The Cost And Consequences Of Bad Investment Advice

By Ken Hawkins AAA

Many investors still rely on their investment advisors to provide guidance and to help them manage their portfolios. The advice they receive is as varied as the background, knowledge and experience of their advisors. Some of it is good, some of it is bad, and some is just plain ugly.

Investment decisions are made in a world of uncertainty, and making investment mistakes is expected. No one has a crystal ball, and investors should not expect their financial advisors to be right all of the time. That said, making an investment mistake based on sound judgment and wise counsel is one thing; making a mistake based on poor advice is another matter. Bad investment advice is usually due to one of two reasons. The first is that an advisor will place his or her self-interest before that of the client. The second reason for bad advice is an advisor's lack of knowledge and failure to perform due diligence. Each type of bad advice has its own consequences for the client in the short term, but in the long term they will all result in poor performance or loss of money.

Advisor's Self-Interest Meets Client's Best Interest
Most financial advisors are interested in doing the right thing for their clients, but some see their clients as profit centers, and their goal is to maximize their own revenue. Although they all like to see their clients do well, in the case of self-interested advisors, their own interests will come first. This will typically result in a conflict of interest and and can lead to the following bad moves:

1. Excessive Trading
Churning is an unethical sales practice of excessively trading a client's account. Active trading is similar, but not unethical, and only a fine line separates the two. Advisors whose primary focus is to generate commissions will almost always find reasons to actively trade a client's account at the client's expense. Excessive trading will almost always mean realizing more capital gains than is necessary, and the commission generated, although enriching to the advisor, comes directly out of the client's pocket. Advisors who excessively trade their clients' accounts know that it is far easier to get clients to sell a stock at a profit than it is to get them to sell a stock at a loss (especially if it is their recommendation). The net result can be a portfolio where winners are sold too soon and the losses are allowed to mount. This is the opposite of one of Wall Street's proverbs: "Cut your losses short and let your winners run." (For more insight, read Understanding Dishonest Broker Tactics.)

2. Using Inappropriate Leverage
Using borrowed money to invest in stocks always looks good on paper. The investor never loses money because the rates of the return on the investments are always higher than the cost of borrowing. In real life, it does not always work out that way, but the use of leverage is very beneficial to the advisor. An investor who has $100,000 and then borrows an additional $100,000 will almost certainly pay more than double the fees and commissions to the advisor, while taking all the added risk.

The extra leverage increases the underlying volatility, which is good if the investment goes up, but bad if it drops. Let's suppose in the example above, the investor's stock portfolio drops by 10%. The leverage has doubled the investor's loss to 20%, so his or her equity investment of $100,000 is only worth $80,000. Borrowing money can also cause an investor to lose control of his or her investments. As an example, an investor who borrows $100,000 against the equity of his or her home might be forced to sell the investments if the bank calls the loan. The extra leverage also increases the portfolio's overall risk. (For more insight, read Margin Trading.)

3. Putting a Client In High-Cost Investments
It is a truism that financial advisors looking to maximize the revenues from a client do not look for low-cost solutions. As an example, a client who seldom trades might be steered into a fee-based account, adding to the investor's overall cost but benefiting the advisor. An unscrupulous advisor might recommend a complicated structured investment product to unsophisticated investors because it will generate high commissions and trailer fees for the advisor. Many of the products have built-in fees, so investors are not even aware of the charges. In the end, high fees can eventually erode the future performance of the portfolio and enrich the advisor.

4. Selling What Clients Want, Not What They Need
Mutual funds as well as many other investments are sold rather than bought. Rather than provide investment solutions that meet a client's objective, a self-interested advisor may sell what the client wants. The sales process is made easier and more efficient for the advisor by recommending investments to the client that the advisor knows the client will buy, even if they are not in the client's best interest.

As an example, a client concerned about market losses may buy expensive structured investment products, although a well-diversified portfolio would accomplish the same thing with lower costs and more upside. A client who is looking for a speculative investment that might double in price would be better off with something with lower risk. As a result, those investors who are sold products that appeal to their emotions might end up with investments that are, in the end, inappropriate. Their investments are not aligned to their long-term objectives, which might result in too much portfolio risk. (For related reading, check out Why Fund Managers Risk Too Much.)

Poor Knowledge, Incompetence Or Lack Of Due Diligence
Many people have the mistaken belief that financial advisors spend most of their day doing investment research and searching for money-making ideas for their clients. In reality, most advisors spend little time on investment research and more time on marketing, business development, client service and administration. Pressed for time, they might not do a thorough analysis of the investments they are recommending.

Knowledge and understanding of investing and the financial markets varies widely from advisor to advisor. Some are very knowledgeable and exceptionally competent when providing advice to their clients, and others are not. Some advisors might actually believe they are doing the right thing for their clients and not even realize that they are not. This type of poor advice includes the following:

1. Not Fully Understanding Investments They Recommend
Some of today's financially engineered investment products are difficult for even the savviest financial advisors to fully understand. Relatively simple mutual funds still require analysis to understand the risks and to ensure they will meet client's objectives. An advisor who is very busy or who does not have the highest financial acumen might not truly understand what he or she is recommending or its impact on the individual's portfolio. This lack of due diligence could result in concentration of risks of which neither the advisor nor the client is aware.

2. Overconfidence
Picking winners and outperforming the market is difficult even for the seasoned professionals managing mutual funds, pension funds, endowments, etc. Many financial advisors (a group not lacking in confidence) believe they have superior stock-picking skills. After a strong market advance, many advisors can become overconfident in their abilities – after all, most of the stocks they recommended saw price increases during that period. Mistaking a bull market for brains, they start recommending riskier investments with greater upside, or concentrating the investment in one sector or a few stocks. People who are overconfident only look at the upside potential, not the downside risk. The net result is that clients end up with riskier, more volatile portfolios that can turn down sharply when the advisor's luck runs out. (For more on psychology, read Understanding Investor Behavior.)

2. Momentum Investing - Buying What's Hot
It is easy for financial advisors and their clients to get carried away in a hot market or a hot sector. The technology bubble and consequent burst of 1999-2002 demonstrated that even the most skeptical investors can get caught up in the euphoria surrounding a speculative bubble. Advisors who are recommending the hot mutual funds and the hot stocks to their clients are playing into clients' greed. Buying a hot stock provides an illusion of easy money, but it can come with a cost. Momentum investing typically results in a portfolio that has considerable downside risk, with potential for large losses when the markets turn.

3. Poorly Diversified Portfolio
A poorly constructed or diversified portfolio is the cumulative result of bad advice. A poorly diversified portfolio can take a number of different forms. It might be too concentrated in a few stocks or sectors, resulting in greater risk than is appropriate or necessary. Similarly, it could be over-diversified, resulting in, at best, mediocre performance after fees are deducted. Often portfolios are too complicated to understand; this could mean that risks are not apparent, they become difficult to manage and investment decisions cannot be made with confidence. At best, a poorly constructed portfolio will result in mediocre performance and, at worst, it could suffer a large drop in value. (For more insight, see The Importance Of Diversification.)

Conclusions
Bad advice advice frequently results in poor performance or loss of money for investors. When choosing an advisor - or evaluating the one you have - stay alert for clues that might indicate that the advisor is not working in your best interest or is not as competent as you would like. After all, it's your money - if you're not happy with how you're being advised to invest it, it could pay to take it elsewhere.

You May Also Like

Related Articles
  1. Investing Basics

    Online Portfolio Management, DIY or ...

  2. A Monte Carlo simulation allows analysts and advisors to convert investment chances into choices. The advantage of Monte Carlo is its ability to factor in a range of values for various inputs.
    Fundamental Analysis

    What Can The Monte Carlo Simulation ...

  3. Investing Basics

    Using Normal Distribution Formula To ...

  4. Investing Basics

    Human Capital, An Important Asset For ...

  5. Investing Basics

    Tracking Your Portfolio On Yahoo! Finance

Trading Center