In Part One of this post, we highlighted strategies that proactive investors can use to better protect their financial security.  The strategies mentioned in Part One were more oriented toward the investment account as a whole.

However, most securities claims involve allegations of unsuitability and/or breach of fiduciary duty regarding investment products and/or investment advisory services.  Given the number of investment options available to investors today, it is easy for an unscrupulous stockbroker or investment adviser to take advantage of an investor, especially an inexperienced investor.

The following strategies can be used by the proactive investors to avoid some of the more common complaints in securities claims.

1.  Choose appropriate classes of mutual fund shares to reduce expenses.  Fees and other expenses reduce an investor’s return.  Therefore, no-load mutual funds and/or exchange traded funds should generally be an investor’s first choice due to their reduced fee structure.

If an investor chooses not to use either no-load funds or exchange traded funds, A shares and B shares are the only type of mutual fund shares most investors should consider.  Many investors immediately lean toward B shares since they do not require the investor to pay front-end sales charges, or commissions.  B shares, however, may not be the best choice for the long-term investor due to the higher annual fees associated with B shares.

Generally speaking, A shares are often a better deal for a long-term investor due to the fact that annual fees for A shares are typically less than the annual fees charged by B shares.  If an investor has a large amount of money to invest, A shares often offer breakpoints to reduce any applicable sales charges.

Breakpoints are not generally offered on B shares.  B shares are often a better deal for short-term investors, since B shares do not impose a front-end sales charge.  While B shares generally carry higher annual fees and often impose deferred sales charges if an investor redeems the shares within a specified period of time, the holding period during which deferred sales charge are applicable is usually relatively short.

The investor’s ability to redeem B shares without penalty within a short period of time also allows the investor to minimize the effect of the higher annual fees of the B shares.  Some mutual fund companies offer to convert B shares into A shares after a certain period of time has elapsed.  Each investor must evaluate their own situation to determine the choice that is best for them.

Investors with managed accounts should always check to see whether their advisor is using A shares or B shares in the management of their account.  In most cases, it is generally agreed that advisors should only use A shares in managed accounts due to the lower annual fees charged by A shares and the fact that most mutual funds offer to waive sales charges for A shares held in managed accounts.

Another factor favoring the choice of A shares over B shares in managed accounts is the deferred sales charges on B shares.  Since managed accounts often involve frequent reallocations of the account’s assets, holding B shares in a managed account may ensure that the value of the investor’s account is reduced by the payment of deferred sales charges.

2.  Use breakpoints, when possible, to reduce the commissions on mutual fund purchases.  Most mutual fund companies offer investors a discount on front-end sales charges once an investor has invested a certain amount of money in their mutual funds.  Most mutual funds begin to offer such discounts once an investor has invested a cumulative total of $50,000 in their funds, with additional discounts for certain levels of additional investments.  Recommendations spreading investments among a multitude of asset classes may be cause for questioning, especially when large amounts of money are being invested and/or the recommended amounts are just below breakpoint levels.

3.  Get more than one opinion.  Medical patients are often advised to get a second opinion on major medical decisions.  Decisions affecting one’s financial security are equally important.  Unsuitable investment advice can drastically affect one’s life.  Unfortunately, some people holding themselves out as financial planners and investment advisors may be more interested in selling insurance and investment products than in the quality of the financial advice they are providing.

4.  Avoid the variable annuity trap.  Without question, variable annuities are one of the most over-hyped, most oversold, and least understood investment products.  A much publicized article in the Wall Street Journal reported that annuity salesmen at an annuity “boot camp” were instructed to treat potential annuity customers “like blind twelve-year olds,” and to tell customers that the annuities were “like credit cards.”

The NASD and the SEC are investigating various complaints regarding the sale of these investment products and have already imposed sanctions in some cases.  The high fees and expenses associated with variable annuities, along with their lack of liquidity and their negative tax aspects, make them an unwise investment choice for most investors.

Annuities can also have devastating effect on an investor’s estate plan, resulting in most of the investor’s money going to the company issuing the annuity rather than the investor’s heirs and loved ones.  For a more detailed analysis of variable annuities, click “Variable Annuities” on the navigation bar on our site.

5.  Don’t buy life insurance for investment purposes.  A popular mantra among insurance agents is that variable life insurance is the “Swiss army knife of financial planning.”  Anyone who hears such advice should look for another financial adviser.  If an investor needs life insurance, then they should buy life insurance that guarantees the amount of protection needed, which is the intended purpose of insurance.

Life insurance is neither intended for or appropriate for investment purposes.  The high fees and expenses associated with insurance are totally inconsistent with one of the basic tenets of investing, namely to minimize loss of principal so as to maximize the amount of money working for the investor.  While it is illegal for an insurance agent to misrepresent the nature of an insurance product, recent cases involving the alleged misrepresentation of life insurance as retirement/ investment programs demonstrate the need for investors to get advice from more than one investment advisor to better protect their interests.

6.  Beware of “black box” financial planning and portfolio recommendations.  Many financial advisers will offer to provide customers and potential customers with financial plans or asset allocation plans.  The price for such plans can range from free to thousands of dollars.

In most cases these are created with software programs based upon the input entered by the financial adviser.  While investors are warned that “past performance is no guarantee of future returns,” and we scoff at fortune tellers predicting the future, that is exactly what is generally used in creating such plans, historical returns or “guesstimates” of future returns, resulting in the familiar “garbage in, garbage out” scenario.

Furthermore, such software programs can be easily manipulated to produce whatever results are desired.  Most of the commercial software programs are based upon a financial theory known as Modern Portfolio Theory, which is known to have an inherent bias toward certain types of investments.

By manipulating the input data in favor of the preferred investments, certain results can be guaranteed.  This inherent instability of such computer programs has led one expert to refer to such programs as “error-estimation optimizers.”  For a more detailed analysis of “black box” financial advice, click “Faux Financial Planning” on the navigation bar on our site.

© 2011 InvestSense, LLC.  All rights reserved.

The information provided in this post is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.