Your stock broker ain’t no friend

MUMBAI: “The broker is not your friend. He is more like a doctor who charges patients on how frequently they change their medicine”
—Warren Buffett

The guys who really know what is happening in the stock markets either make a living out of it or regulate it. And there are very few individuals who would fall in both the categories.

Arthur Levitt, former chairman of the US Securities and Exchange Commission (SEC) is among the few who actually have earned a living out of the stock markets as well regulated it.

Levitt first became a broker way back in 1963 and rose to become the SEC chairman three decades later. He was at the helm at SEC for 12 years, which made him its longest serving chairman, too.

After retirement, Levitt wrote a book titled Take on the Street - How to Fight for Your Financial Future with Paula Dwyer, where he revealed the inside secrets of how stock brokers on Wall Street fleece the retail investors who buy and sell stocks through them.

“If they have it, sell it. If they don’t, buy it. That was the whispered joke on Wall Street in 1963 when I joined the brokerage firm of Carter, Berlind and Weill. It was only half in jest….

Brokers may seem like clever financial experts, but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in accounts they manage.

They want you to buy stocks you don’t own and sell the ones you do, because that’s how they make money for themselves and their firms. They earn commissions even when you lose money,” writes Levitt.

“Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc and one of the smartest investors I’ve ever met, knows all about broker conflicts.

He likes to point that any broker who recommended buying and holding Berkshire Hathaway stock from 1965 to now would have made his clients fabulously wealthy.

A single share of Berkshire Hathaway purchased for $12 in 1965 would be worth $71,000 as of April 2002. But any broker who did that would have starved to death,” writes Levitt.

There are a lot of problems plaguing the entire brokerage industry. Levitt feels brokers are “good people stuck in a bad system, whose problems remain fourfold.”

As he writes, “First, some brokers are not trained well enough for the enormous tasks they are expected to carry out. Second, the system in which brokers operate is still geared toward volume selling, not giving objective advice.

Third, to increase sales, firms use contests to get brokers to sell securities that investors may not need.....Fourth, branch-office managers and other supervisors, who are paid commissions just like their brokers, have an incentive to push everyone to sell more and to turn a blind eye to questionable practices.”

Largely, the broker gets a certain percentage of the commissions he generates by making his clients buy or sell stocks. But, there are other commission structures in place as well.

One popular form of compensation is the grid system. “Typically, brokers receive a percentage of the commissions that they generate, ranging from 33% to 45%.

As their commission sales increase, they can jump to a higher payout level on the grid. Imagine it’s December 27. Your broker’s payout rate is 33%.

He has generated $470,000 in commissions so far this year. But if he gets to $500,000 by December 31, his payout rate jumps to 40%, applied retroactively.

This means your broker can earn a windfall of $44,900 in additional compensation by just generating $30,000 in commission sales in four days,” writes Levitt.

In such situations, the chances of a broker selling the investor the wrong stocks are much greater.

Another situation where an investor has to be careful is when he has moved with his broker to a new stock broking house.

When a star broker moves from one broking house to another, chances are that he has been paid a large upfront bonus. At times, this bonus can be equal to or even greater than one year’s salary.

“This sum is paid on the presumption that the broker will bring his customers with him to the new firm by telling them “the big lie” - that his new firm offers better customer service and more sophisticated research.

The broker, of course, never reveals that the new firm is paying him a huge bundle to move. In such cases, customer accounts are bargaining chips that brokers use to increase their personal wealth, not their customers’.

Once a broker moves to a new firm, he must produce. And that means, the broker is more likely to push unwanted or unheeded products, especially those paying higher commissions,” writes Levitt.

Other than this, brokers who switch firms ‘get what is known as an accelerated payout’. As Levitt points out “This means that instead of the normal 33% to 45% of the gross commissions on every trade, the broker receives 60% or more of the commission for several months, or several years.

The justification for enriched payouts is that brokers who jump to a new firm will be preoccupied for months with administrative details involved in account transfers and helping to orient clients at the new firm, leaving little time for salesmanship.

But the reality is that such payouts boost the broker’s incentive to meddle in client accounts and increase the volume of trading activity.”

So what is the way out for a retail investor? “If you have less than $50,000 to invest, you don’t need a broker.

The strategy that makes the most sense is investing in low cost mutual funds, especially index funds that match the performance of a stock index… If you have more than $50,000 to invest, you should fire your broker and find an investment adviser,” writes Levitt.