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Investment Rules That Do Apply to Your Financial Advisor

From movies to television, it may seem like the stock market is the Wild West and financial advisors are cowboys. But, there are many rules financial services professionals must follow, contrary to the disproportionate attention the media gives to the few who break those rules.

While celebrating your cousin’s birthday, your rich uncle Ted asks you how your investments are doing. Looking across the patio table you falsely say, “Fine.”

Thinking that your uncle knows a thing or two about money, you finally make an appointment to meet a financial advisor the next week. However, your only other context for investing are the movies Wall Street, The Wolf of Wall Street, and The Big Short; therefore, you wonder if you’re entering a lion’s den the first time you visit with a financial advisor.

Will your advisor give you a secret tip?

The investment rule violation most novice and well-versed investors alike are familiar with is insider trading. Respectable celebrities from golf professional Phil Mickelson to homemaking mastermind Martha Stewart have been charged with it.

Are you next?

As professionals who work in close collaboration with publicly traded companies and media, stockbrokers of all stripes are exposed to inside information. Inside information is material that has not been distributed to the public and gives the holder of the inside information an unfair advantage over other traders and investors. Learning inside information itself is not illegal, however,trading on insider information is.

For example, publicly traded companies are always making new product investment or changes within their business to stay competitive. These investments and modifications may hurt or help its stock price. For this reason, individual employees may be prevented from placing trades on the company stock until that information is shared publicly. If a company employee traded on that inside information, even if they’re not financial services professionals, they’d break the law.

Financial advisors, because of the nature of their business, are often exposed to more inside information than others and may be tempted to trade on this information in their, their friends’, family, clients’ or company’s accounts.

Most don’t because it’s illegal, unethical, and they could lose their job for violating this rule.

What if your advisor is a copycat?

Shadowing or piggybacking occurs when a financial advisor knowingly mirrors the trades of someone else. Shadow trades are placed after another advisor, trader or investor makes the same trade.

For example, a new financial advisor wants to perform well for their bosses and clients. Therefore, they may mirror the trades of celebrity fund managers thinking the celebrity fund manager’s trades will work for them and their customers.

The problem is the fund manager’s trades may not be appropriate for the advisor’s clients. Most, nearly all, advisors want to do right by their customers. It’s better for the clients, and it’s better for the advisor. Plus, brokerage and advisory firms have systems in place to prevent such violations.

Aside from violating an investment rule, shadowing creates a “herd mentality” that minimizes the efficiency of the markets and creates bubbles and troughs where they wouldn’t otherwise exist. Finally, it’s not fair for investors to pay full price for an advisor not doing their job.

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Can your advisor trade the same stock ahead of you to gain optimal pricing?

They could but likely won’t because it’s front running, and that’s illegal.

Front running occurs when an advisor buys or sells ahead of their customers. Trading ahead of another trader or their clients can get an advisor a better price than their clients. This creates a conflict of interest, especially if an advisor trades at their own discretion in their clients’ accounts.

An advisor learns in an office meeting that several of his colleagues are selling shares of XYZ stock for their clients. If being privy to news that suggests XYZ’s stock price will drop, the advisor preemptively sells his shares of XYZ stock to prevent his own losses, that’s front running.

Likewise, with advisors trading ahead of their clients.

Can your advisor and their peers team up against you?

You take a break from your meeting with your advisor to get some water and notice a bunch of your advisor’s colleagues huddled around the water fountain. As you approach, they disperse, and you wonder if they’re all agreeing on stocks to buy or sell together.

This is called painting the tape and it, too, is a violation of Security and Exchange Commission (SEC) investment rules. The “tape” refers to the old fashion ticker tapes used to price stock trades. Painting the tape is when advisors or traders collude to buy or sell to create the appearance of trading activity. When this happens, it’s often done to falsely generate excitement or concern in a stock. It manipulates the market to let those in the know benefit from the buying or selling of others.

Contrary to what the name suggests, painting the tape is not a good thing and gets financial services professionals fired and barred from trading when it’s discovered.

Can I trust someone else to manage my retirement plan?

The fiduciary rule says that a fiduciary, Certified Financial Planner, or a Series 65 or Series 66 Licensed advisor must make investment decisions in their clients’ best interests.

Traditionally, fiduciary rules have not applied to accounts that fall under the Employee Retirement Income Security Act of 1974 (ERISA). Accounts that fall under ERISA’s jurisdiction are employer-sponsored retirement accounts, such as 401(k)s and 403(b)s. In 2010, under President Obama, a proposal to expand the fiduciary rule under ERISA was adopted and scheduled to be phased in starting April 2017.

The change would apply the fiduciary rule to anyone who works on or with a retirement plan, including Individual Retirement Accounts (bot traditional and Roth IRAs). However, President Trump put a halt to the start of the phase-in to allow for more “economic and legal analysis” on the effects of the rule changes.

The financial services industry agrees that it’s important to focus on their clients’ best interest. However, many critics of the proposal are concerned that language in the proposed rule is too broad and the benchmarks to measure the application of the rule too burdensome with compliance, paperwork, and oversight systems. They, also, claim that current legislation already prohibits the activities the rule change proposes.

That said, financial services firms from small to large have spent millions of dollars preparing to implement the proposed fiduciary rule changes. To now not implement them will mean a lot of wasted money.

There’s more to come with the fiduciary rule changes. For now, know that there are systems and legislation in place to protect you and you have recourse if you are the victim of malpractice.

Though it may not seem it like from movies, the financial services industry is a highly-regulated industry. Between the SEC and the Financial Industry Regulatory Authority (FINRA), financial advisors and all financial services professional must follow rules that protect investors and maintain faith in the markets.

To be clear, protecting investors doesn’t guarantee you won’t experience investment losses. Rather it means that you are protected you from being ripped off or deceived by an investment professional or company.

Knowing what to watch for will help protect you. It’s, also, helpful for investors to know how to talk with their advisor. As they say, “knowing is half the battle.”

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