“A market is a combined behavior of thousands of people responding
to information, misinformation, and whim.”
-Kenneth Chang
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
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