Book Excerpt

In those moments when the stakes are highest, emotions run strongest, and mistakes are made, investors need a consultative voice of reason, not a sales pitch. Consider a common example from the frenzied (dot-com) era, which will solidify the point and also bring us to our next subject. An investor turns on the television, reads a newspaper, listens to the radio and is inundated by images and messages about the dot-com millionaires. Surely you remember yuppies making fortunes with their (seeming) techno-investment prowess, early retirements, Leer Jets, yachts, and other symbols of mass wealth attached to a profile barely able to support facial hair. Over Thanksgiving, our unfortunate saver has to listen to a brother-in-law touting his technology shares and how they went up in value by 3,000 percent since he last bragged (about two weeks earlier) about his superior acumen, really cool new boat, plans to quit work and trade online, all the while narrowly avoiding Freudian slips about the size of his enormous portfolio. Exhausted and frustrated, our responsible hero calls his investment guy for advice. Take a moment to ponder the difference between the two possible responses:

"... Dot-com. What a great idea. Lucky you called us because we are the best and can get stuff that nobody else has..."

Versus:

"... a 3,000 percent rate of return? When we spent four hours creating your financial plan, we discovered that you will likely be okay with a 7-percent return that is somewhat consistent. Are you sure that risking everything on an unproven high flyer is wise? Let's talk about the dot-com mania..."

What were the key differences between these approaches? Besides the obvious fact that we know how the story ended (brother-in-law asking if your company is hiring), there are other important distinctions. In the first example, a quick and easy sale was certainly made, but a poor choice was the resulting outcome. In the second example, it was likely that several hours of conversation occurred, resulting in no sale of any kind, but a far wiser conclusion was likely drawn. 

What about discount brokers? Are they any better? Unfortunately, in my opinion, they have every appearance of being cut from the same mold as the traditional brokerages since their sales pitch appears to echo the other: “buy our stuff; we are better because we are cheaper.” There are, of course, many circumstances in which the discount brokers are quite appropriate, but like all else financial, it helps to get a fair presentation of the pros and cons. In our previous example, I do not think it much mattered if the brother-in-law paid a thousand dollars a trade for a full-service broker or $7 to a discount outfit; in either case he wound up on our hero's doorstep with an outstretched hand. The real issue for responsible investing has more to do with answering the following question: what resources do you use to enable wise decisions? The following graphic provides some insight into the relative appropriateness of the various financial services providers. 

Discount broker:

Main benefit is reduced cost, which can be significant over time. However, the discount arrangement typically leaves the investor bearing the full brunt of responsibility. Even the best trading tools and occasional anonymous phone conversation will not likely prevent common investor mistakes. This relationship may be best suited to the do-it-yourself investor who looks forward to a lifetime of immersion in financial management. 

Full-service traditional broker:

These service providers are historically transaction oriented, charging a one-time commission for a buy or sell transaction that may be as high as 5% or more. Investors looking to simply buy and hold and who want help with their decisions might be well served. Use caution, however, as a certain conflict of interest is inherent with this arrangement. 

Fee-only investment advisor:

As the name implies, the fee-only advisor does not charge a sales commission but an ongoing fee, often around 1%. The idea is to avoid...