8 Ethical Guidelines for Brokers

It is no secret that the investment industry is plagued with awkward and seemingly unsolvable conflicts of interest. Brokers want to earn commissions and are often under intense pressure to do so. But what brings in the most money for the broker is not always what is best for investors—or what they really want. The temptation is to sell excessively risky products because they are more lucrative than low-risk alternatives.

While everybody has to try and make a living, brokers included, deliberate attempts to confuse or mis-sell in any way are not only unethical, they may come back to haunt the broker in the form of soured relationships or even claims for damages. There are obvious things a broker should avoid: lying, misrepresenting, and hard-sell tactics. However, some unethical behavior is more subtle but no more acceptable.

Classic Unethical Broker Behavior

Before getting into the ethical guidelines, it's important to be aware of some of the different, classic types of unethical broker behavior that may occur. These no-nos are related to one another and constitute the core of the problem. All of the types entail some combination of poor or inadequate communication, a tendency to mislead investors, or simply not bothering to do a good job. Much has to do with taking advantage of the informational asymmetry between buyer and seller.

The half-truth (or quarter-truth or three-quarter truth) - One of the most insidious temptations of bad brokering is to mix truth with untruth. For instance, a broker could tell a customer that they watch the market every day, implying that appropriate action will be taken in-line with market developments and events. But if a fund manager will literally do no more than watch, the customer is being misled.

Insufficient explanation - Some brokers simply do not take the trouble to explain things, and they prefer clients not to know too much. An offshoot of this is "blinding with science." It is possible to mesmerize and impress clients by talking above their heads about internal rates of return, long gilt futures, options, currency derivatives, and countless other financial terms.

Discreet silence - It can be very tempting for a broker selling a structured fund, for example, to praise the built-in protection and guaranteed returns that it offers. Especially these days, investors love security, plus (reasonably) good returns. But if this comes at the price of all the dividends, the investor really must be told this. There is no way it can be taken for granted or assumed that they know.

Not offering alternatives - From both an ethical and legal standpoint, inexperienced clients, in particular, are not equipped to make meaningful decisions unless they are aware of other options. And there are many, many investments out there. If a broker offers a novice investor one particular fund, or even a combination of funds, with the attitude "this is right for you," they are not providing an optimal service. Even if the offer is in fact suitable, investors should be given a choice of alternatives. At a minimum, the broker should point out to the client that this is merely a suggested option and that one could earn similar returns with a similar level of risk in many different ways.

1. When in Doubt, Spell It Out

If it even occurs to you that an investor may need or want to know something, tell them. Never succumb to the urge to keep quiet, even when you know this may cost you the deal.

2. Do Unto Others

Put yourself in the position of the investor. If you would prefer not to be handled in a certain way, don't do it to someone else. Above all, avoid self-deception. The best test is to ask yourself whether you would want your mother, brother, best friend, or indeed yourself to have these investments.

3. Avoid One-Size-Fits-All Approaches

Everyone has different needs, preferences, and circumstances. Therefore, they need a portfolio that truly caters to them. Each communication that is sent out should be tailored to the individual client. Nothing is more useless to a client than a standardized quarterly letter containing general information that they could get from the internet or on financial television. Most clients will just ignore them. What customers need is customized information about their own portfolio, how it's doing and why, what changes you plan, etc.

4. Ask the Client, Don't Expect Them to Know

A client won't ask for clarification if they don't realize it's needed in the first place. Make absolutely sure that the client knows what they are getting. They do not need to know every intricate detail, but they certainly need to know, at minimum, how risky the product is in relation to the probable returns. There should be no surprises in store for the unwary and trusting investor.

5. Be Specific About Market Conditions

You should discuss the market with your client in general and with respect to the specific asset classes. This does not mean attempting to time the market, but the investor ought to know whether the market has been booming for years and is regarded as possibly overpriced, or whether the opposite is true.

In the same vein, if people are saying that commercial property may well have peaked, tell that to the client. There is nothing wrong with stating that "opinions are divided and it could go either way." But there is something wrong with keeping quiet about potential disadvantages and risks in order to push through the sale.

(For more, read Deadly Flaws in Major Market Indicators.)

6. Explain Monitoring and Control

A client should know how often you will monitor their investments and what this really means. For instance, will you call the client if there is news in the media that things may go be going sour for a particular asset? This also applies to positive new opportunities that can pop up. If all you plan to do is take a look at the asset allocation once a year, that may be OK, but the client needs to know that they cannot expect more from you.

7. Show the Client How Things Work

The classic multi-color pie chart with asset class combinations for high, low and medium risk is a great way to demonstrate the very essence of the investment process. Likewise, "pyramids of risk" which show how one moves from a low-risk basis of cash, upward through bonds to equity funds and so on, should always be the starting point of the advisory process.

8. Explain Reports and Research 

Simply emailing your client a report is not enough. There is a good chance it will not be easily understood and it may not even get read. Go through the main points with clients, so you can be sure they really understand the main elements of the investment and what the text means. The man on the street does not know the meaning of such phrases as "optimizing portfolio risk," "sector allocation," "over-weighting mid-caps" and many others.

Similarly, ordinary investors are generally unaware of the meaning and implications of long-term versus short-term investments, or the difference between investment styles like value and growth. There is an optimal (and minimum) level of communication and understanding that is essential for good brokering best practices.

The Bottom Line

Investment ethics are essentially about two interrelated things: giving the client good advice and then making sure they understand it. It is necessary to be completely frank and open about what you and/or the providers of the assets can and cannot do. Equally vital is ensuring that the client is able to see the advice and products in context—and that context extends to the markets in question and to the other potential investments that are available.

Over time, good communication and being totally honest will pay off with good returns, positive client relationships, and frequent word-of-mouth recommendations.

(If you decide to ignore this advice, you should check out Policing the Securities Market: An Overview of the SEC.)

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