illinois, the phone number is 800-628-7937. The CRD lists complaints or disciplinary actions against a broker. Unfortunately, some states’ CRDs include only final actions, not pending complaints, which is the case in Illinois. You can also get a CRD from the National Association of Securities Dealers (800-289-9999).
– How much commission will you and your firm earn on this trade? To figure out whether your broker is truly on your side, advises John Markese, president of the American Association of Individual Investors, determine “whether the broker’s compensation is likely to bias his advice.”
In general, brokers collect the highest commissions on complicated and risky investments that require some effort to sell. For example, commissions run 6 percent or more on limited partnerships, which invest in speculative ventures such as oil wells or real estate, but less than 1 percent on plain-vanilla U.S. Treasury bonds and just 1 to 3 percent on actively traded stocks. Whatever the investment, the broker typically keeps 30 to 40 percent of the sales charge, while the brokerage house gets the rest.
If your broker recommends any type of investment that pays a commission of more than 5 percent, ask whether a less costly alternative could help you achieve the same financial goal.
– Will my transaction help you win a prize in a sales contest? Whether the prize is an expensive bottle of wine, a trip to Hawaii or a cash bonus, brokerage firms frequently use contests to encourage brokers to sell, sell, sell. Just because a broker is participating in a sales contest doesn’t mean that he or she doesn’t have your interests at heart-but it might.
“There’s generally nothing wrong with contests that encourage brokers to open new accounts,” says Mary Calhoun, a former broker who is now a securities arbitration consultant in Watertown, Mass. “But contests that reward brokers for selling a particular product, such as an annuity, are always detrimental to clients because brokers are tempted to sell one product to everyone, no matter what their real needs.”
An NASD proposal now under review would crack down on some of the worst sales abuses by barring mutual fund companies and insurers from offering brokers big prizes to sell their funds, insurance policies or annuities. But the rules would still allow brokerage firms to sponsor their own contests, as long as they didn’t reward brokers for selling specific mutual funds, annuities or other types of products.
– How long do you expect me to hold this investment, and what’s your reasoning? Because brokers earn a commission on every sale, they have an incentive to encourage trading. But you’re almost always better off with a buy-and-hold strategy. “In general, you’ll want to hold on to a security for at least a year so commissions won’t eat up your profits,” says David Shellenberger, a Boston attorney who represents investors.
To discourage your broker from churning your portfolio, ask him how long-and why-he expects you to hold each investment, then write him a letter confirming what he said. Having a written record will bolster your case if you’re forced to complain to his boss or to an arbitrator.
– Can I get my money out of this particular investment quickly? You should be able to count on an upstanding broker to tell you before you invest whether the product she’s recommending is especially difficult or costly to unload. For example, there may be few, if any, buyers for an individual municipal bond, an obscure over-the-counter stock or a limited partnership. “A lot of investors didn’t understand that partnerships are illiquid,” Shellenberger said. “You’re stuck with them for life.”
Other investments are easy but expensive to ditch. For instance, if you sell a mutual fund with a back-end load within five years of when you purchased it, you’ll get hit with a 1 to 5 percent sales charge. And annuities carry steep surrender fees of as much as 9 percent if you bail out before the contract expires, which can be as long as 13 years.
– Will I have to pay any account management fees? Commissions aren’t the only way that brokerages make a buck. Some charge you an annual fee just to maintain an account; others nick you if you fail to generate any commissions within a year. For example, Merrill Lynch charges $40 a year to maintain a brokerage account, and its annual fee on IRAs can climb as high as $100. Prudential and Smith Barney slap a $50 fee on accounts that have been inactive for a year, while PaineWebber levies the same charge after 18 months.
– What kind of service can I expect for the commissions I pay? If you’re paying for a full-service broker, you should expect to receive research reports on investments that interest you from the brokerage analysts or sources such as Standard & Poor’s, Value Line and Morningstar.
Just how often you’ll want to talk with your broker is something you should spell out at the start of the relationship.
Of course, full-service brokers don’t come without a cost. But if you enjoy plotting investment strategies with a pro-and find one you can trust-the service you get can well be worth the price you pay.
