Ray and Sheila Beauchamps were fortunate. Few investors recover anything from lost assets as a result of bad investment advice, and the road leading to even a limited settlement tends to be long, winding, and rough.
Financial advisors and their employers battle ferociously to defend themselves against client claims of malfeasance and outright fraud.* Even in cases where the industry’s regulator has decreed that the advisor or broker was at fault and imposed penalties, the investment firms may refuse to discuss compensation, claiming the investors are “authors of their own misfortune”—this from an industry that decrees most investors are not qualified to manage their own portfolios and, thus, need professional consultation and management.
Yet few qualified professions set lower qualifications for entry. Scoring a 60 percent average on a course examination approved by the Canadian Securities Institute, offered by community colleges across the country, wins you a licence as a mutual fund salesperson and begins the process of qualification to sell other securities. No apprenticeship is required, no residencies are involved, and no articling exists. As a result, there is no formal requirement to observe and interact with experienced individuals who may provide guidance and establish standards of behaviour. Should we be surprised that, as one legal advocate of investor rights has said, “There are some excellent financial advisors out there, those who go through a planning process, who disclose risk. They’re excellent and they’re a really important part of our economy and our community. Problem is, they’re a very small minority.”*
The Risk of Making Your Own Decisions versus
the Risk of Dealing with “Experts”
The differences between advisors and clients can be measured by the industry’s dependence on sales commissions as a source of immediate income; on receiving future income via mutual fund trailer fees; and on maximizing overall income via larger commission payments in return for bigger sales volumes. Even when investors are aware of these aspects of the business, they agree with proposed strategies often inappropriate for their needs. How can this happen?
In March 2009, Gregory Burns, a neuroeconomist—now there’s an academic specialty for you—at Emory University in Atlanta, Georgia, conducted a series of experiments to measure the brain responses of subjects making decisions on their own and with the assistance of an “expert.”*
The process involved tracking blood flow in the subjects’ brains while the subjects evaluated near-certain rewards and risky gambles. The first series of tests, permitting the subjects to make decisions on their own, activated two distinct areas of the brain. One region began measuring the payoff, and the other measured the risk, essentially triangulating the measure of loss and gain to reach a verdict favourable to the subject.
When subjects were asked to reach a decision based on the advice of “experts,” however, the normally activated parts of the brain remained quiet. None of the purposeful logic seen in the first test was evident, even when the “expert” proffered bad advice. In essence, the “expert” assumed the role of the subject’s brain.
Burns called this process “off-loading”—letting the expert do the work your own brain would normally perform. “Your decisions are being driven by the [expert’s] advice, not by your own valuation structures,” Burns explained. The lesson is clear: The act of seeking an expert’s opinion may erase your own opinion. And if you remain unaware of the motive imbalance between you and the commissionpaid expert, who seeks immediate and measured reward versus your delayed and indeterminate gain, you are at a severe disadvantage. “You should beware of people offering advice not only because they might be wrong,” Burns concluded, “but because [that advice] may inhibit your ability to form judgements.”
A Convoluted Trail That Often Leads Nowhere
When an advisor’s proposals and actions cost clients dearly, they discover themselves wandering across a desert of mirages and disappointments. All the smiling faces, firm handshakes, and promises of expert assistance evolve into cold shoulders and legalese.
The standard procedure unfolds thus:
Clients with concerns about their investment portfolio are told to raise them with their advisor. If their advisor cannot satisfactorily respond, they must turn to either their advisor’s supervisor or the appropriate compliance officer. The unfolding trail, if the dealer or brokerage rejects their complaints (and it usually does) may lead to the firm’s ombudsman or someone appointed to fill that role. This may give the investor a sense of comfort, but it shouldn’t. In too many cases, the ombudsman’s office is not a sanctuary but a trap.
A client’s detailed discussion with a supposedly neutral ombudsman provides the investment firm with confidential information from the complainant, who usually is not accompanied by legal counsel. The ombudsman is employed, after all, not by clients but by the brokerage or investment firm. The firm can and will use any information provided to the ombudsman in the firm’s defence, turning the investors’ own words against them where appropriate. Moreover, the firm has neither an obligation nor an incentive to reveal similar details of its operations and its advisors’ actions to the client. This is a highly stacked deck, enabling brokerages and investment firms to dismiss many legitimate claims with impunity and perhaps even sympathy, but rarely with a satisfactory settlement.
Clients who retain enough energy to keep battling may seek legal assistance at this point. The decision often leads them into a Kafkaesque world where counsel demands a five-figure retainer fee plus monthly charges to pursue a case that is almost certain never to go to court and rarely, if ever, produces an adjudicated settlement of more than a fraction of the lost assets.
Should the advisor or brokerage be a participant in OBSI, the possibility exists for a settlement of some kind, but the odds remain against the investor. Of 346 investment complaint files opened by OBSI in 2008 only 64, or fewer than 20 percent, resulted in a recommendation for funds to be paid to the client. In 103 cases, OBSI sided with the investment firm or advisor.
The odds are even stacked against investors being aware of the procedure; OBSI’s own statistics reveal that 6 out of 10 complainants to OBSI had not been told, by OBSI-participating firms, of the dispute regulator’s existence when the two sides could not reach agreement.* When investors eventually learned of OBSI’s existence and services, they also discovered that the ombudsman is limited to settlements under $350,000 and that the service has no direct authority to force offenders to settle according to its recommendations. You cannot, by the way, approach OBSI until you have exhausted all the means for settlement at one of its member firms which means, if the firm employs an ombudsman, you will have already made statements on the record that could weaken your case.
Should you defy the odds and win, OBSI’s only means of enforcing its rulings against participating firms is via publicity, the thinking being that investment companies depending on a positive public image will choose to avoid appearing as deadbeats if they fail to comply. This usually works. But not always, as clients of Financial Architects Inc., a Toronto mutual fund dealer, demonstrated in May 2007.†
The case involved a 76-year-old widow whose monthly income consisted of a $179 pension, CPP payments, and OAS benefits. Her home mortgage-free, she owned a RRIF with a balance of $142,000 invested in medium-risk income and equity mutual funds, set up by a financial advisor. When the advisor left his previous firm to join Financial Architects in the summer of 2000, a substantial portion of the woman’s RRIF was shifted to high-risk (and high MER) mutual funds; by the fall of 2000 all of her assets were in equity investments, of which at least 60 percent were considered high risk, leaving nothing for income generation. The client could obtain income only by redeeming units of highly volatile DSC-based equity funds during a declining market, meaning she lost money through both declining values of the units and substantial penalties imposed on her by the DSC funds.
By 2003, the mandatory annual RRIF withdrawals based on the woman’s age had declined from more than $10,000 to less than $5000, reflecting a drop in the RRIF’s value of more than half within three years.
In a news release, OBSI ombudsman David Agnew commented, “This unsophisticated investor was relying on her advisor. There is no evidence to suggest that any strategy was explained to her, and we do not believe she was aware of the downsides she faced with this risky advice. Leading a widow in her late 70s living on a limited income into a portfolio containing 60-per-cent high risk mutual funds with DSCs is simply unacceptable.”
He went on to note that the investments were unsuitable, the strategy ill-conceived, and the firm’s recording-keeping “unhelpful,” adding, “Financial Architects Inc. could not produce any kind of Know-Your-Client form either on account opening, when the account was transferred, or any other time. Nor could we find a written investment plan. The advisor’s notes were spotty at best.” OBSI was not persuaded by Financial Architects that the client understood the possible negative consequences of being invested entirely in equities and for the most part in high-risk mutual funds. It recommended that the elderly client receive compensation of $79,797.
Financial Architects responded with an offer to pay the client $248.50 in tax penalties for excess foreign content and $180.86 toward DSC fees.*
OBSI’s only rejoinder was to publicize the case and attempt to embarrass the firm into agreeing to the negotiated settlement. Financial Architects refused, resigning from OBSI and a year later resigning from the Mutual Fund Dealers Association. The firm’s president (and compliance officer, raising questions about conflict of interest) dissolved the firm. In mid-2009, the same individual was managing a new investment firm operating out of the same offices and with the same telephone number as Financial Architects Inc.
You Are the Last Defence
The widow’s experience is unusual because of the refusal of Financial Architects to comply with OBSI’s ruling. Similar incidents, in which clients fail to recover any losses at all, are reported on an almost daily basis among investor advocates and, to a lesser degree, in the trade and consumer press. When they occur, investors discover that the investment industry, eager to attract them with promises of future wealth, is swift to reveal that, while the investors and the industry (via MERs, fees, and commissions) will share the upside, only the client pays on the downside. And only the industry can boast favoured organizations to support its position, none of them interested or equipped under any circumstances to enforce the return of lost funds even when the misconduct of advisors has been proven and unchallenged.
Let’s be fair here: Investors have to begin accepting a share of responsibility for actions that produce major asset losses. In cases of outright theft and fraud, the primary error committed by the investor may be one of granting the advisor or broker too much trust. At some point, the question of trusting too much becomes a matter of caring too little. Claims made by investors in response to queries about the client’s assets and investment knowledge too often reflect an attempt by the investor either to conceal his or her ignorance about the subject or boast of an inflated asset base.
These fictions usually occur when completing the Know Your Client (KYC) form or Risk Questionnaire, the investment industry’s attempt to construct a suit of armour where investor claims of mismanagement are concerned. Investment firms are legally required to have new investors complete such a document as a guide to the investment strategy followed by the advisor in constructing a suitable portfolio. Investors are asked to estimate the degree of their investment knowledge, the level of acceptable risk they are prepared to endure, and the value of their liquidable assets, among other elements, as part of their account-opening activity.
How effective are KYC forms? “Really stupid,” according to Meir Statman, professor of finance at the Leavey School of Business, Santa Clara University. “Unfortunately, investors think they must answer them. If you ask someone, ‘How many stars do you think there are in the heavens?’ they have no idea. But they’ll probably still answer the question. Same with investment knowledge.”
Statman went on to make a provocative and instantly comprehensible statement: “We all want two things in life. One is to be rich and the other is not to be poor. [For most people,] not being poor is more important than being rich … On that basis, I think the primary responsibility of advisors is to protect the downside of their client’s portfolio.”*
How Much Risk Can You Tolerate?
RRSP/RRIF/TFSA investments are directed toward providing postemployment income, but determining how much will be needed (beyond “As much as possible!”) is complex. The objective of saving and investing during your working years could include generating inheritances to assist your children, pay college and university tuition for grandchildren, create a trust or bequest for favourite charities or causes, and a dozen other goals, each with its own priority and target value.
Another variable reflects market situations at the time the risk assessment is made. Ask an uninformed investor about his risk tolerance after a steady rise in the market index over several months and he is likely to claim it’s relatively high. Why not? What’s to risk? When the bulls vanish and the bears take over, his risk tolerance will decline in relation to the market’s devaluation.
Filling in the data demanded by KYC forms and risk-assessment questionnaires is like drinking a cup of chicken broth when you’re battling a bad cold; it makes you feel good but it doesn’t address the basic problem. Nor can it do so automatically. No trustworthy mathematical formula exists that will crunch figures based on your age, income, knowledge level, assets, net worth, time horizon, and other information and then spit out your level of risk tolerance.
Some astute advisors disregard all of this feel-good formulation and ask prospective clients a question that can be answered with a simple yes or no: If I invested $100,000 of your money today, and 10 years from now handed you back $200,000, would you be satisfied?
In almost every instance, the answer is “Yes.” This means the client would—or should—be content with an average 7 percent annual return on the initial investment, a level that historically can be achieved at least 75 percent of the time.
Is Your Risk Tolerance High or Low, Steady or Variable, Real or Imaginary?
To this point, the term risk has been used as though it has a nearuniversal definition. In truth, it hasn’t. No one can determine or even estimate your definition of risk (as it relates to your investments) and the degree of risk you are willing to tolerate.
So here is a test with neither right nor wrong answers. The purpose of these questions is to persuade you to determine your own risk personality, then consider it when reading the rest of this book.
Write your responses to the following questions, then take a few moments to reflect on them when you have finished. You might consider marking this page and returning to it when you have completed this book, and perhaps a few weeks later, when you have absorbed changes in the value of your portfolio, either up or down.
1 You are on board a sinking ship heading toward port. The ship is taking on water even as it keeps steaming forward. At what point, measured in percentages (0% = full flotation, 100% = sunk beneath the waves), do you jump into the water and hope you swim safely to shore?
 10% | 20% | 30% |
| 50% | 70% | You won’t jump |
2 Of these events, rate the one you fear most with a value of 1, the next 2, and so on to 5, the one you fear least.
| Collapse in the value of your investment portfolio | |
| Loss of employment | |
| Alienation from family | |
| Serious illness or death of spouse | |
| Global war | |
3 Using the same rating system, which of these do you fear is most likely to occur over the next 10 years?
| Loss of your job | |
| Personal bankruptcy | |
| Destruction/loss of your home | |
| 50% decline in value of your investment portfolio | |
| Serious illness or debilitating accident to you or spouse | |
4 Again, using the same system, rate these decisions in order of the greatest risk they represent to you:
| Crossing a busy street in the middle of the block | |
| Neglecting to have a flu shot each year | |
| Smoking | |
| Making investment decisions | |
| Avoiding exercise/ignoring weight gain | |
5 A commission-based advisor brings you an investment opportunity that is widely acknowledged as legitimate. The advisor, who will make 10 percent sales commission on the transaction, assures you that the investment will yield a minimum 20 percent net return for you over the next 12 months. How much of your portfolio would you agree to invest in it?
| 10 % | 25% | 40% | 50% |
| 75% | All of it | None of it |
The Surest Thing to Remember in Investing:
There Are No Sure Things
I keep an investment book in my library that is either laughable or tragic, depending upon your point of view and experience. It’s there not because it makes me feel superior but because it serves the same role as the slave whose duty it was to whisper in the ear of the Roman emperor when the emperor was receiving accolades from the cheering populace, “You are not a god; you are a mere mortal.” Or something like that (I wasn’t there at the time).
The book is titled The 50 Best Internet Stocks for Canadians, 2001 Edition. Among the advice readers could glean from the book: Buy Quality (“Leaders in their sectors or upstarts with high growth potential”); Don’t Worry about High Share Prices (“Share price does not matter”); Accumulate—Don’t Buy and Sell; and Start Immediately (“The sooner you get started … the greater your potential for longterm returns.”)
Timing isn’t everything; it’s the only thing. The authors and publishers of The 50 Best Internet Stocks for Canadians (Mark Pavan, Gene Walden, and Tom Shaugnessy; Toronto: MacMillan Canada, 2000) had all the timing of a one-eyed drunk in a chorus line. On Friday, March 10, 2000, around the time their book was published, the tech-heavy NASDAQ Composite Index peaked at 5038. On Monday, March 13, it began dropping faster than a skydiving rhino, sinking almost 80 percent in value.
The authors’ timing was not only bad, their recommendations were appalling. Of the 50 best internet stocks for Canadians to accumulate in 2001, guess which rated numero uno, the pick of the litter, the cream of the crop, the first past the post?
Nortel.
In September 2000, when Canadians were browsing through The 50 Best Internet Stocks for Canadians, seeking ways to profit from the mountain that was really a bubble, Nortel stock topped $200 per share, defying the NASDAQ collapse. Expensive? Cheap at the price, the authors concluded. It rated four stars (the highest rating) each for earnings progression, revenue growth, stock growth, and consistency. How many stars should we give the authors for accuracy? (In mid-2009, if you had a quarter in your pocket, you could acquire a share of Nortel.)
The authors were not the only people in Canada, or in the global investment industry for that matter, who failed to foresee the meltdown of Nortel and the entire tech bubble. Major damage to Canadian investment portfolios, especially those within the RRSPs of Canadians over 50, was inflicted by dealers, advisors, brokers, or anyone who had a certificate from the Canadian Securities Course on their wall or in their drawer, entitling them to deal in securities and assist clients to reach their financial goals. They assumed conservative financial-planning principles could be set aside during market boom years, and they ignored mandatory planning processes such as asking, “When do we take profits?” And they were wrong—dramatically, spectacularly wrong.
Let’s Be Realistic
Examining the relationship between financial advisors and RRSP investors over the past decade or so, I have been struck by the lack of one element in particular: realism.
Investors too often are unrealistic about the prospects and degree of long-term growth for their portfolios. Beginning investors overestimate the amount of assistance they can expect if their portfolio is minuscule in size. A couple of thousand dollars may represent wealth to you, but if that’s the value of your portfolio, don’t expect a professional advisor to respond to your queries every time the market slips a few points.
Experienced investors fare no better when it comes to realistic expectations. It is not realistic for investors to expect near-continuous positive returns without losses and pullbacks. Yet some (supposedly) informed people in the marketplace never questioned claims made by Bernie Madoff in the United States, or homegrown fraudsters such as Michael Holoday here in Canada, that they could deliver consistently higher returns than the market with no risk of loss, even when the overall market declined. Would you believe someone who promised sunshine every day of the year in Canada? That’s the scale of the promises made by Madoff, Holoday, and allegedly by Earl Jones.*
The events of 2008–2009 were not pleasant for anyone in the investment industry, clients and advisors alike. Investors grew first frantic then angry at the losses that appeared in their monthly statements, and aimed their anger at the people who, in many instances, had constructed their now-gutted portfolios. Was their anger justified? Not according to some advisors, who vented their rage at clients in industry forums with comments such as these:
Yes, the current market has taken everyone by surprise, but regardless of the KYC, people (will) still attack anyone … and try to blame someone else for the drop in their portfolios.
If people are going to invest, then they must be informed that there is risk. Nothing is guaranteed.
And my favourite, posted by an obviously irritated financial advisor:
I have been reliably informed that human beings have only three essential needs: food, shelter, and someone else to blame.
Cute. Perhaps someone should draw this advisor’s attention to the fact that Canadians are attracted to the services of financial advisors by promises made through advertising and promotion on behalf of investment firms. Who is really to blame if investors respond to pitches such as the following, culled from various media and marketing vehicles in mid-2009?
Our advisors work … to deliver customized investment solutions and integrated wealth plans that meet the diverse financial needs and goals of our clients.
—Assante
You can trust in our expertise to help build a wealth management strategy uniquely designed to achieve your wealth management objectives.
—BMO Nesbitt Burns
Do you want to go it alone? Or do you want to get expertise on your side, to help you devise an investment strategy that can work for you, no matter what you’re investing for?
—CIBC Wood Gundy
A dedicated professional, your Investment Advisor devotes time to fully understand your financial situation, life goals and tolerance for risk when creating a strategy that is right for you …
—RBC Dominion Securities
Your ScotiaMcLeod advisor’s top priority is gaining a comprehensive understanding of your needs, so that he or she can develop a strategic plan to help you reach your goals.
—ScotiaMcLeod
You will receive comprehensive and personalized investment advice while staying involved in the key decisions about your portfolio.
—TD Waterhouse
We will provide a personal, thoughtful and intelligent strategy, delivered by a highly qualified professional you can trust.
—Wellington West
Banks and investment firms are hardly the first to stretch the truth in their promotional come-ons. The key point is that they are all promising to deliver the same thing: personalized service dedicated to individual investor needs and goals, along with heavy dollops of trust. So why doesn’t this translate into better protection for client assets in the event of a market meltdown? Why should aggrieved investors be told “markets go down as well as up,” and be expected to nod dutifully and go away?
Choosing an Advisor. It’s a Little Like Choosing a Spouse …
I’m not convinced that all Canadians need financial advisors to ride shotgun on their clients’ retirement-savings vehicles, but I believe most do. That’s because too few of us pay sufficient attention to the investments we’re making to finance our future. We can’t repair the transmission in our cars, but we know how to use and maintain them. Unfortunately, the same cannot be said for Canadians and their RRSPs.
The process of choosing a good financial advisor is a little like choosing a mate, in a couple of aspects (and not at all in others). Here are some guidelines:
• Chemistry is critical. If you do not feel that the advisor honestly relates to your investment needs and expectations, keep looking.
• Honesty is essential, on two levels. The first, of course, is based on trust. The other is based on the advisor’s policy of expressing caution and disagreement with proposals from you if the proposals conflict with a strategy you have both agreed upon.
• Third-party involvement is essential. Many of the advisor horror stories you hear concern independent individuals who accept your funds, manage your portfolios, issue statements and cheques, and generally function as a one-man/woman show. Should you choose an advisor who is not associated with a large and prominent firm, do not grant him or her the right to make withdrawals or write cheques on your account, and insist that your portfolio is held by a third party who acts as an independent custodian and issues the monthly statements.
• One person alone cannot handle a number of client portfolios. Look for backup staff and support.
What should you realistically expect from an advisor? Three things:
1 Transparency. A good advisor explains why he or she is recommending a particular investment vehicle, how it matches your investment strategy, and how much it is costing you.
2 Honesty. Without dragging in the prurient aspect, your relationship with a financial or investment advisor should resemble the one you share with your spouse. Lying is betrayal, and betrayal is intolerable.
3 Protection. Beware of “Yes!” men (or women). Some of the most valued services a good advisor can provide extend beyond “You should …” to include “You shouldn’t …”—especially if the negative comment is in response to an unsuitable investment idea you have. Good advice in any situation consists of offering differing opinions, discussing them with the client, suggesting intelligent action, and preventing unwise client actions.
*Pseudonyms. Source of case study at www.obsi.ca.
*For a detailed examination of the investment industry’s tarnished record of response to client complaints of poor or misleading investment advice, see my book The Naked Investor: Why Almost Everybody But You Gets Rich on Your RRSP (Toronto: Penguin, 2005).
*Harold Geller, “The Hired Guns: ‘Problem is people finding us,’” The Globe and Mail, April 21, 2009.
*Jason Zweig, “This Is Your Brain on Investment Advice,” The Wall Street Journal, March 31, 2009.
*This and other OBSI statistics were obtained from the OBSI 2008 Annual Review.
†OBSI News Release: Mutual Fund Firm Refuses OBSI Recommendation, May 10, 2007.
*OBSI news release, Mutual Fund Firm Refuses OBSI Recommendation, May 10, 2007.
*Mark Noble, Building a Better Risk Profile, Advisor.ca, March 10, 2009.
*For more on them and others, and the techniques they employ, see Chapter 8: Wolves on the Road to Grandma’s House.