In his book, "5 Lies About Investing," CEO Eric Ball explains that investment "pros" often don't measure their success by your results. Read this important excerpt:
I mentioned in my introduction that I began my career as a securities analyst for a regional brokerage firm. The firm is no longer in existence. It had been managed by people who could best be described as “old-timers” and it was sold several years ago for a mere fraction of what other similarly-sized firms were worth—mostly because it hadn’t generated similarly-sized revenues. That’s one reason I consider it to have been a reputable firm. Management wasn’t fixated on inventing new ways to separate its customers from their money.
During my second year (of three) that I worked there, someone decided that I should take time each Friday afternoon to discuss the concepts of investing with new brokers. I was glad to do this and the meetings were well attended. After a couple of months, though, I noticed that a few of the newer brokers had never joined the group. I made it a point to discuss this with the brokerage’s office manager.
Investment pros are judged by their “production”
I asked the manager, who was responsible for supervising the firm’s “investment executives” (sometimes called advisors, consultants or brokers), what I could do to encourage them to participate in our training sessions. He smiled and walked me out of his office towards a large poster hanging in the midst of the brokers’ cubicles. Then he asked me to look at the display. It was a bar chart showing commissions generated by each of the firm’s brokers against a goal—an amount which guaranteed them the right to go on a group trip to Mexico. He said, “Every minute they spend with you is a minute in which they’re guaranteed not to earn a commission. You might think that you’re helping them in their careers, but really, prospecting for new customers is what helps them the most.”
I went back to my desk embarrassed. I hadn’t recognized that my sessions were costing my fellow workers real money. But then I remembered that my emphasis had been on helping the firm’s customers reach their goals. I felt that if our clients would achieve strong returns in their portfolios, their brokers would also benefit. Some of them (as well as their supervisor) did not agree and probably for good reason: Brokers are not evaluated (or compensated) by the investment performance of their clients; they are measured solely by the amount of commissions that they generate. This was true even at our old-line firm. The primary role of any investment executive was to produce revenue for the firm. In fact, the best brokers earned the title “big producers.”
What it takes to become an investment “pro”
Skeptics may think that the answer to what it takes to become an investment professional is an EKG that shows a heartbeat. That’s not entirely true. First, you need a brokerage firm to sponsor you so that you can get licensed.
It is impossible to obtain a license to sell securities without one of these firms sponsoring you. Brokerages have created an industry trade group (usually described as a self-regulatory organization) called the Financial Industry Regulatory Authority (FINRA and formerly called the National Association of Securities Dealers). The US Securities and Exchange Commission allows this trade group to set the standards for licensing. And the SEC requires that an individual have some sort of securities license before he or she deals in securities with the public.
When I arrived at the brokerage firm, my first assignment was to obtain my General Securities Representative (Series 7) license. I was told to register for the test which was to be given two weeks later.
I had never worked for a brokerage firm before, let alone walked into one. I had no clue as to what the rules and regulations were—and if you had asked me about such crazy things as margin limits and ex-dividend dates for stock splits, I wouldn’t have known how to answer. But I was given an already-used workbook to study and told that all I needed to do was to score 70% in order to pass the test. I got some encouragement from the fact that a 70% was the lowest grade eligible for a “D” at my college and I figured that I had at least a chance to achieve that score. Two weeks later, I took the test and scored in the 90’s. I asked our human resource officer for information on the state licensing (Series 63) test and she assured me that I did not need to study for it at all. She was right; I passed it on my first try.
I don’t say this to boast, I say this because I have never met anyone who has not (at least eventually) passed these tests. In fact, the only person I ever heard not to pass was a former professional athlete who figured in a humorous chapter of the firm’s folklore.
But what I’m not saying is that just anyone can get a securities license. In order to be sponsored by a firm to take the test, you need to get hired. In order to get hired, the firm wants to ensure that you will “produce.” A securities firm will generally make a prospective broker take a psychological profile test in order to determine the candidate’s suitability for sales. In reality, this is the most difficult test to pass in order to become an investment pro. If you pass, the firm will likely send you to an exam preparation school in order to train for your licensing exams. (Since analysts aren’t producers, I didn’t get the same treatment).
It’s safe to assume that the same values hold in the annuity, life insurance and mutual fund businesses. The measure of an investment “pro” is the commission revenue he or she produces; it is not the portfolio returns earned by his or her clients. In fact, you might be tempted to say that the “pro” in “investment pro” stands for “producer.”
Modern variations of investment “pros”
What about financial planners? They often describe themselves as being “fee based.” I find this term to be extremely misleading as well as offensive because it means something opposite to what many people think. It means that the planner charges a fee for his or her services and also receives commissions on the products he or she recommends. Basically, the planner is a broker who tacks on another fee. Many of these planners go into business for themselves so that they can keep more of the commissions they generate. They are big producers for themselves.
You can often tell if a financial planner is also a broker by looking to see if his or her advertisement has a sentence that begins with “Securities offered by…” That’s a sure tip-off that the planner has contracted with a firm who specializes in working with independent brokers interested in maximizing their own commission revenue. Often the planner can keep as much as 75% of the commissions earned on stock transactions and 90% of the fees earned on annuity and mutual fund sales. Brokers who work for traditional firms often keep less than 35% of commissions earned. Combine the higher payouts (percentage of the commission kept by the broker) with a planning fee and you can see why this is such an attractive route for many brokers.
If you think that my view is jaundiced, you need to keep reading.
One of the more successful financial planners in my area advertises that his firm offers a “personalized approach to wealth planning, accumulation and preservation.” It would appear that he is very customer-focused. Yet the very same planner operates a sales training company whose stated goal “is to empower financial advisors to achieve the business and quality of life they desire by offering proven tools and innovative programs that ignite their burning desire to succeed!” In the company’s literature, he is described as a “multi-million dollar practicing producer.” (In fact, his bio claims that he makes over $7 million a year.)
This planner also is a member of a speaker’s bureau. For a stated fee of $10,000 to $15,000, he will speak on “The Secrets to Becoming a Million Dollar Success,” where he reveals to other financial planners the recipe that helped to make him a multi-million dollar producer so that they, too, can increase their income.
I believe that this planner truly has achieved success as an “investment pro.” He began his career selling insurance and annuities and became very successful when he adopted the “fee based” financial planner model. For many years, he has been the top broker of one of the “securities offered by…” firms. It certainly has worked for him. He boasts of taking one week off a month and spending as much time as possible working at home and playing golf. I’m not sure, however, that being his client would be so comfortable—especially since this man’s clients are the source of his multi-million dollar earnings.
The more things change…
Fred Schwed recounted a story of a visitor who “was being shown the wonders of the New York financial district” over a century ago. “When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, ‘Look, those are the bankers' and the brokers' yachts.’ ‘Where are the customers' yachts?' asked the naïve visitor.’” The implied punch line, of course, is that there weren’t any.
The truth has always been that too many investment pros measure their success by the size of their take.
Since you, however, are interested in growing your portfolio, you need to take preemptive action before you work with an investment “pro.” First, ask how he or she is compensated. Does the agent receive commissions? Does the agent receive payments or bonuses when a security transaction is made? Does he or she participate in contests that reward the agent for the number and/or size of transactions? How are fees calculated? Does the firm send a bill that shows an accounting of these fees before they are paid? Similarly, ask for an explanation of all the fees and commissions you will be responsible to pay. In order for an advisor to place trades, commissions will have to be paid to someone—check to see if the advisor will use a discount broker which can save much in transactions fees. What you’re looking for is a firm whose interests are best aligned with yours, or at least one whose financial motivation does not encourage the agent to act as a speculator rather than an investor.
Secondly, ask who the primary regulator is of the firm’s business. Brokers will be primarily regulated by the Financial Industry Regulatory Authority (FINRA). Insurance firms are regulated by the state insurance authorities. Firms and brokers who are subject to FINRA regulation or to state insurance authorities are often not subject to the same fiduciary standards as investment advisors.
Small investment advisers (less than $100 million of client assets) are regulated by state investment or banking departments and larger ones are regulated by the Securities and Exchange Commission. These advisors are called a “Registered Investment Adviser,” and must adhere to a fiduciary standard of care laid out in the US Investment Advisers Act of 1940. In each case, ask to see the firm’s disclosure document, which will show information required by the regulator and possibly any negative issues they might have with the firm.
Finally, ask the representative to describe the firm’s investment philosophy. It should be a simple and to the point description of the process of investing. Remember that most people are not investors, but are speculators. If he or she does not clearly describe a philosophy of investing, you need to look elsewhere.