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 stock investing advice. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “There are too many occasions when an investment that is in a broker’s best financial interest will actually bring the investor higher costs and greater risk.”

Overall, investors lose more money to conflicts of interest than to any other single risk. That’s not a comment about the average broker’s sense of ethics. It’s simply a matter of frequency of exposure times risk per exposure.

For example, suppose you tell your broker that you have some money and you want to invest it aggressively. He could suggest buying, say, some stock in Google. It’s a relatively young company in a fast-changing field, and it’s non-dividend-paying, so it’s somewhat aggressive as an investment. It has substantial profit potential, however, since it is the leader by far in a field with a lot of growth ahead. But if the broker advises you to buy Google, you’d only have to buy it once, and you might pay a commission of, say, 2% to 3% of the stock’s price.

The broker is far better off financially if he advises you to try your luck in stock options. (These are investment products that give you the right but not the obligation to buy a stock for a fixed price, within a fixed time period.) In stock options, you’d pay a higher percentage commission on your outlay, perhaps 3% to 10%. Also, your stock options would have a limited life—they would expire in a fixed period of weeks or months. Then you would pay another commission to replace them.

Stock options trading is a great deal for brokers, because options players pay much higher commissions than stock investors, and they pay commissions much more frequently. For the same reason, options are a terrible deal for investors who get involved in them.

Of course, a handful of options players make money—after all, somebody has to win the lottery. But on average, you just can’t make enough of a gross profit to pay the commission costs and leave yourself with any profit. That’s why most options players wind up losing money.

The shift to a fiduciary standard

You’ll find lots of conflicts of interest like this in the investment/financial business. It’s hard for a broker to settle these conflicts in the investor’s favour and still make a good living. However, brokers have no legal obligation to settle conflicts of interest in the clients’ favour. By law, they only need to ensure that investments they sell are “suitable” for a client. Stock options generally qualify as suitable for a client who wants to invest aggressively and who can afford to absorb the inevitable losses.

Portfolio managers, like lawyers and doctors, have to live up to a “fiduciary” standard. That is, rather than simply adhere to the much looser “suitability” standard, they have to do what’s best for the client. They have to try to avoid profiting from any conflicts of interest with their clients.

Several countries have already changed the law so that brokers have to adhere to a fiduciary standard. Later this year, the U.S. Department of Labor is likely to issue new rules that require brokers to live up to a fiduciary standard when dealing with individual retirement accounts (the U.S. equivalent of RRSPs). Similar rules may follow in Canada in the next few years.

A shift to a fiduciary standard is one of those proverbial ideas-whose-time-has-come. It will be good for investors and good for the economy. Rather than simply supporting the change, however, we take the idea a step further. In fact, I designed our business plan to eliminate conflicts of interest with our clients. I want to eliminate these conflicts altogether, rather than simply overcoming the all-too-human urge to profit from them.

That’s why, for example, we don’t accept client referrals from brokers. Those referrals come with strings attached. This policy may slow our growth at times, of course. But keeping independent of the brokerage business will pay off for our subscribers and clients, and our most powerful advertising is word-of-mouth from satisfied customers.

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

What do you think is the best way to eliminate conflicts of interest? Have you ever questioned a broker about what you perceived as a clear conflict of interest? Do you have any specific instances in which you feel a conflict of interest was particularly costly for you?