An inexperienced trader or investor will undoubtedly rely on a broker's advice for his initial trade. If that broker is incompetent or motivated by the thought of some quick commissions, the odds of success will be considerably diminished. Even accounts that have been exposed to the markets for years can suffer. For example, the failure of an account executive to call at the right time, or to correctly enter an order can be crucial. This is especially true in the futures markets where leverage leaves virtually no margin for error.
Keep in mind that brokers are usually paid on a commission basis. Consequently, if they are not completing orders, they are generating little or no income. When business is slow, even the most ethical of brokers cannot counsel you without the tiniest thought of the commissions influencing their advice. The pressure to sell can sometimes be even more intense since many firms bring underwritings to the market and require brokers to sell an allotment whether the broker believes it to be a good investment or not. He cannot be legally forced to sell such issues, of course. Nevertheless, the pressure from management and the competition from peers are sufficient to trigger a significant number of "borderline" sales. Moreover, most of these new issues carry a generous commission that cannot but contribute to an even greater conflict of interest.
Another problem that we all run into occurs when, after very careful consideration, we call our broker with an order to buy or sell a specific security. The next thing we know is that he has managed to talk us into something else. This is by no means an unethical practice, but one by which a broker can inadvertently and, probably with the best of intentions, sway us into making a wrong decision.
You may wonder why I assume that the account executive will give you the wrong, rather than the right, advice. This happens because the broker is literally sitting in the "crowd." He watches the newswires, probably listens to the financial channels, is inundated with the firm's research, and is heavily influenced by his fellow account executives. The odds that he will give you the right advice are therefore pretty poor.
Several factors influence the broker. For instance, investors commonly do not recognize that most of them are really conduits for their research departments. Recommendations to clients are not necessarily made on the basis of what the broker himself thinks but more on what "our research department likes." If this isn't running with the herd, I don't know what is!
Peer pressure is another unhealthy influence so far as the client is concerned. Usually, one particular broker in the office takes the lead, because he is either a successful salesperson or has had a few lucky recommendations. This is enough to set the ball rolling as the urge to imitate this "leader" becomes irresistible. There are two problems here. First, the broker who is following the leader usually recommends the stock more on the basis that the leading broker is selling it than on its own merits as he sees it. Second, the very spirit of this competitive activity means that sales are being made purely to generate volume in a competitive spirit, not because a stock is the appropriate security for a specific portfolio. Managements, of course, love this competitive atmosphere since it generates more commissions. It is questionable whether this is also true for the poor clients.
I do not mean to imply that there are no brokers that can think for themselves, merely that they are a rare breed. After all, the brokerage community is, in psychological terms, a crosssection of the rest of the population. Why should it be blessed with an abundance of independent thinkers? Brokers are hired principally to generate sales, not to think creatively. Better for the management to do the thinking by placing some juicy commission-generating ideas on the broker's plate. Since members of this select breed of independent thinkers are few and far between, it is of paramount importance that you either learn to think for yourself or give full discretion to a professional who can. By all means consider a broker's recommendations and include them as part of your decision-making process, but don't give the advice greater significance than it deserves.
How to Choose a Broker
The first place to start is to examine the type of firm with which your prospective broker is associated. You should give top priority to ensuring that the firm is stable. This is not an easy matter since the size of the company is not necessarily a good indication of the firm's financial standing. In recent years, we have witnessed many mergers of major brokerages as well as the failures of futures brokers. One method for testing the stability of a firm is to evaluate how aggressive they might be in their advertising and recommendations. Get hold of some of their promotional material or research. Compare this with other brokers' material, and a pattern will probably emerge. Generally speaking, the greater the hype and the more aggressive the recommendations, the more vulnerable a firm is likely to be. A firm that is willing to risk its customers' money in questionable ventures is unlikely to have its own financial house in order. Also, if a firm is going through some difficult times, your broker cannot but help to be caught up in the office gossip and politics. This is bound to adversely affect his ability to service his clients.
A second area to consider is the firm's capability to provide you with information-not the information that they want you to have, but the type of information that is helpful to you. After all, you will be paying for this material indirectly through commissions, so it should be tailored to your needs as much as possible.
The level of the commission structure can also be a serious consideration since it often reflects the kind of service that the firm provides. If you are just placing orders and are acting as your own information source, then it makes no sense to deal with a broker who offers lots of research but charges you high commissions for it. Commissions are not the only cost of doing business; poor executions can, and often do, represent an even greater expense. This is especially important for short-term traders where high turnover means that transaction costs have a greater effect on the ultimate outcome. It is usually better to pay a little more for commissions if you are satisfied that the orders are prompt and properly executed.
Establishing the competence of executions is a difficult matter. Even in the best circumstances, the execution of orders can, and often does, go wrong. Do not expect your broker to be perfect. However, if a pattern of poor executions starts to appear, you are advised to question seriously whether you should continue to retain his services. Still, if you have a long-time horizon and do not place orders very often, these commission and execution factors will be far less important.
Finally, choosing a firm that can provide you with up-todate reports of your account and with readable monthly statements can help you tremendously in doing a more efficient job of managing your money.
Once you have settled on a firm, the next step is to choose an account executive (AE). I realize that you may select the AE first, but even in this case it is also prudent to check out the firm itself. If a broker is going to do a good job in helping you to manage your portfolio, he first needs to know quite a bit about you, your financial position, and your investment objectives. If he does not have the important facts on your financial background, he will not be able to tailor his recommendations to your requirements. If he asks for the order first and then ask questions about you, a red flag should immediately go up in your mind.
You, in turn, need to know some things about the broker. Is your business important to him? If so, you need to know how many active accounts he has, their average size, and so forth. If you are a small account and his average size is much greater, perhaps he will not be able to find the time to service you properly. It is also helpful to have an understanding of his investment philosophy, so ask him to explain it. If he likes charts and you like balance sheets, you may not have much in common. Also, by asking him what he thinks drives the market, you may find out that he has no idea and therefore no philosophy. This is an indication of someone who blindly follows the crowd.
We usually think of a broker solely as a source of recommendations, but even if you make your own decisions, he can still
be helpful in other areas. In my own case, for example, I like to make my own decisions but am terrible at record keeping. This is a role that my broker, a former accountant, is happy to fulfill. He also provides me with information that I cannot get for myself. He watches the markets closely while I get on with the job of publishing a newsletter. Even with this necessary detachment, he is my eyes and ears, reporting faithfully when some prespecified market condition materializes. In this way, I have someone watching the markets for me, and my time is not taken up looking at computer screens. Alternatively, you may be new to the markets and require your broker to fulfill an educational function.
A broker-client relationship should be a customized one, tailored to your needs and desires. You are the only one who can establish such criteria, but once you have, you are in a better position to locate a broker who can fulfill these needs.
The potential for clashes is always present, even in the best of relationships. If your personality and that of the account executive are different, it's much more likely that you will have disagreements. This aspect is crucial because such clashes introduce emotions that are bound to affect your investment performance adversely. Let's suppose, for example, that you decide to buy XYZ stock contrary to your broker's recommendation. If you do not have a good rapport with him, you will find it difficult to sell the stock because you will have to admit, not only to yourself, but to the broker that you've made a mistake. Selling a stock at a loss is difficult enough, but when you also have a personal hurdle to overcome with the broker, it may be the last straw that precludes you from making the sale. Alternatively, you might want to buy ABC for perfectly logical reasons, but are afraid to do so because you know that your broker doesn't like the stock or the industry. These types of conflicts are bound to arise from time to time even with the best relationships. However, if your philosophies and personalities are markedly unlike, the potential for losses to materialize will be that much greater.
Your first step in establishing a relationship is to agree on the ground rules. Don't assume that your broker will fulfill all the functions you want him to. You should state clearly and precisely what you expect of him and ask him what he expects of you. Always be completely frank about your views and expectations. A good broker-client relationship should mirror a partnership, because that is what it really is. Competent brokers realize that maximum long-term commissions are a direct function of the success of their clients. It's a fact that when they are making money, most people trade more; and when their equity is declining, they are far less active. A broker may talk his client into executing numerous transactions, but if the client loses money, he will either trade less or move the account to another broker.
We have discussed the relationship with the broker from your point of view, but his reaction to you can be equally important. For example, he may recommend a stock to you and later the price will drop. His rationale for the recommendation may have been perfectly logical and justifiable, but a conscientious broker is bound to feel some sense of regret concerning the purchase. In such circumstances, you must communicate to him that you do not blame him for the result and continue to believe that he was acting in your best interest. If you don't, he will hesitate before calling you next time even though he might have some valuable information about one of the companies you hold, or a recommendation that will turn out to be profitable. Consequently, if you do not have an open, friendly, approachable, and frank relationship with him, it means that an unnecessary and unprofitable barrier has been set up between you.
You have to begin by deciding what role you want the broker to perform. If you want him to provide research, you should tell him so. If you want him to inform you promptly concerning order executions, he should be informed of this as well. Just think about all the services that you need or don't need and let him know. It's just as important to let him know the things that you do not need, so you will not be unduly bothered and he will have more time to perform the tasks that you feel to be of greater value.
Money Managers versus Clients
The psychological dynamics between a money manager and client can be as crucial as those between a broker and client. You might assume that once you have handed over your account to be professionally managed that everything will work smoothly. This may be true if the manager has sold you on his philosophy and then performs satisfactorily. Unfortunately, this is rarely the case. In previous chapters, I stressed that success in the financial markets requires a totally objective and flexible outlook. When a money manager takes on a new account, he faces more than the twin battles of beating the markets and mastering his own emotions that the rest of us have to deal with. He also has a third challenge revolving around his relationship with the client. This does not imply that the manager is in an adversarial role with his client, for such a relationship could never be maintained for very long. The problem is more subtle. The manager often finds himself asking, "What does my client want? What will he think if I buy company XYZ and then sell it at a small loss because my view has changed?"
If the manager is buying and selling for his own account, he does not have to worry about such matters, since he has to answer only to himself. However, when managing an account, he has to look over his shoulder continually and worry about what the client may be thinking. Consequently, the objectivity he may have obtained for himself stands a good chance of being replaced by concerns about his relationship with his client. Even though the client may have researched the track record and philosophy of the money manager and they have a good personal relationship, problems can still arise because many clients continually second-guess what the manager is doing.
The client places his assets under management because he does not have the time, expertise, or aptitude to invest for himself. If the manager is a real pro, he will be constantly going against the crowd. He will be buying when the news is bad and selling when it is good. If the client doesn't have an aptitude for investing, he will more than likely be of the opposite frame of mind. When prices decline, the news background is invariably negative; so it is little wonder that we find the customer calling up the manager when he has just made some purchases at fairly depressed levels. The manager, for his part, is also questioning his new acquisitions, because it is rarely easy to buy at the bottom. The client's call expressing uneasiness therefore clouds the manager's judgment and adversely affects his confidence. Whereas he might have plucked up the courage to buy some more stocks at bargain basement prices, this kind of concern is likely to make him hold back and make purchases when prices and the client's comfort level are much higher.
Client-manager relationships can interfere with a successful investment program in numerous ways. There are two approaches for avoiding some of these dilemmas. The first is for you, as the potential client, to make sure that your investment objectives are not only realistic but are also consistent with the investment philosophy of the firm that you have selected to manage your money. Second, once you have made the decision to give the manager discretion, let him get on with his job. Avoid the temptation to interfere. Obviously, this does not mean that you cannot or should not periodically critique his performance, but you do need to give him the benefit of the doubt in questionable circumstances. The media and fast-talking brokers have led many of us to expect instant success, but that is rarely the case. Quick profits usually arise from being in the right place at the right time-luck rarely strikes in the same place twice.
If you compare the long-term performances of cash, stocks, and bonds, you will find that stocks offer the best rate of return. If you then analyze the performance of the stock market over the past 100 years, you will learn two things: First, the market can be extremely volatile over short periods; second, the longer the time horizon, the less the volatility and the greater the reward. Consequently, if you allow your manager to concentrate on the big picture and do not worry him with day-to-day concerns, he will be in a far better position to give you the superior results you dem
and. In effect, the longer the time horizon, the greater the opportunity for the long run (upward) trend to offset short-term volatility.
If the manager does not perform after a period of two years or so, you need to reassess your relationship with him. It may be that his particular investment philosophy is still relevant, but that it has produced below-average returns over the past two years. This can happen to the best of investment approaches and is a simple fact of life. Table 10-1, for example, shows the total return performance of both stocks and bonds using Stock and Bond Barometer models that I developed. We use them in the Pring Turner Capital Group, the money management firm with which I am associated, to allocate assets in our clients' portfolios. The overall performance is fairly good, but if we consider the results for some specific time periods, such as 1967-1968 and 1980 for bonds, we can see that there have been a number of instances where the performance has been disappointing. This underscores that even the well-designed models for investment approaches can and do fail from time to time. Remember, there is no Holy Grail.
Investment Psychology Explained Page 17