You, too, can be a hedge fund manager  [a Sentinel excerpt]  

by Pat Huddleston, Investor's Watchdog

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:

What do you mean ‘she only wants me for my money'?! You’ve got it all wrong. She cares about me . . . ME, I tell you! Every time we talk she asks about my family. She even sent flowers last year when my mother passed away. Does that sound like somebody who’s only after my money? And she’s a sports fan too! Half of our conversations are about baseball, for heaven’s sake. Where am I going to find someone else like that? How can you be so cynical? If anybody is obsessed with money, it’s you, pal. That’s all you ever talk about.

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.

Churning

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.

Margin

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.

Unsuitable Investments

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 sales tactics.

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 Attraction?