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Investment Risk: Another Key to Understanding Financial Services

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I just finished reading Melanie Waddell’s May 30 story, “New Evidence of Fiduciary Rule’s Harm, Chamber Report Says,” about the U.S Chamber of Commerce’s contention that the embattled DOL fiduciary rule will raise costs for investors while reducing their access to investment advice. I’ll save my observations about this report for another time, with this exception: The report focuses only on the costs of “advice,” not on the total investment costs paid by investors.

As we all know, under the current suitability standard, many “advisors” aren’t required to consider the cost to investors when making investment recommendations. Consequently, as many studies have shown, those investors can end up paying costs in their long-term portfolios that are many times what the clients of fiduciary RIAs pay.

While excess investment costs potentially cause the greatest harm to clients of non-fiduciary advisors, there is another factor that doesn’t receive as much publicity these days: Risk. As part of my ongoing, if intermittent, series on understanding the financial services industry, let’s talk about investment risk and its impact on investors’ portfolios.

One of the reasons that the topic of investment risk doesn’t appear in most discussions about the financial services industry is that it’s a lot harder to understand and to quantify. However, that doesn’t mean that it’s not important. As far as I can tell, the most highly compensated professionals in financial services are those who can accurately calculate the current and future risks of specific markets and investments.

Under currently accepted investment theory, risk is defined as the volatility of a given asset class or investment; the range within which the market price fluctuates. (I believe this idea originated in Bill Sharpe’s Nobel Prize-winning capital asset pricing model.) However, at the risk of differing from the eminent Dr. Sharpe, I’ve always found this notion to be a bit odd.

To my mind, the problem with this notion is that it considers the upward movement of an investment to indicate the same level of risk as an equal but downward movement of another investment. It seems to me that when it comes to investing, risk universally means the chance of losing all or some of our money, not of making more of it.

That brings me to risk within the financial services industry. After all too many years of observing the industry, I’m come to believe that management of risk is the name of the game for large financial institutions and high-net-worth investors. (See the above reference to higher compensation.) Consequently, they spend a lot of money collecting and analyzing data to determine whether their current — and potentially future — holdings are more likely to increase or decrease in value.

Now, here’s the point. When they identify an investment that appears likely to increase in value at some acceptable point in the future, they buy it or buy more of it. Simple. But what if they determine that one of their current holdings is likely to lose value? Well, obviously, they sell it, right? As it turns out, things aren’t so simple.

The problem is that while the investment risk gurus are some of the smartest people on the planet, there are still more than a few of them around. If one institution’s gurus think the Hong Kong market is overvalued, it’s likely that some of the other institutions’ gurus will see that, too. So, who are they all going to sell their Chinese stocks to?

In the financial services industry, many of the big investment firms buy their securities through the big brokerage firms, and that tends to be a lot of securities. When they decide to sell some of those holdings, they expect the BDs to find the buyers. Are you beginning to smell a conflict here?

You don’t have to watch “Wall Street,” “Bonfire of the Vanities” or “The Big Short” to understand that the primary business of Wall Street brokerage firms is to sell stocks and bonds to their “clients,” mutual funds, other institutional investors — and the clients of outside financial advisors.

Now, all this doesn’t mean that these stocks they are selling are unsuitable, or even bad investments. However, it does often mean that some really, really smart investors have determined that their risk outweighs their potential for gain. I’ll let you draw your own conclusions.

It’s been awhile since I’ve done this, but I’ll bet it hasn’t changed much; if you look at the annual report of any major brokerage firm, you’ll find that their primary business is underwriting securities (stocks, bonds, mutual funds, etc.) and then using their in-house sales force to sell, and then support, the prices of those issues.

The result of this system is that retail investors often end up taking investment risk that the “smart money” has decided is too high; a situation that, even if only some of those risk assessments are accurate, will end up costing investors money.

I’ve never seen the economic impact of this increased level of risk for retail investors quantified. I do know that the conflicts of interest that lead to this increased risk are not permissible under law for either RIAs or pension advisors (under ERISA). I suspect it’s another reason that the brokerage industry is so adamantly opposed to the new Labor Department rules.

— Read Do Too Many Rules Really Lead to Bad Advice? on ThinkAdvisor.