Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment advice. Each Investor Toolkit update gives you a fundamental piece of investment advice, and shows you how you can put it into practice right away.

Today’s tip: “Here are 3 warning signs that tell you when stocks brokers are clearly putting their own interests above those of their clients.”

A good stock broker (the brokerage industry prefers the term “investment advisor”) can provide a cost-effective way to manage your investments. However, a good broker has always been hard to find. We mainly hear about them after they’ve retired, when investors complain about the bad brokers who have taken over their accounts.

As any good stock broker or experienced investor can tell you, bad brokers are all too common. By “bad brokers,” we mean those who put their own interests above their clients’. Keep in mind, however, that most of these brokers do this in a perfectly legal fashion, by catering to their clients’ whims and weaknesses.

Here are three “bad stock broker” warning signs you should always be on the lookout for:

Conflicts of interest come in many forms

Some brokerage firms offer portfolio management for a yearly fee of perhaps 2% or so of client assets, rather than charging trade-by-trade commissions. This is supposed to eliminate a conflict of interest over commissions between the broker and the client. But it’s not an especially attractive arrangement for the investor. After all, brokers and their clients have a variety of conflicts of interest, apart from those related to brokerage commissions.

A truly bad broker turns fee-based accounts from a bad deal into an abusive one by loading them up with securities that generate additional income for themselves and their employers.

These securities include in-house mutual funds, or any funds that pay trailer fees. New issues are another big earner for the broker and his firm; the company that issues the stock pays the commissions of 5% or more, but ultimately that money comes out of the investor’s pocket.

Fee-based accounts are also a convenient market for securities that the brokerage firm has in inventory and wants to unload. The firm may have bought these securities to accommodate a larger client who was eager to sell.

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Sophisticated strategies that cost you money

In response to the losses they suffer in stock market downturns, many investors become much more sensitive to risk, or even to fluctuations in the value of one of their investments. Bad brokers respond to this fear with supposedly sophisticated strategies that bring great portfolio stability.

However, this kind of stability costs money. It can virtually eliminate any chance of a significant long-term profit.

Some of these stabilizing but profit-killing strategies involve buying or selling stock options. Others focus on “structured investments” (see warning sign #3). Now that stock brokers can also sell insurance, many bad brokers have begun to focus on high-fee insurance products like Universal Life.

Low risk, low return and high fees

“Structured” investment products are created when brokerage underwriting departments take genuinely desirable securities and slice and dice them into what you might call Frankenstein investments. These investments come with special characteristics that make them superficially attractive to investors, yet far more profitable for brokers. A good example is principal protected notes, which can be linked to a variety of underlying investments.

You may not lose much money buying these investments. You may even make a few dollars. But it is certain that these investments will generate big underwriting fees like any new issue, followed by a string of management fees. When the structured investment gets redeemed in five or seven years, or sooner, the broker gets an opportunity to sell the investor something new.

After commissions and other fees come out of these investments, there’s little chance that investors will wind up with a profit to match their risk.

COMMENTS PLEASE—Share your investment knowledge and opinions with fellow TSINetwork.ca members

Have you had one particularly bad experience that caused you to get rid of a broker? What did you look for when you set out to find another broker? Did you find a good one?