11/18/2008 05:12 am ET | Updated May 25, 2011

A Tale of Two Investors: A Moral You Should Heed

Falling markets don't tell the whole story. You need to understand the real world consequences of the way you invest. Otherwise, you are bound to repeat the problem. The only change will be the name of culprits.

Here is the tale of two investors. Both are true. The names have been changed to protect their privacy.

Fred is the only child of immigrants who came to this country with no money and a strong work ethic. He built up his business through twenty years of hard work and sold it to a large corporation. He is in his mid-forties. When he cashed the last check from the buyer, he retired, secure in the knowledge that he would never have to work again.

Fred had no need to take risks. His business was eagerly solicited by all the large firms. He was wined and dined, given tickets to sports events, trips in private jets, and generally treated like a rock star. He settled on one well known firm. The broker there became his new best friend, attentive to his every need.

On their advice, he invested a portion of his portfolio in Auction Rate securities. He was told they were "as good as cash."

One of these bonds recently defaulted. Fred called his broker and asked the firm to buy back the bond. In that instant, the relationship with his former "friend" changed dramatically. The broker told him that he was a wealthy and sophisticated investor who knew exactly what he was buying and that "hell would freeze over" before the firm would take him out of his position.

He retained counsel who made a demand on the firm and filed complaints with regulatory authorities.

A cold wave must have hit hell because the firm caved.

Fred pulled his account.

Bill and Marianne are wealthier than Fred. They sold their real estate business for over $100 million. They invested with another well known broker. They thought they were in a conservative portfolio. They lost over $40 million in the last year.

An examination of their portfolios indicated excessive trading (called "churning"), risky securities and an asset allocation inconsistent with their investment objectives.

They hired a firm that specializes in securities arbitrations. The firm suggested mediation, which is a process in which an independent expert attempts to settle cases.

At the mediation, the law firm representing the broker pulled out a copy of a study on mandatory arbitration which I co-authored. The firm correctly noted that our study demonstrated that investors in these arbitrations are unlikely to recover any meaningful portion of their losses. The industry has basically gamed the system against investors. The firm offered to settle for pennies on the dollar.

The lawyer for Bill and Marianne told them the data in our study was consistent with his experiences. He also advised them that brokers know that wealthy investors are unlikely to have any effective redress so they are "fair game."

Bill and Marianne rejected the settlement offer and decided to proceed with arbitration. I don't like their chances.

Here's the moral, in case you have not already gleaned it:

Rich or not-so-rich, the securities industry views you as sheep waiting to be shorn. The industry is premised on a demonstrably false set of assumptions. They cannot pick stocks or mutual funds that will outperform their benchmarks over the long term. Investors who use them are likely to underperform those who don't, according to many independent studies.

This system, relied upon by most investors, is geared to separate them from their money, and not to build their wealth.

Investors need to fundamentally change the way they invest and to think differently about the information they rely on to make investment decisions.

Your broker may be a "great guy" (or woman), but his agenda is in direct conflict with yours.

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