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Fundamentals of Physician Investing

By Daniel B. Moisand CFP®, and ME-P staff

It used to be that the only way to get investments and investment information was through paying commissions to a traditional broker. Then in the 70’s (specifically, May, 1975) the brokerage industry went through significant deregulation allowing for the discounting of commissions. Charles Schwab and Company, among others, was able to eliminate the advice component and offer trades at dramatically reduced rates. The full service brokerage business responded by emphasizing the scope of their services namely research and advice in order to compete. The demand for both has continued to grow, even though research information is now readily available through many sources. These brokerage firms continue to thrive despite their poor performance in analyzing tech stocks and the Enron and Global Grossing debacles. More recent debacles in 2008-09, the flash crash a decade ago and more recent developments are legion, as well.

Fundamental Flaws

The fundamental flaw with these firms is the array of conflicts of interest between the firm and its customers.  While the incentive to trade has been well chronicled as a conflict, these firms have not let consumer’s demand for a better-aligned compensation arrangement go unnoticed. Fee-based account relationships have proliferated accordingly. In theory, this type of arrangement, usually a percentage of assets, gives an incentive for performance and service rather than trade activity. This certainly has merit. However, conflicts remain that should be considered.

Pay to Play

The practice of paying brokers, higher levels of compensation for in-house products was commonplace. Today, explicitly higher payouts still exist but are less common. Instead, many firms use the sale of proprietary mutual funds and other products as part of management’s compensation. Other forms of non-monetary compensation such as a better office can be used as incentive for the brokers. The greater profitability of these in-house offerings will keep this conflict around for some time.

Subtle Conflicts of Interest

Less obvious is the conflict between the investment banking arm, the research department, and the retail brokerage operations of a firm. Even firms with no proprietary funds to sell may grapple with this issue.  Here, research is pressured to say favorable things about a particular company’s stock by the investment bankers in hopes of obtaining more of that company’s business. When a firm brings a company public odds are great that a “strong buy” rating will come with the IPO. Of course, the lesson remains – consider the source.

Assessment

Traditional brokers have a somewhat higher standard of accountability than the on-line firms as to their accountability. If you buy the stock of a company that goes bankrupt through an on-line broker you have little recourse. After all, that was your choice. If a full-service broker recommended the stock to you, that broker will have to defend the recommendation.

Conclusion

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