“A market is a combined behavior of thousands of people responding to information, misinformation, and whim.”
Garrison Keillor talks about the mythical village of Lake Wobegon, where all the village children are “above average.” The financial industry is a bit like those children. Every segment and company think they are best. Truthfully, each one offers certain structural strengths.
Experience suggests that clients often reach decisions by default – the firm where an advisor works, for instance, or a bank close to home. These are understandable choices, but hardly an informed way to decide. An objective consultant would likely consider a whole matrix of factors including safety, convenience, flexibility, financial expertise, investment expertise, ease of evaluation, and overall costs of service.
Safety and security. One topic that commands attention is client safety. Virtually every investment client should be concerned about the people and firms they use. Surprisingly, though, there is a lot of bad information about this general subject. Perhaps we can shed some light.
First, it’s important to recognize that different regulations apply to different types of firms (all claiming that they’re best and safest). Most brokerage firms fall under scrutiny of the Securities and Exchange Commission (SEC). So do many Registered Investment Advisors (RIA), although smaller RIAs are covered by state regulation (In Missouri, RIAs are regulated by the Secretary of State Securities Division).
Most investment professionals are required to pass examinations conducted by the National Association of Securities Dealers (NASD), a self-regulatory body of the investment industry. Various examinations apply to different kinds of securities, but virtually everyone selling or managing investments in our industry is required to pass at least one examination. (Passing isn’t always enough – in Missouri, one qualifying officer of an RIA firm must earn at least an 80% grade on the Series 65 exam. That’s 10% higher than a “passing” grade.)
Banks, as a rule, are governed by banking regulators. So, the trust department of a bank or independent trust company is regulated by the Office of the Comptroller of the Currency (OCC) or state banking department. Certain bank employees that sell investments – through a discount brokerage division, perhaps – must pass NASD exams, too.
Surprisingly, I spent fifteen years as a trust officer for three different banks and never had to pass any securities exams. Banks were specifically exempted from most securities laws because they fall under banking statutes instead. Both banking and investment firms are required to meet certain capital, insurance, and bonding guidelines.
Many investment firms are also registered with the United States Department of Labor (DOL) to manage pension and other retirement plans. The DOL provides oversight for retirement plans and advisors must register to comply. Special bonding is required for each retirement plan, both for the employer and investment advisors.
Registered Investment Advisors actively manage client investments. A federal law requires separate custodial accounts for each client. In plain English, this means that investments (stocks, bonds, or mutual funds) must be held at another investment firm (this law provides protection against two obvious perils: that an RIA employee might steal cash or securities, or that an RIA firm might declare bankruptcy. Clearly requiring an outside custodian avoids both situations).
Each custodian brings another level of safety. Charles Schwab (one choice for many people), for instance, insures each client account against brokerage default up to $100 million. Other custodians provide similar insurance. Remember, custodial accounts are where client investments are actually held, so this protection is extremely important.
Several other types of protection are covered through bonding or insurance. The best investment firms or advisors carry professional liability insurance as protection against claims of error or negligence. Separate coverage should protect against employee dishonesty or fraud. Firms that handle retirement accounts must have special ERISA bonds.
Excerpt taken from Million Dollar Management: Simple Lessons to Use Wealth Management Principles for Your Family Investments by Dan Danford (with Gary Myers), 2002