Red Flags: How to Spot Financial Advisor Misconduct
As you build your investment portfolio, you’ve probably wondered: “Do I need a financial advisor?” Or, “Is my financial advisor really worth their fees?” Competent registered investment advisors might pay off in the long run — they can provide valuable advice about how to minimize your taxes and investing-related fees. On the other hand, there are plenty of red flags that investors should keep in mind.
How Do Brokers Get Paid?
One survey from the National Association of Personal Financial Advisors revealed that 39% of investors consider commissions for brokers a red flag. Recent years have seen a boom in zero-commission trading, which is especially popular among younger investors. But as we saw with the GameStop debacle and Robinhood’s platform outages, zero-fee does not mean risk-free.
Instead of paying brokers a commission, zero-fee trades make money using a method called payment for order flow (PFOF), a technique pioneered by the late Bernie Madoff. PFOF involves selling bulk trade orders to major clearinghouses.
The SEC has concerns about whether these types of trades get the best deal for investors. (SEC-Registered investment advisers are required to look for the best price to execute trades.)
We’re still learning about the risks of zero-fee trading. If investors decide they want to go the more traditional route, they should do their research to get the most out of their financial advisor’s services.
What to Look Out For
Regardless of how your financial advisor is paid, here are seven red flags every investor should know:
1. Buyer Beware: High Returns Almost Always Mean High Risk
Nothing in investing is guaranteed. Sales pitches that promise especially high returns should raise a red flag.
A Goldman Sachs study showed that over the past 140 years, U.S. stocks averaged 10-year returns of 9.2%. Investments that promise considerably higher returns likely come with significant risk. Your investment advisor should emphasize the risk, and not the potential for large returns.
The 10X Rule author Grant Cardone faced a class-action lawsuit in California following an investment opportunity that allegedly didn’t deliver on its investor payouts. These allegations make sense in light of the letter he received from the SEC on July 31, 2020:
“We note… your strategy to pay a monthly distribution to investors that will result in a return of approximately 15% annualized return on investment. We further note you do not appear to have a basis for such a return. Please revise to remove this disclosure throughout the offering statement.”
According to the class-action suit, Cardone continued to quote the 15% figure even after the SEC advised that he remove it.
2. Celebrity Endorsements
The SEC has published investor warnings about celebrity endorsements.
For example, Rapper TI (aka Calvin Harris) recently settled with the SEC following allegations that he promoted unregistered securities. Harris promoted sites where his followers could buy tokens that were meant to fund a new streaming platform. According to the SEC’s complaint, those tokens were never registered with the SEC. As part of the settlement, T.I. agreed to pay a $75,000 fine.
3. Social Media Fads
The SEC also cautions against any investments that garner large amounts of attention on social media. See: GameStop and DogeCoin. We’re not suggesting that these are bad investments, but underlining the fact that the SEC warns that their potential for high returns could be over-hyped thanks to their popularity on Twitter and Reddit.
The SEC states: “Financial ‘manias,’ or a ‘bubble’ is the rapid rise in the price of an investment, reflecting a high degree of collective enthusiasm or exuberance regarding the investment’s prospects.”
In addition to the “mania” around especially hyped investment, fraudsters have used social media specifically to inflate the price of a certain stock, which they then turn around and sell. This is called a “pump-and-dump” scheme.
In March of 2021, The Department of Justice indicted software engineer John McAfee on charges related to a pump-and-dump scheme. The SEC alleges that McAfee promoted a cryptocurrency coin to his followers, earning himself and his team $2 million. McAfee could face a decades-long sentence if convicted.
4. Short-Term Securities
Unless you’re an experienced investor with a high net worth, short-term trading presents too high of a risk. Some short-term investments, like options, come with the possibility of unlimited losses.
Options are contracts that allow an investor to buy a particular security at a specified price by a certain deadline.
Leave this type of high-risk trading to the hedge funds — they can probably afford to take the hit when a swarm of Redditors decides to inflate a particular stock’s price.
5. High-Pressure Sales Tactics
If a financial advisor says you only have a short timeframe to purchase an investment, it’s best to walk away. High-pressure sales tactics are common among disreputable financial advisors. (Wolf of Wall Street, anyone?)
6. Over-Concentration in a Single Stock
Diversification is one of the most basic investing principles. Any financial advisor that recommends you invest your portfolio in one high-risk class of assets probably does not have your best interests in mind. Chances are that the high-risk security they’re pushing comes with a healthy sales commission.
7. Churning: Excessive Fees
Speaking of commissions, “churning” occurs when a financial advisor executes an excessive number of trades to generate commissions for themselves. Make sure that you understand why your advisor is executing trades. They should be able to clearly explain their strategy, especially if they earn a per-transaction fee.
Some investors avoid this problem by selecting a portfolio that charges a percentage of the total value of the portfolio — i.e., the assets under management (AUM). This is usually a 1% to 2% fee. In this case, you should still check on your investments. Investment advisors have been known to simply collect their fees without executing any trades. This is a type of misconduct known as “reverse churning.”
The Bottom Line
Covid-19 created the perfect storm for an increased interest in retail investing: lockdown boredom and stimulus checks made zero-fee commissions seem like an easy and occasionally exhilarating way to earn a little extra money. But as many of those new retail investors have learned, watching stock prices fluctuate can be gut-wrenching.
Your investment portfolio shouldn’t be an emotional roller coaster. Smart financial advisors who reliably achieve excellent returns could justify their fees. It might make sense to try a free trading platform first, and then hire an advisor once you get your footing. There are also financial advisors who charge by the hour, offering an easy way to answer your questions without committing to an annual fee.
Disclaimer
This article is intended for informational purposes only, and should not be considered financial or investment advice. You should consult a financial professional before making any major financial decisions.
