Are you aware of this conflict of interest?

by Manshu on June 21, 2010

in Investments

My dad used to joke that the only person who reads annual reports in the entire country is my grandpa. He used to read a lot of annual reports. He had a large stock-holding (still has quite a bit), and he was the one who got me introduced to the world of investing.

He has made more money in stocks than most people I know, and knows a lot about the markets and investing. His eyesight is really weak these days, and that makes tracking price quotes or just general reading quite difficult. He stopped following the stock market altogether for the past couple of years, but I met him yesterday and he said he has started a new thing.

He has given a small sum to a “business associate” of a big broker, and that guy trades on his behalf. At the end of every day, he sends a report of the money made or lost during the day and the list of trades.

I showed interest in this, and didn’t say anything because I know it keeps him busy and interested, and that is a small price to pay for the loss this business associate will eventually incur on my grandpa’s behalf.

Make no mistake about it, there will be a loss, and it will probably be all of his capital. I say this because of the huge conflict of interest coupled with the frequency of trades. There are so many trades that it is quite apparent that this guy is doing it just for the commissions.

Of all the conflicts of interest that exist in the investing world, a broker / sub – broker / business associate trading on behalf of their customer has got to be the worst one.

There is very little correlation between how much money the broker makes their customer and their own remuneration in the short term.

The broker makes their money by trading as much as possible, and incurring as much brokerage as possible, but at the same time – the brokerage is coming from the pocket of the investor. On the other hand, if the broker just buys once every month on the behalf of their investor and keep accumulating stock for a longer horizon, they’d make very little commission for themselves, even if they increase the chances of spreading out risk and making money for their customer.

If your  broker or business associate or whatever the heck they call it sends you a daily report of the trades they made, you are most likely getting screwed.

You need to compare your returns with the Nifty or Sensex returns and see how they are performing. You will be better off buying low cost index funds if the guy is not even making you as much as the Nifty, which you can replicate just by buying a Nifty mutual fund yourself.

If you have handed over money to someone to manage, you should seek returns that are at least higher than the returns of the stock market, which you can yourself easily replicate. If that is not happening, then it is time to move on.

This is not to say that all brokers who trade on behalf of their clients are crooks, there are plenty of good brokers too, people who advise you not to trade, and people who highlight to you how much you have paid them in commissions while making very little for your self. I have met such people and if you have to have someone manage your money, you should look for someone who will ask you to stop trading even if that means less commissions for him.

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