Saw this subject line in my inbox this afternoon from Wall Street Journal (subscription required): 

Advisers at Leading Discount Brokers Win Bonuses to Push Higher-Priced Products

Investors who seek advice from discount brokerage firms might assume the counsel they get is impartial, given how these firms have rejected the old Wall Street model of working on commissions. In fact, advisers at some of the biggest discount brokerage firms make more money if they steer clients toward more-expensive products, according to disclosures from the firms and people who used to work at them. That means customers could end up with investment products and services that are costlier than they need.

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I don't need to read the rest of the article as this pattern is a recurring theme in financeland. It may come as surprise to many, the adviser recommending financial products to you may not have your best interests at heart. This is why an educated consumer is so important. Here's the pattern that persists: 

Step 1: Companies maximize profits for shareholders

Step 2: Companies like to create or sell products that generate the most profit for given dollar of assets

Step 3: Actively managed mutual funds have highest expense ratios (and therefore highest profits) but do not perform better than low-cost (and therefore low-profit) index funds. Don't take my word for it academic studies have proven this for years as has recent performance. 

Step 4: Provide front-line sales employees with incentives (a.k.a. commissions) to sell said high cost (high profit) actively managed funds to unsuspecting clients. As my mentor pointed out to me over 20 years ago; "mutual funds are sold not bought." 

Step 5: Front-line sales employees advise clients to purchase high cost actively managed funds that on the whole will underperform low-cost index funds. 

Step 6: Rinse, repeat. 

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Want to avoid this problem and don't feel confident being a D-I-Yer? Choose a financial adviser who is fee based and not earning commissions based on the product they sell and this problem goes away. Others wonder why someone would sell products that on the whole are inferior to lower cost index funds. This quote from Upton Sinclair comes to mind: 

"It is difficult to get a man to understand something when his salary [editor's note: or commission] depends upon his not understanding it."

So, how do we arm our students with the knowledge they need? What are the key questions your students should be asking anyone offering investment advice:

• How are you compensated? Do you receive commissions or other compensation incentives based on the products that you sell? 
  • If they are not willing to answer this question, well, you may want to go elsewhere. 
• What are the total fees for this fund (sales load, expense ratio, 12b-1 marketing expense)?
• How does the performance of this fund compare to a comparable index fund?
  • 12% performance may look good for a stock mutual fund in isolation, but relative to a 20% return for the reference index (e.g. S&P 500) well not so much

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Have your students experience what if feels like to own a stock and make buy or sell decisions? Try an NGPF fan favorite, Ravioli Den! 

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.

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