We would all love to have someone we can trust with our money. Someone who can be there to safeguard our portfolios and always have our best interest in mind. A person would typically look to his investment advisor or portfolio manager for that. However, human nature still prevails in any aspect of business and finance. That’s why there are regulatory bodies and trading rules set out to protect investors.
It can’t be all based on “trust.” Actually, there are a lot of cases where the person the investor trusts the most, like his friend or relative, ends up being the one who does the greatest damage to his portfolio. This is mainly because familiarity erodes the arm’s length nature of the deal. Typical control procedures – such as documentation and monitoring are foregone in favor of “trust.”
However, the responsibility to safeguard your assets rests primarily with you. You cannot completely entrust your financial affairs with your broker or advisor. In the end, it’s still your money, not theirs.
This article lays out common infractions in trade execution that are committed by brokers and investment advisors. Investors need to be aware of these so that they can take measures to prevent them and protect their trades and portfolios.
So what are these infractions?
- Failure to deliver best execution. Brokers and dealers are required to always have the best interest of their clients in mind. When you call your trader and ask for him to sell your shares of stock for a certain price “or better,” he is obligated to give his best efforts at selling your shares for the best price available. For example, you asked him to sell your 10 shares at a price of $2 or better, because the stock was doing $2 at that time you called. However, 2 seconds later and before the trader executed your sell order, the bids went up with great volume to $2.90. The trader should sell higher than $2 because that is the “better”price. If the trader decided to still sell at $2, then he failed to deliver best execution for you. To ensure that you get the best execution, it would be best if you are looking at the real-time price movements as you call your trader. If you can stay on the phone until your trade is executed, much better.
- Churning or excessive trading. Your broker earns money from commissions on your trades. Regardless of whether you gain or lose on the trade, he earnsa commission – computed as a percentage based on the gross dollar amount you buy or sell. A natural conflict of interest arises because of this income arrangement. It is in your best interest to make a winning trade. That’s how you earn your income. However, your broker’s interest is that you trade as much as possible, irrespective of whether it’s a win or a lose. The more the total amounts you buy and sell, the higher his commission goes.Regulatory bodies seek to protect the investor by setting rules against this tendency for a broker to trade excessively for the purpose of generating commissions. However, this is one risk you face, particularly when you open a discretionary account with your broker.
By opening a discretionary account, you authorize your broker or investment advisor to make buy or sell orders on your behalf. Of course he wants to please you and make winning trades. However, sometimes the need to earn a commission becomes a greater desire.
To illustrate, it may be an excessively bloody day in the markets and your broker would actually just watch on the sidelines if it was his money. However, he might still sell for your discretionary account because he needs the volume and commissions. It’s a horrible thing but it’s reality.
So how do you protect your account from churning? One way to do it is by not signing up for a discretionary account. Another way is to just monitor your stock ledger daily. A long list of hyperactive buys and sells that lose money should be a sign. Call up your broker and ask about those trades.
- Client priority violations.A first come first serve policy prevailsin the execution of client trade orders. Assume you and a friend of the broker both want to sell the same issue because you both know that the price is going to crash anytime soon. You called first to give your sell order for one million shares. A few seconds after you, the friend of the broker calls giving a sell order for just one hundred shares of the same stock. The broker knows that your sell order is definitely going to send the price crashing. He feels sorry for his friend and decides to post his sell order first in the queue before yours. He violated the client priority rule when he did that.
Hopefully, the friend’s order doesn’t affect the price that much. But we know that the markets can be extremely volatile and unpredictable. It could also turn out that that one trade ahead of you actually forfeited your last chance to sell at a gain. Afterwards it would already be at a painful loss. Nobody can really foretell. Hence, to enforce fairness and justice, the rules of client priority were set by the regulatory bodies.
How do you ensure your rights are protected in this area? When you call, try to stay on the phone until the order is executed. It is also best for you to have real time data on the trading volumes, bids and asks as you call your broker and wait for your order to be executed.
This is not to shed a bad light on investment advisors or brokers. A lot of valuable information and insight can be had from seeking their help. Investment and financial institutions have an army of analysts and researchers who make it their job to know what’s going on about a particular investment opportunity. It would be a shame for an investor not to avail of their knowledge and resources. However, at the end of the day, the responsibility rests on the investor to decide and act for himself and his portfolio.