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Lessons You Can Learn From This Wealthy Investor

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It has long been my view that wealthy people are victimized by brokers just like everyone else. The only difference is they have more money to lose, so they are courted more aggressively. When things go bad, those who so aggressively solicited their business turn on them with the fury of a scorned lover and move on to the next victim.

You can learn a lot from the experience of David and Rebecca DeBerry. Mr. DeBerry made his money the old fashioned way: through hard work and determination. He paid his dues as a factory worker for seven years. He bought a small motel in Kentucky and built his hospitality holdings up to ten facilities. He expanded into the marble and real estate businesses. In the late 1990s he consolidated his investment accounts into one account at Morgan Keegan.

Mistake No. 1: The DeBerrys no doubt felt that brokers had an expertise that would assist them in growing their fortune. They would have been better advised to seek the services of a Registered Investment Advisor who focused on their asset allocation and recommended only a portfolio of low management fee stock and bond index funds in a suitable asset allocation.

It is easy to learn from this mistake. Don't deal with brokers.

His broker at Morgan Keegan invested his funds in four, proprietary bond funds, including its Select High Income Fund, C shares, its High Income Fund, its Strategic Income Fund, its Multi-Sector High Income fund and its Advantage Income Fund.

Mistake No. 2: Never purchase proprietary funds. They are aggressively sold by brokers because they often have a financial incentive to do so. The brokerage firm wants to keep the management fees. Proprietary funds frequently underperform their Morningstar assigned indexes. I recently did an analysis of the performance of the proprietary funds of three of the largest and best-known banks. The majority of them failed to achieve the returns of their benchmark index over a 15-year period.

Mistake No. 3: The DeBerrys were attempting to use bond funds to increase their returns. There is a common misconception about bonds. Investors believe they are "safe." When you seek higher yields from bond funds, you are taking additional risk. The bonds may be lower rated, increasing the risk of default. The maturity date may be long-term, giving you the risk caused by fluctuating interest rates. There is no free lunch. You would be better advised to take risk by adjusting the amount of your portfolio you allocate to stocks, and limiting your bond holdings to short term (less than a five-year duration), very high quality, bond index funds, which will act to smooth out the short term volatility of your stock holdings. Vanguard's Total Bond Market Index Fund (VBMFX) would be a good choice for the bond portion of your portfolio.

The DeBerrys invested $8 million in these funds. According to their Statement of Claim (from which all facts in this blog were derived), they lost more than $7,550,000.

In a Consent Order dated June 22, 2011, the SEC and the Financial Industry Regulatory Authority announced that Morgan Keegan and Morgan Keegan Asset Management had agreed to pay $200 million to settle fraud charges related to subprime mortgage-backed securities. They were accused of causing false valuation of subprime mortgage-backed securities in five funds managed by Morgan Asset Management from January 2007 to July, 2007. The SEC's order found that Morgan Keegan "failed to employ reasonable pricing procedures and consequently did not calculate accurate 'net asset values' for the funds. Morgan Keegan nevertheless published the inaccurate daily NAVs and sold shares to investors based on the inflated prices."

Two Morgan Keegan employees agreed to pay penalties for their alleged misconduct, including one who was barred for life from the securities industry.

The DeBerrys held four of the five funds that were the subject of the SEC and FINRA proceedings.

The DeBerrys filed an arbitration claim with FINRA seeking to recover their losses. Because they had an account with a FINRA member, they were required to resolve all disputes in an arbitration administered by FINRA. In light of the SEC and FINRA orders, you would think this arbitration would be a slam dunk.

Mistake No. 4: Giving up your right to a jury trial is a big price to pay for the "privilege" of doing business with a broker. Agreeing to have disputes arbitrated by FINRA is a crippling error of judgment. Many believe this arbitration process is biased and rigged against investors. I testified before Congress in support of this view.

The DeBerrys learned this lesson the hard way. In a decision dated Sept. 10, 2012 (Case Number: 10-04170), the FINRA arbitration panel denied their claims and awarded them nothing. One member of the panel, Dee Newell, dissented. I admire the courage of Ms. Newell. She may have sealed her fate as a future FINRA arbitrator. Many believe a vote against the securities industry means they will not be chosen to serve in the future. This "repeat player" effect is a reason why the system is inherently unfair. Most investors are one-time users of the system. Brokerage firms are "repeat players." They are unlikely to pick an arbitrator in future cases who has not shown appropriate deference to their interests.

I made several requests to counsel for Morgan Keegan, Ryan R. Baker, to give me his perspective on this matter. I received no response from him.

If you have a claim against your broker, and believe you are going to get justice before a FINRA arbitration panel, this case should give you pause. It should also encourage Congress to adopt the Arbitration Fairness Act, which would abolish mandatory arbitration in consumer and employment disputes, including claims against brokers.

Until Congress summons the courage to pass this Act, you need to heed the lessons you can learn from this experience of the DeBerrys.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book is The Smartest Money Book You'll Ever Read. The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.