When a Firm Handshake and Nice Smile Isn't Enough: How to Get Good Advice and Avoid Getting Ripped Off

Posted by Alex Frey (@alexhfrey )

In the 2000 movie "Boiler Room," Seth Davis is a 19-year old college dropout who joins a New York brokerage shop in order to strike it rich and make his father proud. Along the way, Seth learns how to cold-call the Wall Street way, and finds he is actually pretty good at getting people to part with their cash. In one famous scene, he exhorts his client Harry to buy 100 shares of a fraudulent company, earning himself a huge commission even though the stock promptly plummets in value and wipes Harry out. 

While the movie is a dramatized work of fiction, it is at least loosely based on two years worth of interviews with numerous brokers, and it contains more than a grain of truth to it. The main reason that Seth ended up bankrupting Harry is that Harry thought that of Seth as an advisor looking out for his best interest, when in fact Seth was just a salesman that was being paid to push a product. 

This fundamental distinction still exists today. "Investment Advisers" fall into three different categories, and whether the person you are dealing is a true advisor who has your best interests at heart, or a salesman being paid to sell you a specific product, depends totally on which category of "adviser" you are talking too. 

Registered Investment Advisors (RIA)

RIAs are nothing like the brokers featured in Boiler Room. Registered Investments Advisers are investment advisers (IAs) that are registered with the Securities and Exchange Commission (SEC). RIAs are subject to extensive Federal legislation that demands that they show what is called a fiduciary duty to clients. This means that RIAs are legally and professionaly obligated to act in the best interests of the client at all time. RIAs have to place the client's interest above their own.

RIAs are usually paid an annual fee quoted as a percentage of the assets that they manage or advise the client on. This frees them from any conflict of interest and allows them to make unbiased recommendations to the client, since they will make the same amount of money no matter what product they put clients into. 

Full-service brokers (may also call themselves investment consultants or investment advisers)

The majority of those who call themselves "advisers" are not RIAs, but "traditional" Wall-Street brokers featured in movies like Boiler Room (see below for a not safe for work example...). Brokers used to make their money just like the clip below portrays - calling up wealthy midwesterners and pitching them stocks, usually ones that their brokerage company needed to unload.

Thanks to poor press, brokers today like to play down the "broker" title and have re-fashioned themselves as "investment advsiers" or "investment consultants." However what distinguishes mere IAs from Registered Investment Advisors (RIAs), is that IAs are still legally and fundamentally salesman that are paid not by the client for providing unbiased advice, but by a product provider for generating a sale. This means that, unlike RIAs, brokers have no fiduciary duty to act in the best interest of their clients, even if their clients mistakenly believe that they are paying for unbiased advice. 

Many brokers have graduated from peddling individual stocks on the phone like in the clip above (though some still do). But many of them get paid from the mutual fund or insurance companies, whose products they exclusively will recommend. When you purchase a mutual fund, some companies charge what is called an upfront load, which means that they take up to 6% of your initial investment and give it to your broker as a reward for selling that fund to you. From your perspective, there is little or no reason to pay this fee, other than to give the broker a kickback, because other (and in some cases better) mutual fund companies offer plenty of no-load funds. Other mutual fund companies will pay brokers/advsiors what is called a "12b-1 fee", which means that a portion of the fees that you pay to the mutual fund company go to giving the broker a kickback, even if there is no load visible to you.

What all this means from a practical point of view is that you cannot expect to receive objective advice on financial products from a broker any more than you can expect to get an objective analysis of various vacuum cleaner models from a door-to-door salesman. 

The fact that brokers (and commission-based advisers) are compensated by the providers of the products that they are selling introduces clear and obvious conflicts of interest into the relationship with the client. If a broker wants to make any appreciable money, he or she is virtually forced to put clients into the funds that pay him or her the highest commissions, regardless of whether these are really the best choice for the client (and they usually are not, if for no other reason then their expenses are usually needlessly high in order to pay the salesman off). 

Dually-Licensed Advisers

To make matters even more confusing, many "investment professionals" that are going around calling themselves "Investment Advisers" (IAs) are dually-registered as both RIAs and broker-dealers. This means that they can actually "double-dip" by charging a percentage-of-assets fee for some products, and for taking a commission on other products. For instance, investment advisers from Northwestern Mutual will charge 1-1.25% of assets to manage a mutual-fund portfolio (which, by the way, has another 1% of fees tacked on top of it at the fund company level), and they will also earn a commission on the sale of any insurance products (which they push heavily). Expect regulation from the SEC in the coming years to clarify this very confusing issue, unless the brokerages' lobbyists manage to beat it back.  

To Avoid Getting Ripped Off, Know Who You Are Dealing With

Not every financial professional is evil, and it is possible to get good and unbiased advice. To ensure that you do not get ripped off, the key is to follow the money and follow the letters

To follow the money, learn how your adviser is making money (trust me, he or she is not working for free...) and what incentives this is creating. Bad incentives create a bad relationship. 

To follow the letters, find out whether your adviser is an RIA or just an IA, and what standard this holds them to. 

This stuff is important. Not everyone in finance is a bad apple, but a system that has the wrong incentives will inevitably produce a lot of bad apples, as honest people will find themselves at a competitive disadvantage and slowly get pushed out. 

If you are not proactive in seeking out honest advice, there are enough smooth-talkers out there that you will get taken for a ride. 


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By Alex Frey