When Singapore fell to the Japanese during World War II, William Spencer took off into the jungle to avoid capture. Armed with only his wits, he survived there alone for nine months. All he knew about the jungle was what he had heard in children’s stories: it was a place full of lions, tigers, snakes, and insects just waiting to devour a tasty Englishman, or it was a Garden of Eden full of delicious treats.


The capitalist system, and Wall Street’s markets which make up an integral part of the system, are the economic miracle of the world. But even miracles aren’t perfect.

Spencer soon discovered that it was neither. As he recounted in his famous adventure book, The Jungle is Neutral, it doesn’t care the slightest bit about you. It neither wants to destroy or reward you, it just is what it is.

Wall Street is the same way. The devouring beasts and the delicious bounty are both there. One way or another, you and your money are going to be in that jungle. But it’s up to you to make the best of it.

While Spencer survived quite nicely, and lived to tell his tale, I’m sure he would agree that the whole experience would have been a lot more civilized if he only had had a good guide. My wife and I recently spent a week in the Amazon jungle. Led by a native guide, we marched miles through the jungle at night, chasing down bugs, snakes, and other critters. We fished for and swam among piranhas, and watched while the guides caught caymans with their bare hands. The guides showed us how to make poison darts and hunt with blow guns, introduced us to hundreds of tasty plants, and pointed out scores of medicinal herbs and vines.

Without the guides, we wouldn’t have seen one percent of what was right there before our noses. With the guides, we thoroughly enjoyed a grand adventure with little more danger than we might have had at home in our living room. Even though I was a Boy Scout, and a graduate of the Air Force’s survival school, I am sure that, left to myself, I would have stumbled around until I encountered a disaster. To put it plainly, I would have been nuts to wander around in there alone. A guide familiar with the “local lore” made all the difference.

As Spencer discovered, jungles aren’t always what they seem. There are always a few predators, and an unsuspecting or unwary Englishman might very well find himself as the main course of a jungle banquet. But from a guide’s perspective, most such disasters are entirely preventable.

For this little tour of Wall Street, I propose to be your guide. I’ve survived in this swamp for almost 25 years, so I think I can point out a few things that might help ward off disaster.

Before we start, I want to say that things are good and getting better. The capitalist system, and Wall Street’s markets which make up an integral part of the system, are the economic miracle of the world. But even miracles aren’t perfect. One of the great things about this miracle is that it doesn’t rely on saints or even particularly good people to make it work. In a very real sense, the markets are always under construction and self-improving. As we have seen in the last chapter, improvement has been gradual but relentless. Consumers always want more or better deals. By demanding better, they force change. Just by voting with their feet — or dollars — they make the whole system better.

Make no mistake about it, I’m proud to be a capitalist tool. But there are a few flaws left in paradise, and we might as well discover how to either work around them or turn them to our advantage.

This chapter is devoted to showing you how to avoid totally unnecessary disasters as you execute your investment strategy. In particular, we will discuss non-market risks that could separate you from your hard-earned money. To be more precise, we will examine scams, rip-offs, conflicts of interest, and other dastardly deeds.

All of us have heard the horror stories:

  • A Miami “investment advisor” leaves his family, cleans out a large number of client accounts and disappears. He is found months later living in a house of ill repute on Taiwan. Returned for trial, he is promptly convicted and sentenced. The money is not recovered. Some of Florida’s top physicians are wiped out.
  • Three airline pilots in Atlanta lose their entire retirement accounts after their airline folds. A total of $1.3 million disappears from accounts controlled by a “financial planner.”
  • In Texas, a small state-chartered trust company with strong ties to a major air carrier fails. Accounts are frozen for over a year while the state literally digs through shoe boxes to construct records several years in arrears. It is discovered that the trust company carries only $1 million total insurance to cover more than $100 million of deposits. After the failure, the insurance carrier cancels coverage, claiming fraud. There is no state fund to cover deposits. Fortunately, most of the deposits are recovered.
  • Recently, some of America’s largest brokerage houses have settled multimillion dollar claims for fraudulent sales practices, inappropriate investment recommendations, failure to supervise account executives, and churning of accounts.
  • Each year, boiler room operations swindle thousands of unsuspecting investors out of millions of dollars in total scams.
  • Thousands of investors have complained that banks misrepresented mutual funds as government-guaranteed investments.
  • One of the nation’s largest insurance companies is accused of selling high-cost insurance policies as retirement accounts.

The list is almost endless, but you get the idea. Those kinds of catastrophes don’t have to happen. If you really think about it, a few basic precautions could have prevented each of the tragedies.

Here are a few of “Frank’s Rules of Survival”:


  • Never give any investment advisor a general power of attorney over your account. Use a limited power of attorney to authorize your advisor to make trades within your account for your benefit. There is never a reason to name an investment advisor as owner, contingent owner, or joint owner of your account. It shouldn’t be possible for any other person to ever receive a disbursement from your account. Your brokerage or trust company should only disburse to you at your home address or to your bank account. Insist on confirmation of all account activity, and statements directly from your custodian. Check your statements for unusual or unauthorized activity. Never use your investment advisor’s address as your address to receive statements. As President Reagan used to say: “Trust but Verify.”
  • Select strong custodians for safekeeping of your assets. Use major brokerage houses or trust companies that are properly insured, audited, and regulated. Don’t let some Mickey Mouse little financial institution act as custodian of your assets.
  • Remember, if it sounds too good to be true, it probably is. The markets are far too efficient to allow for excess profits in excess of the risks taken. Con artists almost universally appeal to investors’ greed and unrealistic expectations. They can’t exist without rubes willing to believe the unbelievable. By now you should have a good feel for the range of reasonableness in various investment markets.
  • Consider carefully whether you need a guide. Many investors shouldn’t try to go it alone. Investing funds professionally is a full-time job. It takes specialized knowledge and significant resources. The field is rapidly evolving. It’s a full-time job just to keep up with the research. Evaluate whether you have the skill, judgment, discipline, and experience to do a proper job. Your investment plan is your future. It’s too important to leave to amateurs. I once read a Robin Cook novel, but I don’t think I’m ready to do brain surgery. Heck, I don’t even know how to change the spark plugs on my car.
  • Avoid commission salespeople.All financial professionals get paid. And, of course, all of them have an interest in attracting your business. You can’t expect any of them to send you to the competition. But how they get paid can have a very significant effect on the nature of their recommendations. In fact, how you pay for advice may be much more important than how much you pay. 

The Role of Commissions

The commission sales process opens the door to a host of potential consumer abuses, including serious conflicts of interests, inappropriate investment recommendations, very high costs, and excessive portfolio turnover or churning. With all the hidden agendas possible in the sales environment, it would be extraordinarily naive to expect objective advice.

Business Week’s February 20, 1995, cover story, “Can You Trust Your Broker?” lists an entire catalog of investor abuses. Proclaiming on the cover that, “Too many brokers are working in their own interests, not yours.” Business Week leads into the story with, “Questionable sales tactics fueled by lavish incentives are prompting a rising tide of criticism.” Here’s how the magazine sums it up, in a sidebar called “The Case Against The Brokerage Industry.”


  • PRESSURE: The compensation system at brokerage firms creates intense pressure on brokers to generate a high volume of commissions.
  • INCENTIVES: Brokers are given extra incentives, such as Rolex watches and all-expense-paid vacations, to sell special high-profit-margin products with little regard to their suitability for customers.
  • BAD ADVICE: Firms push brokers to recommend in-house mutual funds, where the firm earns management fees, instead of funds run by outside managers. Most in-house funds have mediocre performance records.
  • BONUSES: Many firms recruit top “producers” from other firms with huge up-front bonuses and extra-high commissions. That gives the producers an added incentive to promote excess trading.
  • POOR INFORMATION: Firms don’t provide customers information on the overall return on their investments and aggregate commissions they’ve been charged.

Commissioned sales have been good to Wall Street. It’s a great way to distribute products. Investors, on the other hand, are often poorly served. The brokerage system is inadequately policed and rife with built-in and undisclosed conflicts of interest between broker and customer. Hardly a day goes by without disclosure of another violation of trust. Unable and unwilling to repair an extremely profitable system, Wall Street responds with slick public relations measures and advertising.

Wall Street’s large brokerage houses are very complex businesses. What you see at your local office is just the tip of the iceberg. But the retail operation is essential to support many of the more profitable lines of business. Commissions are the mechanism that allow the house to manipulate the broker. With the right commissions, incentives, and bonuses, Wall Street can get their brokers to sell anything!

The common thread that runs through many of the worst abuses is the commission-based system of compensation. Commissions create the conflicts of interests between the broker and client.

For instance, many brokerage houses also act as market makers for NASDAQ stocks and bonds. In this capacity, they buy and sell for their own accounts. It’s a neat little business where, like Las Vegas, the house almost always wins. They buy at one price from the public and sell to them at another. The difference is called the spread, and is the profit the house makes for bearing the risk of holding an inventory of stocks. It turns out that making a market is generally very profitable. It also doesn’t have very much risk. It turns out to be a lot more profitable than brokerage on the New York Stock Exchange. If the house has a lot of transactions where they act as market maker, they can make big profits. That’s why many brokerage houses pay higher commissions to brokers for selling stocks where the house makes a market than stocks where they don’t make a market. A little disclosure on the bottom of your confirmation that the brokerage may make a market in the stock is supposed to alert you to this little conflict of interest. But most investors never consider why they get so many buy and sell recommendations where the house just happens to make a market in the stock.

Another interesting peculiarity of the commission system is the way bonds are treated. While commissions on NYSE stocks are tightly controlled and disclosed on the confirmations, bond salespeople are allowed to tack on just about anything they think the market will bear. Bond commissions are never disclosed on confirmations. The buyers just get a statement that they purchased a bond at a particular price. Of course, most brokerage houses make a market in bonds. More obscure and thinly traded bonds have higher spreads. In general, very liquid bonds have about a one to two point spread, but it can go much higher. Occasionally a bond salesperson can sell a bond with a 6 percent spread. These six-point bonds are often referred to as “touchdown” bonds. In some offices whenever a touchdown bond is sold, they ring a bell. If there aren’t any customers about, everybody cheers. Perhaps this explains why brokerages seem so partial to bonds.

Any brokerage house or broker-dealer worthy of the name has a family of mutual funds. They all love this business because it becomes an annuity for them, paying them fees forever almost without regard to performance. As a class, brokerage funds have some of the highest expenses and worst performances being offered. For instance, when Business Week did their story they included a table comparing the largest brokerage-house funds to the largest independent families of load funds. The worst performing family of the independent funds had better performance than the best performing brokerage-house funds. Most large brokerage houses pay higher commissions for sale of their funds than outside funds (a few have recently very publicly abandoned the practice). But you shouldn’t be too surprised to learn that most brokerage accounts are comprised of a high percentage of house brand funds.

Not content to receive the sales allowance alone from outside mutual funds, many brokerage houses have begun to demand and receive a portion of the fund’s ongoing management fee and other allowances from outside mutual funds. Some mutual funds have refused to pay, or have internal expense charges too small to allow a continuing fee to the brokerage house. So some brokerages have established dual lists of outside fund families. Those who pay get preferred treatment, while those that don’t have the commissions paid to the salespeople cut.

Initial public offerings (IPOs) generate lots of fees for brokerage houses. Strangely enough, the “offering allowance” to the brokerage house and the salesperson is never called a commission. This offering allowance is a multiple of the commission that a salesperson could earn on a NYSE trade. Notwithstanding the tremendous frenzy that the recent Netscape IPO generated, most investors in IPOs have very poor results over the following few years. But, perhaps driven by the high offering allowance, Wall Street’s brokers rarely fail to generate tremendous enthusiasm for IPOs.

New unit investment trusts (UITs) and new closed-end funds are similar to IPOs in that brokers earn a multiple of what they could earn from the sale of an existing UIT or closed-end fund. In addition, the offering allowance doesn’t have to be called a commission. Because of the high offering expenses built into UITs and closed-end funds, the overwhelming majority of the time a new offering begins to trade, the price falls to net asset value or below. Most investors would be far better served to wait a few days or weeks after the offering trades and then buy at the far better prices. Almost everybody on Wall Street knows this. But, unfortunately, the commission is very small compared to the initial offering. So, new UITs and closed-end funds continue to be manufactured and sold as if they were some kind of great neat deal.

So far, we have just described cash payments to stock brokers and registered representatives. But there are other neat ways to lead them around by the pocket. Many firms offer deferred compensation in addition to direct commissions. Invariably, these plans are tied to proprietary products and other high profit offerings. Private offices, secretaries, titles, and other perks depend on selling enough of the right stuff.

And, don’t forget the free trips. Hang around most brokerage houses and you will begin to think you are in a travel agency! More time is spent deciding which trip to qualify for than which asset class might benefit a client’s portfolio. Somehow I thought they were supposed to be planning the clients’ financial future, not the salesperson’s next vacation.

If the carrot doesn’t work, there is always the stick. Brokers who fail to meet quotas, including minimum production of proprietary product, just don’t seem to last long. Managers whose offices don’t produce don’t last much longer, and so on up the food chain. The single driving ethic and obsession in the brokerage industry is: Sell more! Success or failure is measured by commission dollars, not client returns or satisfaction. Most stock brokers can tell you to the penny what they earned in commissions last year; few have the foggiest notion what their clients made as a result of their advice.

These conflicts of interest are not just incidental to the business. Rather, they are a fundamental part of traditional commission-based transaction-oriented brokerage. I believe that there are a great many talented and ethical people in the business, but the system is fundamentally flawed. The system makes it very difficult for brokers to do the right thing by clients. A broker who practices a long-term, buy-and-hold strategy is not liable to endure long in the business. She can never get paid for recommending that a client do nothing at all, but we all know that often that’s the best course of action. Finally, a broker who institutes a rigorous cost containment and control program for his clients has just signed his own retirement papers.

But surely, you say, the value of these professionals’ advice makes up for it. These aren’t just used stock salesmen they are highly trained financial consultants. Right? Well, not quite. We have examined the quality and integrity of Wall Street’s research efforts. My opinion is that that advice is worth far less than zero. Wall Street’s research efforts are both a fine justification for excessive trading and a defense against litigation for the house. And for this they expect the investor to pay!

But what does the stock broker or registered representative bring to the table? It’s a mixed bag, but it would be a mistake to assume that they are all choir boys or highly competent. The best of them got that way through their own efforts in a system that demands very little. You wouldn’t be far off if you considered entry requirements to be a total sham.

It turns out that almost anyone without several felonies can qualify. Of course, there are a couple of short exams administered by the feds. But plenty of schools offer three day cram courses which carefully cover only the questions and answers. Any dull tool with a few hundred bucks is guaranteed to pass the test or she can repeat the course as many times as necessary. Fortunately, the cram courses have the questions wired, so few suffer that indignity.

While many brokers are very bright, it’s not a requirement for the job. Neither is advanced or even related education. Several successful brokers I know have never seen the inside of a college or taken a finance course.

Once the aggravating formality of the exam is out of the way, the real training begins. Most brokerages’ in-house training courses could fairly be described as 10 percent product knowledge, 90 percent sales training, then get on the phone and sell. The technique, described as either “smiling and dialing,” or “dialing for dollars” is the fundamental education for new-hire stock brokers at most houses. It’s strictly sink or swim, and attrition is high. You shouldn’t be surprised to learn that once the entrance exams are passed, there is never a requirement for continuing education. What continuing education is provided generally comes from the house, and consists of about the same proportions of product knowledge and sales training. Controlling the education process rather effectively limits the options to the house preferences. So, many brokerage houses actually actively discourage their salespeople from pursuing independent professional training. For instance, one very large brokerage prohibits their salespeople from displaying the CFP certification on their cards, letterheads, or any other client contacts. Whatever their reasons, they certainly aren’t bullish on education.

So, what are the qualifications? The single biggest attribute the brokerage houses or broker-dealers are looking for is sales experience. It doesn’t matter what you sold in the past; if you can sell, the brokerages want you. At a Florida brokerage, for example, the prior job experience of one of its “top producers” was limited to selling swimming pools.

In the real world, financial advisors must get paid. Otherwise they will all close up shop and go sailing or play golf. But how that compensation is structured can play a large role in determining the quality and integrity of the advice received. Wall Street’s failure to resolve the commission compensation issue in a manner favorable to investors has led to the rapid erosion of their market share to independent fee-only investment advisors. Let’s face it: nobody really likes the big brokerage houses. They just didn’t know they had alternatives. But they are beginning to learn.

Not all investors need or want investment advice. For those people, books like this and others will help to define their strategy. Discount brokerages and no-load mutual funds (which weren’t available just a few years ago) now provide eminently satisfactory solutions to the custody and execution problems.

Other investors who need and want professional advice, but are not satisfied with the traditional “churn and burn” brokerage tactics, also have better solutions. (In a later chapter, we will discuss some criteria for selecting and working effectively with financial advisors.)

Voila! Another chapter in the continuing improvement of the market brought to you by an ever evolving capitalistic system. All that is necessary to keep the improvements rolling is to keep demanding better. Pretty neat!

In the next chapter, we will examine mutual funds, the essential building blocks for a globally diversified investment plan that will take you safely into the twenty-first century. Mutual funds may not be perfect. But if you have less than $50 million to invest, they are your best hope. Last year, there were more than 1,500 new funds brought to market, bringing the total to over 6,000 (not counting money market funds!). Now there are more classes of shares and cost structures than you can shake a stick at. Don’t despair. It’s really pretty easy to cut through the clutter.