Beware of Broker Biases

Last Updated Oct 5, 2009 11:49 AM EDT

Imagine you needed to buy a new car and had narrowed your choice to an Accord or a Camry. When you visit the Accord dealer, you know that he's biased. He's going to try to sell you an Accord. You wouldn't expect him to extol the virtues of competitors. While the bias exists, at least you're aware of it. Forewarned is forearmed. If you want unbiased advice you know you need to seek an independent viewpoint, such as Consumer Reports.

On the other hand, when you walk into a Merrill Lynch (or other investment firm) office, you don't have the same awareness that such biases are likely to exist. Many broker-dealers have proprietary products on their shelves, creating the same type of bias you face when you enter the Accord dealer's office. Even if a firm doesn't sell its own products, it doesn't mean no biases exist. They exist because of the sales culture of such firms. And unlike in the case of the auto dealer, the biases are either hidden or hard to uncover unless you read the very fine print.

Brokerage firms have been cited for many abuses. For example, they've acted like supermarkets, renting out the best "shelf space" to firms that pay the most for the privilege. Mutual funds that didn't provide what might called "kickbacks" often lost access to the investment firm's brokers. In addition, investment firms wouldn't put the fund family on a preferred list -- a list the brokers are encouraged to sell, with the brokers usually receiving some form of incentive compensation. And it didn't end there. If the investment firm was successful selling the mutual funds of a particular fund family, the fund family will direct brokerage business to the investment firm. Once again, the brokerage firm benefited -- this time to the detriment of the fund's shareholders as the fund may not be receiving the best execution on its trades.

All of the above abuses occur because of the sales cultures of the firms. The end result is that brokerage firms often create incentives to have its employees sell products that are in the best interest of the brokerage firm and the advisor, not the client. This would be bad enough if you knew the bias existed. That might be the case if, for example, the SEC required the brokerage firm to advertise that it sells certain products and the brokers were required to wear the equivalent of an "Accord" shirt. But that's not the case. The result is that you think you're getting unbiased advice, which is generally not the case.

To avoid this problem, avoid working with an advisor that receives compensation in the form of commissions for selling investment products. Commissions create the potential for bias. The advisor may be selling you a product that generates him the most compensation, as opposed to one that's most likely to help you achieve your financial goals. They may have high fees and loads (either front- or back-end). Working with a fee-only advisor minimizes the potential for conflicts of interest.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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