Evidence of Harm, Part 1: Investors Flee the Capital Markets Forever, Ending Their Hopes and Dreams

"Where is the evidence of harm?" Opponents of the fiduciary standard often ask this question. Permit me to find evidence, over the course of several blog posts.

While these may seem like isolated stories - they are not. I have dealt with hundreds of individual investors, and have seen these stories repeated over and over and over again. I have also discussed, with other fiduciary investment and financial advisors - the huge amount of harm which consumers of non-fiduciary advisors suffer today. At a certain point, the volume of seemingly anecdotal evidence reaches a compelling mass, and becomes admissible evidence in both tribunals and in the context of cost-benefit analyses in rule-making endeavors.

Here is the first tale of ... evidence of harm.

It was October 2006. The stock market had recovered from the substantial downturn seen in 2001-2003. Before me were prospective clients, a husband and wife both in their late 50's, who were seeking financial advice. I will call them "John and Jane Doe" in order to keep their names confidential.

John and Jane possessed a nice nest egg, but it was far smaller than it had been in 2000, and was even smaller (despite ongoing contributions) than it was twelve years before, in 1994.

In the mid-1990's John and Jane Doe thought they were on the path to an early retirement - by age 60. Indeed they were, at the time.

But then John and Jane encountered a "wealth manager," who I will call "Jake." Jake commenced, as a broker, the management of their portfolio. Some well-diversified stock and bond mutual funds were initially purchased, which I learned were Class A shares - with commissions ranging from 3% to 5.75% (depending on amounts invested), and nearly all also had 12b-1 fees of 0.25% a year (in addition to fund management fees, which ranged as high as nearly 2%).

But then, as the stock market took off in the late 1990's, Jake's investment strategy changed. By mid-1999 Jake had advised the clients to move all of their funds into high-flying technology stocks. Despite incurring capital gains in making the move (and despite the fact that sales loads had been paid to enter the mutual funds sold just a few years before), the clients agreed.

Of course, technology stocks then crashed, commencing in 2000. Yet, it was only late 2001 that Jake changed his investment strategy again, to become far more conservative. Jake recommended some high-cost variable annuities to the clients, with investments in a mix of high-cost stock funds and bond funds within the annuities. But, despite the allure of the "guaranteed returns" Jake promised that these variable annuities possessed, this time John and Jane Doe balked. John and Jane had Jake liquidate all of their investments, and they then purchased CDs at several local banks.

Five years later John and Jane Doe were before me as prospective clients. After gathering facts, and analyzing what had occurred, I patiently explained the mistakes of the past. And, I explained, in order to achieve their long-term goals in retirement, a portion of their investments should be in well-diversified, low-cost stock mutual funds. Another portion should be in fixed income investments - such as bonds of high-quality, and/or investment-grade diversified bond funds, and/or CDs. With a proposed Investment Policy Statement in hand, and with recommendations of a strategic asset allocation and selections of low-cost, tax-efficient stock funds and low-cost bond funds and laddered CDs, I felt very confident in my proposal to them.

John and Jane Doe listened, but I could tell they were not receptive. Upon inquiry, John informed me: "You don't understand. We will NEVER invest in stocks or bonds again. We will ONLY invest in bank C.D.s."

I spent two more meetings with them, exploring their fears, and explaining probabilities in accomplishing their goals over the long term with a C.D.-only strategy versus a more diversified portfolio. Despite patient instruction, John and Joe Doe never budged off their stance. They would NEVER, EVER invest in stocks or bonds again - all their savings would be kept "safe" in their local banks.

Their trust had been betrayed.

They felt like they had consulted an expert. But the "Wealth Manager" they consulted turned out to not have any education in investment strategies.

They felt like they were being represented by someone who was acting in their best interests. But, as they had been told before, and I confirmed, Jake their "Wealth Manager" was only a registered representative, and neither he nor his firm was likely to be considered a "fiduciary" to them.

So, where was the harm? In the higher fees and costs they paid. From a review of all of their brokerage statements from 1995-2001, when advised by Jake, I estimated their "total fees and costs" averaged about 2.75% or higher, on an annual basis. Excessive, especially since none of the investment strategies employed generated above-market returns.

But this was not the worst harm suffered.

The harm was also in the horribly tax-inefficient portfolio. The actively managed stock mutual funds placed in their taxable accounts generated huge realized taxable gains. There was no consideration that appeared to be given as to correct placement of different types of assets, as between the taxable and tax-deferred accounts of John and Jane Doe.

But this was not the worst harm suffered.

The harm which was even more severe was the loss of John and Jane Doe's participation in the capital markets. Academic research has revealed that individual investors who are unable to trust their financial advisors are less likely to participate in the capital markets. [“We find that trusting individuals are significantly more likely to buy stocks and risky assets and, conditional on investing in stock, they invest a larger share of their wealth in it. This effect is economically very important: trusting others increases the probability of buying stock by 50% of the average sample probability and raises the share invested in stock by 3.4 percentage points … lack of trust can explain why individuals do not participate in the stock market even in the absence of any other friction … [W]e also show that, in practice, differences in trust across individuals and countries help explain why some invest in stocks, while others do not. Our simulations also suggest that this problem can be sufficiently severe to explain the percentage of wealthy people who do not invest in the stock market in the United States and the wide variation in this percentage across countries.” Guiso, Luigi, Sapienza, Paola and Zingales, Luigi. “Trusting the Stock Market” (May 2007); ECGI - Finance Working Paper No. 170/2007; CFS Working Paper No. 2005/27; CRSP Working Paper No. 602. Available at SSRN: http://ssrn.com/abstract=811545.]

But this was not the worst harm suffered.

Rather, the worst harm which was suffered was the demolition of John and Jane's hopes and dreams. Their inability to retire when they desired. Their inability to provide for the education of their grandchildren. Their diminished enjoyment of life.

Evidence of harm abounds, in the destroyed hopes and dreams of our fellow Americans.

It is time for a bona fide fiduciary standard to be imposed upon ALL providers of personalized investment and financial advice. It is time to establish standards mandating that a high degree of expertise be applied, and that decisions are made in the best interests of the client - at all times. It is time for a bona fide fiduciary standard, in which conflicts of interest are not just merely disclosed (since, as we all know, disclosures don't work), but rather that even for conflicts of interest which cannot be avoided a client is never asked to provide informed consent to be harmed.

It is time for the adoption of the FIVE CORE PRINCIPLES, as promoted by The Committee for the Fiduciary Standard, by all providers of investment and financial advice:

 • Put the client’s best interests first;
 • Act with prudence, that is, with the skill, care, diligence and good judgment of a professional;
 • Do not mislead clients--provide conspicuous, full and fair disclosure of all important facts;
 • Avoid conflicts of interest; and
 • Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

It is time that John and Jane's story never again be repeated, as it has so many times before.

IT IS TIME FOR THE FIDUCIARY STANDARD. Our fellow Americans deserve nothing less.