I had lunch with a colleague the other day.  Although we are competitors in the advisory business, we are friends, and we get together every so often to compare notes about what is going on in our business…the financial services industry.  It was the day after the now-infamous 30-minute market meltdown.  And, it was just a week after the executives at Goldman Sachs were on Capitol Hill, getting grilled by a Senate Subcommittee about their role in the financial meltdown of 2008.  So, we had plenty of things to talk about over our lunch plates.

As our meeting went on, it became clear to both of us that our views on our industry have changed over the last 18 months.  We have both been in the financial industry for a long time and spent a lot of that time in and around the brokerage world.  I have written before about how much I disdain the culture in the major brokerage firms.  While they try to create an image that they are working in the best interests of their clients, more often than not, they are not.  They are sales organizations that make money for their shareholders by creating and selling the latest financial products to their clients. 

My friend verbalized it first, although we were both thinking it.  “I don’t trust our system any longer,” he said.  “I don’t trust the firms on Wall Street.  I don’t trust the government regulators that are supposed to be watching them.  I don’t trust any of it.”  And, unfortunately, I had to agree with him.

As I write this, the Wall Street Journal is reporting that federal prosecutors are working with securities regulators on a criminal probe into whether several of the major Wall Street banks misled investors about their roles in the mortgage mess.  We already knew that Goldman Sachs and Morgan Stanley have been under scrutiny.  Today, we learned that JP Morgan Chase, Citigroup, Deutsche Bank and UBS are also being investigated.  That pretty much covers the major players on the Street, and there may be more to come.

The issue at hand is whether the firms made proper representations to investors while marketing, selling and trading the pools of mortgages called collateralized debt obligations, or CDOs.  Most of the major banks created these CDOs for other clients who made bets against them, and sometimes even the banks themselves made bets against them while imploring their brokers to sell them to their clients.  The bets against the CDOs paid off when the mortgage market collapsed.  But the clients who bought them lost millions.

This is just the latest example of how the deck is stacked against the individual investor.  In past articles, I have written about the dreaded “F-word” in the financial industry.  In this case, the “F” stands for fiduciary.  As an independent Registered Investment Advisor, my firm is subject to the rules set forth in the Investment Advisors Act of 1940 which says that an advisor must act as a fiduciary for their clients.  That means that we must always act in the best interest of the client.

Brokers and their firms are subject to the rules of the Securities Act of 1934, which regulates the exchanges and the broker-dealers while trying to protect the investing public.  They live by a different standard.  A broker only needs to make sure that an investment is “suitable” for a client.  Suitability provides a much wider latitude than Fiduciary.  It’s easy for an investment to be suitable, but still not be in your best interest.  For example, a broker can sell you an S&P 500 Index fund with a sales commission and a 1.2% management fee  even though you can easily find a no-load S&P500 fund with a .10% management fee.  Suitable?  Yes, but clearly not in your best interest.

 When the Goldman Sachs executives were questioned by Senators about their role in the meltdown, they danced around questions relating to their duty to clients and the ethics of betting against the same securities they were selling.  They couldn’t even answer the questions!  And now we learn that it wasn’t just Goldman…it was Wall Street. 

There is some movement towards change for the better.  The Chairwoman of the SEC has said she favors expanding the fiduciary requirements to all advisors and brokers as part of the financial reform legislation that is currently being debated in Congress.  But I don’t give it much of a chance to be a part of the final bill.  Wall Street has some very rich and powerful supporters who donate heavily to political campaigns.

So, what’s an investor to do?  Be skeptical.  When you entrust your nest egg to an advisor, ask questions.  How are they getting paid?  How much are they getting paid?  Do they have a duty to act in your best interest, or their company’s?  Make sure you understand the investments they are presenting.  One of your first rules in investing should be, “If you don’t understand it, don’t buy it.” 

My firm advocates spreading your investment risk by diversifying your portfolio across several different asset classes.  We use institutional index funds to keep expenses as low as possible and we don’t try to outsmart ourselves by trying to time the market, or a specific sector or security.  Following these simple time-tested rules greatly increases your odd of success as an investor.