Love her or hate her

Despite how you personally feel about Suze Orman she probably does more good than harm. As a financial professional, I will begrudgingly admit that I have, on occasion, enjoyed listening to her and have even caught a glimpse of her on TV. Shhh - don't tell anyone. You simply cannot deny that she has a tremendous reach and I suspect her impact on improving overall financial literacy ranks her in the top five. However, I have heard that she told her listening audience that the stock market was too risky and she did not trust it for her long-term money. Whoa - hold on a second!

I think we need to clarify this a bit. Yes, the stock market is risky and, yes, it is not for everyone, however, the investment risks associated with the stock market are less so than the risk of significantly reducing the purchasing power of your savings and outliving your assets! Let me give you a very simply example. If you wanted a nearly risk-free investment you can expect to earn about 4% a year on average (higher or lower depending on current market conditions). If the average annual inflation rate (increased costs of goods and services) is approximately 4% how much are you really making? I am no mathematician, but that would be approximately ZERO! What about bonds, you ask? Well, since you are assuming a bit more risk than money markets, CDs, and other cash equivalents Bonds tend to fair better over time. On average the bond market has returned about 6% on average per year which helps out pace the ugly head of inflation by some (see Templeton Financial Services Blog). Investing in the stock market does not come with risks, however, it still remains on of the best inflationary hedge there is. Even those nearing or in retirement should have a decent portion of their portfolio in stocks/equities. Many people are living 20-30 years in retirement and inflation plays a big part. The key is to manage risk and find ways to obtain most if not all of the potential return/rewards of the stock market with the least amount of risk. Certainly one way is to lime exposure to you the market by having a mix of stocks, bonds, and cash appropriate to your situation. In addition, diversify your assets to include large cap, mid and small cap, and international as a way to mitigate risk. Overall, however, I think Ms. Orman misses the mark when suggesting people avoid the stock market all together. To achieve the necessary growth and to out pace inflation, stocks are necessary in everyone's, young and old, portfolio. Smart strategies and risk management, however, remain paramount.

Merrill Lynch Rule

Have you heard of the Merrill Lynch Rule? Have you heard of Merrill Lynch? For the most part, the ruling has a lot to do with industry standards and regulations that protect the public. The financial industry is not as transparent as one would think. Knowing what kind of advice you are truly getting is difficult. For your reference here is a few answers to some common questions.

What is the difference between how brokers and fiduciary registered investment advisors are regulated?

The public is protected in two very different ways from any malfeasance by these professionals. Brokers must submit to what is called "compliance," which basically means they have to "comply" with the rules governing their sales activities. Meaning? For instance, that means if they recommend a mutual fund that is owned and operated by their firm, and which pays them an extra commission, they have to make sure that this is disclosed somewhere in the fine print of the many documents they give to the customer. Registered investment advisors are held to a fiduciary standard, which basically means that they have to put the customers' interests ahead of their own or that of the company they work for.

Brokers will tell you that they have to comply with so many rules that their protections are better, but this argument is seriously weakened by all the scandals that brokers have been involved in over the years. Anybody who reads the papers the last few years knows that this "compliance" standard somehow didn't stop the brokerage firms from having their research departments recommend initial public offerings even though they knew they weren't sound, or the brokers from recommending them to customers. It hasn't stopped brokerage firms and insurance companies from misleadingly selling variable annuities and life insurance contracts as retirement plans.

In fact, under this compliance regimen, there have been so many problems with customers that 36,379 different arbitration claims have been filed against brokers and their firms over the five years ending December 31, 2006.

Why are brokerage firms fighting so hard against having to act as fiduciaries?

The brokerage business model is founded on what we in the profession call "conflicts of interest." The company manages its own in-house mutual funds, which charge above-average fees--AND the company's brokers recommend mutual funds to their customers. (Guess which ones often come highly-recommended?)

The company sells initial public offering shares to the public AND the company's brokers recommend that their customers buy IPO shares. (How many tell their customers that these are often poor investments right out of the gate?)

The company has its own life insurance subsidiary AND the company's brokers recommend that their customers buy life insurance coverage.

The company owns stocks, just like other investors, in its own investment account AND the brokers recommend stocks to their customers. (Is it possible that the brokers are told to recommend stocks that the company wants or needs to dump because the analysts have discovered a problem with the company's earnings?)

If brokerage firms were held to a fiduciary standard, instead of a lot of paperwork requirements, all of these recommendations would be examined in light of whether they really were best for the customer. Every expensive in-house fund recommendation, every IPO recommendation, every piece of advice regarding insurance or stocks would have to primarily benefit the customer, not the broker or the brokerage company's bottom line. Brokers would be forced to recommend the better (often no-load) investments, and the company's in-house products would languish.

AND these companies would be required, by law and by the SEC, to fully-disclose their conflicts of interest in plane language to their customers--who would, of course, have a strong hint that they're being sold something that is less than ideal for their situation. That's why the brokerage firms see this fight as a life or death struggle.

Is there a solution that would allow the brokerage firms to survive, but still offer adequate protection to the public?

The brokerage firms, in their advertisements and in their sales pitches, are slyly positioning themselves as financial advisory firms, making it seem as if they're giving independent advice. The traditional brokerage role has been to sell investments and insurance to customers who were fully aware that they were involved in a sales process, or get people to buy or sell a stock or bond in return for a commission.

One uncomplicated solution would be to have the brokerage firms publicly acknowledge that their brokers serve in a sales capacity, just like the people who work at car dealerships--and you should no more expect them to sell you a low-cost mutual fund than you would expect a person working at a Ford dealership to tell you that the Toyotas down the street are better cars for the price.

The solution is to make them stop pretending to be something they're not. It really is that simple.

Is there an easy way for a consumer to know whether a "financial advisor" is held to a fiduciary standard or not?

The easiest thing to do is ask the person if he or she is a registered investment advisor or is registered with the SEC. If this person says that "a division of the company is registered," that means that he or she is probably not held to that standard, and can recommend awful investment products, so long as they fill out the right paperwork.

You could also ask if this person is willing to be held to a fiduciary standard in his or her recommendations, and whether he or she would be willing to put that in writing.

In addition, you could look at the name on the door. If the "financial advisor" works for a large brokerage firm, the way things stand now, that person is not a registered investment advisor.

One last question: why did the SEC allow brokers to be exempt from the fiduciary rules in the first place?

There's a very long answer to this, but the short answer is that brokerage firms have an exemption from registering as registered investment advisors, in the Investment Advisers Act of 1940, but only if their advice is solely incidental to their brokerage activities (which was selling investments and clearing stock and bond transactions) and only if they were not receiving special compensation for their advice (meaning advisory fees).

With the rise of the discount brokerage companies, the business of handling stock and bond transactions has become much less profitable--essentially a break-even business. It looks like the SEC was trying to give the brokerage firms a little time to evolve their businesses toward more of an advisory model, to make their money on fees rather than on transactions or selling in-house products.

Unfortunately, the brokerage firms decided, instead, to charge fees AND sell in-house products--to try to have the trust of a fiduciary, but still be free to make profitable or conflicted recommendations.

As the Appeals Court said in its ruling, the brokerage firms were never intended to have it both ways:

"A fundamental purpose, common to these statutes, was to substitute a philosophy of full disclosure for the philosophy of caveat emptor, and thus achieve a high standard of business ethics in the securities industry..."

Why should investors voluntarily settle for anything less than full disclosure and advice that is designed to benefit them?

Why indeed.