Chapter 1 from The Frugal Investor

The Four Cornerstones of Frugal Investing

When I graduated from Merrill Lynch's three month course designed to teach rookie stockbrokers the difference between stock and bonds - and to separate the pigeons from the bulls and bears - my wiley old mentor, a broker with decades of experience, told me an amazing fact:

"Well, Scott, you've just received a $100,000 education. Merrill spent the first $30,000. Your new clients will now spend the rest: the $70,000 they'll lose bringing you up to speed!"

Why You Shouldn't Buy Securities from a Stockbroker

What he meant was that the training all stockbrokers get to pass the Series 7 NASD exam has less to do with earning money from investments than it does charging commissions from buying and selling them. My new business card said, "Scott Spiering, Financial Consultant." What it should have read, as the cards of commission-happy salespeople in many industries ought to read, is" "Licensed Pickpocket." Here's why:

Most new stockbrokers have two things in common. First, they have little or no background in investing or professional money management. Second, they're great potential salespeople. Both of these traits are exactly what the big "wire houses," or national brokerage firms - and even many big banks that now sell securitized financial products out of their lobbies - screen applicants for. Professional credentials, investment experience, and freedom from conflicting interests seldom enter the picture.

Most individual investors also have two things in common. First, they've been conditioned by advertisements, financial journals, and even our regulatory agencies to trust financial intermediaries such as stockbrokers. Second, virtually all of these investors already have twice the money management sense of the typical stockbroker. Why? Because in order to gain investable resources, these people had to succeed in the real world where good ideas, honesty, and true productivity still count:

As a result, the best qualified and most conscientious half of the investor-broker team hands over a sizable portion of the investor's life savings to the one who is the least capable of managing it effectively. In fact, most brokers are highly motivated to put client interest not only second, but third behind their own hunger for commissions and their company's insatiable demand for profits.

To prove this, take a tour through a branch office of a typical brokerage firm. See all those young men and women in the "bull pen" - the low partitioned common area surrounded by private offices? Each is equipped with the three essentials of the trade: a quotron screen listing securities prices (particularly those the firm is pushing at the moment); a telephone headset just like the 800-number operators use that allows them to make scores of cold-calls each hour without getting tired; and a canned sales pitch tailored to wear down the most resistant prospects - provided they don't hang up.

Most new stockbrokers spend their first two years in the bull pen "building their lists" - selling clients investments made through (and often sponsored by) the firm. They graduate to the private offices when their gross sales - upon which brokerage fees and commissions are based - reach a high enough level. It makes no difference if the security pays off for the client. Stockbrokers make money whether you win, lose, or break even, so increasing the number and size of transactions is the name of their game, even for the honest ones. In the brokerage business, this generation of fees and commissions is called "production." Brokers who achieve high production through guile, half-truths, and outright lies are called "rogues" or "gunslingers." In other industries what they do would be called self-dealing, sharp practice, or worse.

While brokerage firm executives officially condemn such practices, they often promote the worst offenders - keeping their consciences clean by not looking too closely at a high producer's tactics until a client complains. And for a client to even suspect sharp practice, he or she must know the firm's commission policy and commission rates paid for different investment products - impolite questions to ask, and facts your broker won't volunteer.

Unless you've been in the business, for example, it would be almost impossible to know that limited partnerships and annuities pay better commissions than CDs, T-bills, or even stocks. And when your broker assures you there's no commission - be even warier. Investment product sponsors have other ways to compensate the sales force. As you'll see shortly, a "commissionless" bond or a Class B share of a bond fund has, in fact, a commission built into the quoted price which never shows up on your statement.

Another favorite broker tactic is to reassure a reluctant client that "no cash" is required to buy a new product since the money will come from selling an old one. What the broker neglects to mention is that you'll be nicked for a commission on both ends of the securities' "round trip" (the sell and the buy transactions) and that new cash would have been a cheaper way to go, assuming you even wanted the new investment in the first place.

As SEC enforcement official Joseph Goldstein put it in a newspaper interview:
Consumers have to realize that somebody who is selling you something is doing it for a purpose, And that purpose is to make money on the sale. Be skeptical of what strangers tell you on the phone. They're not your mother, your father, or your friends. They're not going to do something special for you. What they want from you is your money.
A good example of the broker's mentality is reflected in a 1994 "asset gathering" contest (euphemistically called A Tribute to Excellence) sponsored by Prudential Securities at a time when that company was being investigated for the use of questionable sales tactics. Under its rules, brokers earned points toward luxury vacations by selling retirement plans and money market accounts to anyone they could talk into buying them.

So, what's wrong with such a contest?

From Prudential's perspective, nothing. Commission-based sales contests aren't new, or even peculiar to stock brokers. And nobody claims that the investment products are fraudulent or too risky. Problems arise, though, when the broker's main incentive is "asset accumulation" rather than client satisfaction and the existence of such contests is not disclosed to prospective customers - to say nothing of the propriety of a firm launching a hard-ball sales contest during a major investigation of its sales practices.

So let's add a third reason why that Series 7 NASD ticket is a virtual license to steal: it connects people with extra money to people who will do just about anything (short of outright theft, but sometimes new roman,times that's no barrier) to get it. For the investor, it's a dangerous combination. Here's a true and all-too-typical example of what I mean.

Never Buy Securities from a Bank

Long after I left the brokerage business, I met a young financial salesperson at a party. She had started out at Dean Witter but had flunked their tough "production" standards. Luckily for her, some of our bigger commercial banks draw heavily from this population of stockbroker wannabes, so she was hired by one right away to sell securities out of their lobby - and this she did with a vengeance.

Today she was on top of the world: had just put almost all of a new client's assets into Class B shares of a back-end loaded bond fund with a 12b-1 "trailer" of 1 percent. This meant that, unlike Class A shares where the broker's 5 percent commission is taken up front and is over and done with, the fund's sponsor hides the commission by telling customers that the commission "is saved" if the investor holds the shares for a least six years. What they don't say is that the broker receives the full commission up front anyway, and the investor reimburses the sponsor a little each year via the 1 percent fee (which is above and beyond the fund's annual operating expenses). Even worse, the broker continues to receive .25 percent of that trailer annually for as long as the investor holds the shares - a gold mine for the broker and a strong incentive to sell them to anyone who can hold a pen long enough to scribble a name. In this case, not only was the investment substantial - on the order of $400,000 - but the sales commission was enormous: over 4 percent to the broker, or $16,000, just for making a couple of very persuasive phone calls.

As you would expect, certain alarm bells went off in my head as soon as I heard this. At the time, interest rates were just beginning to climb after a long period in the doldrums. Existing bonds with lower coupon rates were dropping in value and even if her client had escaped the immediate payment of an exorbitant, if hidden, front-end sales commission, a portfolio concentrated in bonds would undoubtedly look bad at the end of the year - and like a train wreck after that.

When I asked why she hadn't also put her client into at least one other asset category, such as stocks, cash equivalents, or, perhaps, an international fund that would benefit, and not be penalized, from rising interest rates, she looked at me as if I had two heads. She mumbled something about bonds being a conservative investment and seemed satisfied with that until I pointed out that even bondholders can lose principal, as well as interest, if they liquidate in a down market. This was news to her - a little fact of life not covered in the Series 7 classes.

"Besides," I said, "the longer your client holds Class B shares, the more money he continues to pay you out of the 1 percent trailer. If he really is a long-term bond investor, he would've been much better off buying Class A shares and getting his sales cost out of the way. Now he can't win for losing; If he has to sell in the next few years, he'll lose principal and get dinged for the hidden sales cost. If he rides out the down market, he gets killed with the annual back-end commission. What kind of investment is that?"

The answer is obviously, a lousy one. What it ultimately came down to was (a) the salesperson really didn't have a clue as to how bond investors made money, and (b) she simply chose an investment that paid the biggest commission and fast-talked her client into a sale. As a result, she became a hero at the office - a "high producer" marked for big things by her boss and, undoubtedly, was given a better list of prospects. The fact that her client would very likely experience an immediate and serious loss didn't merit a second thought in the firm's - and her own - value calculation. When I asked what she would do when the investor noticed his 400K was now worth 350 and called back in a panic, she only laughed.

"Well," she said, "I'll just flip him into something else. We've got some new annuities coming out where the commission is almost as good. I'll have something for him, don't worry."

Sleazy sales practice? Of course. But is it illegal?

No- not according to the SEC. Our guardian of investor rights only protects you from fraud, not from greed or the ignorance of stockbrokers. Even when the securities you buy are appropriate and competitive, the brokerage firm's commissions, fees, and other tariffs on your account will virtually assure that it doesn't stay that way for long. Here's a "what if" example to show you what I mean:

Suppose a typical investor (who hasn't read this book) goes into a local branch of a major brokerage firm - say, my old alma mater, Merrill Lynch - and says she wants to invest $50,000 in the stock market. The first "product" she'll be sold isn't a stock or a mutual fund, but a cash management account (CMA) Which features check-writing, and VISA-card privileges (which she may or may not want or need) for "only $125 a year. After an initial discussion of her investment objectives, let's say the broker puts her into five proprietary mutual funds with a sales load of 6.75 percent. Suddenly that $50K has been reduced to $46,600 and not a dollar has yet been invested. Suppose, too that those funds nick each investor 2 percent per year in annual fund operating expenses and the 12B -1 fees (paid directly to your broker) to keep you locked into the investment. This means that our hapless investor will have only $45,500 left to work for her during that all-important first year. If the stock market continues to return the 10.3 percent per year it has over the pas 65 years, she'll need almost all of the first year just to break even - and if the market is down, it could take even longer.

Now, let's assume this same investor passes a bookstore on the way to Merrill Lynch and a copy of this book catches her eye. Now a Frugal Investor, she marches straight past the full-service firm to a discount broker, say Charles Schwab, armed with the same $50,000 and a list of good equity funds she researched herself, to open a comparable account. This time, her cash management account, check and VISA card are free, and there is no transaction cost or hidden recurring fees to acquire the five no-load mutual funds she selected. Also, because she followed the advice in Part III of this book, her fund managers charge her only 1 percent per year, putting $49,500 to work directly. If the market experiences an average year, this modest cost is earned back in one month, not ten or eleven; and if the no-load funds perform even remotely close to the broker-offered load funds, she'll retain this advantage throughout the life of her portfolio.

The first thing all Frugal Investors must learn, then, is how to eliminate or minimize their reliance on such dubious "helpers" as full-service brokers and a high-priced management team.