Watch out for Conflicts of Interest When Looking for Good Investment Ideas. Instead, use our Successful Investor approach.

One crucial element in succeeding as an investor is that you have to stay alert for conflicts of interest in the information and advice you receive. Conflicts of interest vary widely in the risk they expose you to. Some are huge—others, barely worth mentioning. Meanwhile, they are your greatest risks because they exist all around you.

Today, many investors looking for good investment ideas understand the conflicts of interest that brokers and other investment salespeople face when deciding what investments to sell to their clients. Brokers can sell a wide variety of investments; commissions and incentives vary widely as well. The general rule is that the commission on and incentives for a sale rise with additional risk—and/or—cost for the investor.

Why conflicts of interest are worse for investing than for other industries and how that rarely leads to good investment ideas

Of course, in every industry, some salespeople routinely settle conflicts-of-interest in their clients’ favour—that is, they buy or sell what’s best for the client. This means they make less money in their early years than they could if they focused on month-to-month earnings. Instead they hope to profit in the long run by building a reputation, a growing clientele, and a high degree of customer loyalty.

However, the investment industry deals in intangibles. Successful investors have to wade through a lot of subtleties and conflicting ideas to spot good investments. Not all brokers are able to make those fine distinctions. Brokers face another series of choices when they decide which investments are best for a particular client. What’s more, sales managers may pressure salespeople to sell products that are most profitable for the firm. (These choices may also be highly profitable for the salesperson, but less desirable for the client.)

Even the best-intentioned sales people may give in to this pressure from time to time. That’s especially so for newcomers. To keep their jobs, junior salespeople need to reach minimum revenue levels set by the firm. Senior investment salespeople may also succumb to the selling pressure if they are in a sales slump, due perhaps to personal issues. That’s because the proportion of revenue that goes to the broker rises and falls with the broker’s sales. The more revenue that brokers bring in, the higher the proportion they get to keep.

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Good investment ideas rarely start with broker jargon

You may have noticed that your stock broker sometimes uses unfamiliar words and phrases to describe investment concepts. Some of this broker jargon is simply shorthand that brokers use amongst themselves, to refer to familiar situations without having to explain the underlying concept. However, the concepts that these “broker-ese” words and phrases represent are also naturally conducive to furthering the goals of the brokerage business.

If you find yourself thinking in broker-ese, you’ll naturally make assumptions that are in tune with the goals of your stock broker, and may be out of tune with yours.

Standards that lead to good investment ideas

In Canada and the U.S., brokers and investment salespeople have to meet a “suitability” standard in the investments they sell to their clients; the investments have to be fair and suitable for the client, based on the client’s personal circumstances. This lets brokers sell a wide range of high-cost or high-risk products to clients, even if there are safer, lower-cost or otherwise better choices available.

In contrast, portfolio managers (such as our firm, Successful Investor Wealth Management Inc.) have to adhere to a fiduciary standard. This goes beyond the “suitability” standard. Fiduciary recommendations have to be the best choice for the client, not merely suitable.

For a number of years, regulatory authorities in Canada and the U.S. have been trying to impose a fiduciary standard on brokers. They have run into a lot of political opposition. After all, the investment industry employs a lot of people, and is active in politics and industry lobbying.

We’ve been writing about conflicts of interest for decades. Still, many readers say it took them years to grasp the importance of the issue. So, we’ve decided to spend more time on it. Let us stress what we said earlier: conflicts of interest are the greatest single risk you face as an investor.

Our Successful Investor approach has a proven record of good investment ideas

First, invest mainly in well-established companies. When the market goes into a lengthy downturn, these stocks generally keep paying their dividends, and they are among the first to recover when conditions improve.

Second, avoid or downplay stocks in the broker/media limelight. That limelight tends to raise investor expectations to excessive levels.

Third, spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities). This helps you avoid excess exposure to any one segment of the market that is headed for trouble.

Do you believe a fiduciary standard needs to be employed by the brokerage industry, or is a suitability standard enough?

What is your experience with brokers settling a conflict of interest in their favor? Did you realize the problem right away or did it take some time to figure out?