by Pat Huddleston,
There’s something about
this time of year. As Valentine’s Day
comes and goes and winter gives way to
spring, friends will confront each other
with ugly truths. As so often happens,
though, the recipients of bad news will
sometimes attack the messenger:
How Do I
Love Thee? Let Me Count the Fees
As painful as it is to admit, your accountant
is right: Your stockbroker only wants
you for your money. As good as she makes
you feel, as interested as she seems to
be in your family and your job, and as
remarkable as it seems that you like the
same sports, the same foods, the same
music, if you lost your money tomorrow,
she’d drop you like a bad habit.
But it hurts to admit that doesn’t it?
It’s a savage kick in the gut, a blow
to the ego that implies a degree of vulnerability
and, worse, gullibility that you’ll do
almost anything to avoid confronting.
And so you will lie to yourself. You will
magnify everything in the relationship
that supports what you want to believe
and turn a blind eye to everything that
tends to prove the painful truth.
Given that this is how you will approach
the situation, isn’t your accountant in
a better position to judge whether your
relationship with this stockbroker is
good for you? The accountant sees the
numbers, unclouded by emotion. When the
accountant sees excessive trading, he
will not dismiss it because the broker
likes to talk about the Braves. When your
accountant sees that the broker has been
using margin to make trades, he will wonder
whether you are the sort of investor for
whom margin is suitable, regardless of
whether the broker sent you a birthday
card. When the accountant sees that the
broker has bought inappropriately risky
securities in your account, he will not
remain silent just because the broker
makes you feel like a captain of industry.
The documents your accountant reviews
in preparing your tax returns can reveal
whether you have been the victim of the
most common types of stockbroker misconduct.
Pay attention, therefore, if your accountant
raises concerns about any of the following.
If your accountant has to wade through
a two-inch stack of trade confirmations
to determine your gain or loss on stock
trades, you may have been the victim of
churning. “Churning” is excessive trading
for the purpose of generating commissions
rather than for any legitimate investment
purpose. It is the most basic of all the
fraudulent schemes perpetrated by brokers.
As are most forms of broker misconduct,
churning is a direct result of the compensations
system in operation at U.S. brokerage
firms. Stockbrokers get paid to trade,
to buy and sell stocks and other securities.
From the broker’s point of view, therefore,
the equation is simple: the more he trades,
the more he makes. Naturally, this leads
the broker to favor frequent buying and
selling even though a more conservative
“buy-and-hold” approach is more likely
to benefit the customer.
Churning is fraud, and investors damaged
by it have a right to recover from the
stockbroker and his firm. If your accountant
tells you that you may have been a victim
of churning, listen.
In searching for every possible deduction,
your accountant may notice that you paid
margin interest to your brokerage firm.
While your accountant may be pleased that
he can claim the margin interest deduction,
he will recognize that the interest is
a drain on the value of your brokerage
account and ask you why you are using
margin at all.
Margin is nothing more than a loan from
your brokerage firm to enable you to buy
more stock. Of course, the additional
trading that the loan allows you to do
results in more commissions to the firm
and to your individual broker.
Apart from the additional commissions
the firms reap from margin trading, margin
interest is an enormous revenue source.
Firms are therefore anxious for you to
use margin. They encourage their brokers
to convince you to use margin by providing
the brokers with up-to-the-minute information
on the “buying power” of your account.
The buying power figure is simply the
maximum amount of securities you could
buy if you were to margin yourself to
the hilt. A stockbroker who talks to you
about “buying power” is the securities
industry equivalent of the mortgage broker
who tells you that you can afford a $1.2
million mortgage on a $75,000 salary.
Margin is dangerous, and most investors
simply have no business using it. Margin
rules designed to protect the brokerage
firms set limits on the amount of margin
allowed in an account. If the stocks in
your account fall in value and the equity
therefore dips below an acceptable level,
the firm will issue a “margin call” directing
you to deposit cash or securities. If
you cannot do so, the firm will sell your
securities to raise the equity level.
The firm has no obligation to ask you
which stocks will be sold, and will have
no liability to you if the stocks they
sell to meet the margin call eventually
quadruple in price. Indeed, use of margin
often forces investors to “sell at the
bottom” during market downturns, forcing
them to accept panic prices when they
otherwise would have waited patiently
for a market rebound.
If your accountant raises concerns about
margin, listen. Unauthorized or unsuitable
use of margin is improper.
Your accountant knows your financial
situation. He’s got a good idea about
whether you have surplus cash to invest
in highly speculative stocks or whether
you still need to build wealth with minimal
risk to buy a bigger home or to send your
children to college. If he expresses concern
over some of the investments you made
last year, listen.
Brokerage firms have an obligation to
know their customers’ financial situation,
investment experience, and risk tolerance,
and only to recommend investments that
are suitable in light of that information.
But brokerage firms and their individual
brokers make more money by trading highly
speculative stocks than they do for trading
blue chip stocks. Not surprisingly, therefore,
brokers often recommend unsuitable stocks
to their customers, support those recommendations
with misrepresentations and material omissions,
and close the sales by creating a sense
of urgency and using other high pressure
If your accountant questions whether
your investments were suitable, or raises
any other questions about your broker
account, listen. After all, unlike your
stockbroker, your accountant has no financial
incentive to mistreat you.
Your relationship with your stockbroker
may be exciting, but remember Fatal