Working with the best broker to invest in stocks that you can find may pay off—but you still need to be cautious. Here’s why.

Finding a good full-service stock broker is hard but not impossible. Some successful investors view their brokers as a valuable source of investment research, information and advice. But they keep in mind that brokers operate under the potential for enormous conflicts of interest. That’s why they carefully assess a broker’s advice before acting on it.

If the best broker to invest in stocks on your behalf can help you invest successfully in high-quality stocks, and do it consistently, the extra commission cost per trade is probably worth it.

Working with the best broker to invest in stocks will keep you away from conflicts of interest

I’ve often written that conflicts of interest are the greatest risk you face as an investor. This idea seems to make sense to most of our readers, even if they never thought of it that way before. But when I mention it to experienced investment professionals, most react in one of three ways:

• A blank look, as if I’ve referred to something that they know nothing about, or a sensitive issue they don’t want to talk about;
• An aggrieved or defensive look, as if I’ve raised a sensitive issue and they expect me to follow up with criticism of something they’ve done;
• A big smile, as if they know of an outrageous instance of a conflict of interest and are eager to share.

Recently I got response #3—a big smile—from a fellow portfolio manager. He told me about a new client who had previously been investing through a discretionary portfolio-management arrangement with a broker. Previously this client owned a portfolio of mutual funds with an average MER (management expense ratio) of more than 2% of assets. The broker sold him on the switch to a portfolio-management arrangement, because it would only cost him 1% a year (plus “standard” brokerage commissions).

Unfortunately, this kind of arrangement with a broker exposes you to many conflicts of interest.

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Working with the best broker to invest in stocks: Be alert if your broker retires

We’ve all been exposed to bad barbers, bad restaurateurs, bad school teachers, and all sorts of other people who reflect poorly on the rest of their occupation or profession. It should come as no surprise that you can also find bad stockbrokers and bad financial planners/mutual fund salespeople. After all, the financial industry deals in intangibles, so bad advice can take a lot longer to spot than, say, a bad haircut.

Classic investment errors that generate a lot of commissions can also generate profits for a time, at least in a rising market like the one we’re now in.

Moreover, unlike other livelihoods, the brokerage industry provides financial incentives that can make it highly profitable to abuse client trust. These incentives are so insidious and powerful that they can warp the decisions of brokers who honestly want to do the right thing for their clients.

You always need to be on guard. That’s especially so if you find yourself switching brokers involuntarily.

When a broker retires, he can sell his clientele (or “book of business”, as it’s called) to another broker. The sale price of a book is based on assets in client accounts, and on commissions and fees those clients generated in the prior few years.

A truly ethical broker would be extremely choosy about who he sells to. On the other hand, the final sale price usually includes a percentage of commissions and fees the book generates for several years after the sale. If a retiring broker sells his book to a more aggressive buying broker, he may wind up receiving a higher total sales price.

By the time a broker puts his book up for sale, he may be more concerned with his own retirement than yours.

The buyer is often a younger broker who has to borrow the down payment, then follow it up with a series of payments. That usually means the new broker needs to wring a larger flow of commissions and fees out of the clients than the retiring broker ever did, just to service his debt.

This came to mind recently when a friend told me about his experience with a new broker. It started out like a lot of financial horror stories that I’ve heard over the years.

He had a high opinion of his old broker. His new broker seems even more knowledgeable and sophisticated than the old one. But my friend often finds himself going along with recommendations from the new broker that seem aimed largely at generating commissions. That’s a particularly bad sign this early in the relationship, when presumably a new broker is on his best behaviour.

When a broker starts out making recommendations that serve his interests better than yours, things can only get worse. After all, he can earn ever-higher commissions and fees by advising you to take steps that are even further out of tune with your long-term needs. You may not find out just how bad they are until the next inevitable market downturn.

Use our three-part Successful Investor approach to build a sound portfolio—whether you use a full-service broker or not

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Is your preference to work with a full-service broker, a discount broker, or do you invest on your own?