Unscrupulous brokers engage in excessive trading to generate commissions for themselves, which is a clear warning sign. Similarly, it is advisable to stay away from brokers who suggest investments below breakpoints solely to safeguard their commissions. It is the responsibility of brokers to understand your financial requirements and limitations and provide appropriate investment recommendations accordingly.
Basics
Although the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) have effective regulations in place, conducting your own research is the most reliable method to avoid untrustworthy brokers. Despite thorough background checks on firms, brokers, or planners, investors may still become victims of fraud. This article examines the unethical tactics used by brokers to increase their commissions and deceive unsuspecting investors with subpar investment options.
Churning: Excessive Trading for Broker Gain
Churning is a practice where brokers excessively trade client accounts for their own financial gain. Instead of focusing on the investor's best interests, these brokers prioritize increasing their own commissions. Even a single trade without a legitimate purpose can be considered churning. Unusually high transaction volumes without corresponding portfolio value growth are warning signs of this unethical behavior.
To protect against churning, you may consider a wrap account. This type of account involves a broker managing your portfolio for a fixed fee, ensuring they only trade when it benefits your investments. Regardless of whether you've authorized your broker to trade on your behalf, it's always important to stay informed about your portfolio's activities.
Dividend Selling Tactic
Dividend selling is a tactic used by brokers to persuade customers to buy investments based on the promise of upcoming dividends, intending to generate commissions for themselves. However, this approach often results in little gain for investors.
For example, if a company's stock is priced at $100 per share and is expected to pay a $5 dividend, a broker might advise a client to quickly buy the stock for a 5% return. But in reality, the stock price will drop by the dividend amount ($5) when it goes ex-dividend. This means the investor gains very little in the short term and may face additional tax liabilities.
This practice also applies to mutual funds, in which advisors recommend purchasing funds that invest in dividend-paying companies. However, these dividends can reduce the net asset value of the fund, benefiting the broker's commissions more than the investor's returns. Waiting until after the dividend payout allows investors to buy at a lower price and potentially avoid higher taxes on the dividend income.
Sales Charges and Breakpoints
Brokerages and mutual fund companies often impose sales charges on certain investments, which can lead investors to pay more than necessary. For instance, if a mutual fund company charges 6% for investments below $20,000 but only 5% for investments of $20,000 or more, investing exactly $20,000 qualifies for a lower sales charge, known as a "breakpoint sale."
However, some unscrupulous advisors may recommend investing slightly less, such as $19,500, instead of the qualifying amount, causing investors to miss out on $500 or 1% in potential savings. Moreover, these advisors may suggest dividing investments among different companies, even if those companies offer similar services, resulting in the loss of higher breakpoint benefits. In such cases, advisors benefit from earning higher commissions, while investors lose the opportunity to take advantage of lower commission rates at higher breakpoints.
Unsuitable Transactions: What to Look Out For
Unsuitable transactions refer to investments that are not suitable for a client's circumstances or investment goals. Brokers have a responsibility to understand their clients' financial needs and constraints and provide recommendations accordingly.
For example, investing in double tax exemptions is often unsuitable. This occurs when an advisor puts already tax-protected funds, such as those in an IRA, into tax-free bonds or other securities. This is inappropriate because it doesn't meet the client's needs and usually results in lower yields compared to other investments.
Other unsuitable transactions include high-risk investments for those with a low-risk tolerance, concentrating funds in a single stock or security, and choosing illiquid investments when easy access to funds is required. By being aware of these unsuitable transactions, investors can make informed decisions and ensure their investments align with their specific circumstances and objectives.
Conclusion
All investors, regardless of their financial backgrounds, should regularly monitor their accounts. While it's not necessary to check every day, staying informed by periodically reviewing your investments is important. By carefully evaluating your broker's investment proposals and regularly checking your accounts, you can effectively safeguard yourself against most types of broker fraud.