Danger Ahead

Adam M. Grossman

I’LL NEVER FORGET MY first interaction with Wall Street. I was in my early 20s and just getting started in my career, when I was introduced to a stockbroker—let’s call him Eddie. He was a pleasant fellow with a good reputation and all the trappings of success, including a DeLorean in the driveway. He seemed like a safe choice.

My interactions with Eddie were straightforward. He would call from time to time with stock ideas. Since I worked in a different field at the time, I trusted his judgment and generally went along with his recommendations. And things appeared to work out very nicely. Because it was the late 1990s, everything he recommended rose in value—quickly. He seemed like a genius.

But our relationship didn’t go much beyond discussions about stocks. When I got married, we didn’t talk about life insurance or buying a home, and when we had our first child, we didn’t talk about saving for college. To be fair, I’m not sure if Eddie even knew that I’d gotten married or become a parent. We didn’t talk about things other than stocks. At one point, he suggested I set up a margin loan to buy a new car, but that was as close as we got to discussing financial planning.

During the dot-com crash that started in early 2000, the U.S. stock market dropped by about 50%, but my portfolio did far worse. Many of the stocks dropped 80% or 90%. What I later understood was that my account consisted almost entirely of technology stocks. They all moved up together during the boom and they all crashed together in the bust.

I don’t necessarily blame Eddie as much as I blame the system. The financial services industry sometimes seems like it was intentionally designed to be as unhelpful as possible to its customers. To be sure, it’s gotten better since the 1990s, but it still feels like a minefield. Here are some recommendations for navigating that minefield:

1. Naive diversification. My 1990s portfolio was 100% stocks, and more than 80% of those stocks were tech stocks. It doesn’t get much worse than that.

Unfortunately, the investment options in many 401(k) plans today could lead you to the same result. Though it may feel like you’re diversifying when you buy more than one mutual fund, that’s not always the case. Since many funds own similar sets of stocks, you may just be doubling up on the same investments. Psychologists refer to this as “naive diversification.” I find the term condescending, but it’s a real problem. My advice: First decide how much you want in stocks and how much in bonds. Then use the free tools on to research funds for potential overlap.

2. Hidden fees. Back in the 1990s, traditional stockbrokers made a living by charging hundreds of dollars per trade. That created incentives for dishonest brokers to “churn” accounts unnecessarily. As a result, most of the industry moved to a percent-of-assets model, where advisors no longer charge per transaction.

In some ways, this has been an improvement. But now it’s trickier to know exactly what you’re paying. There is, for example, a practice known as soft dollars. Investment advisors direct clients’ trades to a particular broker and, in exchange, the broker will pick up the tab for some of the advisors’ bills, such as their pricey Bloomberg terminals. If that sounds convoluted, it is. Fortunately, disclosure rules require advisors to tell you if they’re doing things like this. Just read their Form ADV, which you can find on the SEC’s website.

3. Unnecessary coverage. Life insurance companies seem to have a knack for hiring amiable people with wide groups of friends. Invariably, these people will find their way to your doorstep. They’ll tell you that you’re doing the right thing when you buy one of their policies to protect your loved ones.

The reality is, you’re doing the right thing when you buy life insurance—sometimes. But you don’t need life insurance if you don’t have anyone depending on your salary. If you’re single—and often if you’re married but have no children—resist their clever arguments (and they’ll have many) for buying a policy before you actually need it.

4. Ticking time bombs. When my broker Eddie suggested that I borrow against my portfolio of tech stocks in the middle of a bull market, he was giving me a match to light the fuse on my investments.

Similarly, if a life insurance salesman suggests you borrow against the cash value of your policy, he’s constructing a very delicate house of cards. When something like this falls apart, it can wreck your investments and leave you with a tax bill. My advice: Keep doing what you’re doing right now, which is to read widely. Don’t take any one person’s advice—mine or anybody else’s—especially if that person has something to sell.

Adam M. Grossman’s previous articles include Know DoubtBeat the Street and After the Windfall. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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