Investors Should Look Out for Conflicts of Interest

In his new book, "Negotiating Your Investments," Steven G. Blum discusses some of the traps investors confront when they seek financial advice. This book contains a wealth of helpful information, but I am going to focus on two areas of particular interest: conflicts of interest and asymmetric information. They are inextricably intertwined and present formidable barriers to maximizing investors' expected returns.

Conflicts of interest. You would think investors would be sensitive to their broker or advisor having a conflict of interest. This is often not the case. Notwithstanding the wealth of information written about this subject, many investors still do not understand the critical difference between the duty to clients owed by Registered Investment Advisors and brokers.

Registered Investment Advisors have a fiduciary obligation to their clients. Registered Investment Advisors are required by the Investment Advisers Act of 1940 to act in the best interest of their clients. They must put the interests of their clients above their own and disclose any possible conflicts of interest.

Brokers are held to a lower standard. They do not have to place their clients' interests above their own. If they believe a recommendation is consistent with the interests of the client, they are permitted to make that recommendation without advising the client of the availability of other investments that might be more suitable for them, at a lower cost and with the same or higher expected return.

Blum provides an example of a broker recommending a mutual fund with a 5.75 percent sales load when an equally good fund exists with no sales charge. Both may be suitable for the client, but the one with the sales load will result in higher compensation to the broker. The broker's recommendation of the fund with a sales load would not violate the "suitability" standard. If a Registered Investment Advisor made the same recommendation, under the same circumstances, it would violate his or her fiduciary duty to the client.

Just because Registered Investment Advisors are held to a fiduciary standard doesn't mean they will never have interests which conflict with yours. Blum gives the example of a client who asks his financial advisor whether he should pay off a mortgage. The advisor understands that paying off the mortgage will reduce assets under management, which will reduce his fees. An ethical advisor will give advice that is in the best interest of his client and ignore the adverse economic consequences to the advisor. A savvy client will be aware of this potential conflict of interest.

Blum cautions investors that people "usually" act to advance their own interests, and that you are vulnerable when you rely on any advisor or broker who has an actual or potential conflict of interest.

Asymmetric information. Asymmetric information describes the situation that exists between you and your broker or advisor. In most cases, that person knows much more about investing than you do. You are relying on his or her expertise. This combination can create an environment where your best interests are not being served.

The potential for abuse, in which there is asymmetric information, is heightened when you are dealing with a non-fiduciary. Perhaps the most egregious abuse of asymmetric information was engaged in by Goldman Sachs in connection with a collateralized debt obligation called Abacus 2007-AC1.

As noted by Blum, Goldman Sachs was accused by the Securities and Exchange Commission of working with one client to create a financial instrument likely to go down precipitously in value so its client could short the instrument and profit from its decline. Goldman Sachs allegedly then sold the same financial instrument to another client, who expected it to retain its value. Goldman Sach's defense to the SEC accusations was that it did not violate any duty to the second client, a sophisticated investor, who presumably should have been able to figure out that the investment being recommended was not suitable.

According to The Wall Street Journal, Goldman settled with the SEC by paying a record fine of $550 million. In the settlement, Goldman Sachs acknowledged that it should have revealed the role of its first client in the creation of the financial instrument recommended to the second client.

Although this is an extreme example of abusing asymmetric information, Blum's advice should be heeded by every investor. If you are in a situation in which asymmetric information is a factor, you need to educate yourself, stay vigilant and do not trust blindly.

Blum's book has other helpful advice. His background as an expert in negotiations, coupled with his expertise in investing, brings an interesting perspective to investors.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, "The Smartest Sales Book You'll Ever Read," has just been published.