Trust, but verify

11Jan07

Trust, but verify. – Ronald Reagan*

Although former President Reagan used this phrase in the context of strategic arms reduction talks it also relevant to the financial services industry and investments in particular. This point was driven home by a story by Randall Smith in the Wall Street Journal.

In the article Smith examines the substantial profits certain brokerage firms are earning on the ‘idle’ cash balances held by customers in their accounts.

The blue-chip securities firms are reaping bigger profits from a few simple changes to how investors’ idle cash balances are treated. And most investors either don’t notice or don’t care that Wall Street’s gains are coming at their expense as brokers turn around and reinvest the money for their own benefit at a higher rate.

While disappointing, one probably shouldn’t be all that surprised that the brokerage firms would look to do this. Maybe more disappointing is that their customers would let them do it so easily.

“One of the questions that has come up is why customers would put up with this,” says Connie Bugbee, managing editor of iMoneyNet. She believes one answer is the inattention of customers who focus instead on which stocks to buy or sell.

Indeed, brokerage executives say their own soundings confirm investors generally aren’t focused or overly concerned about rates they receive on cash balances.

The return on cash balances may be small for any individual investor, but as a whole they add up to an opportunity cost for investors. In a world where investors are on the lookout for new stock ideas or a hot ETF the pursuit of higher money market returns seems like an easy way to generate higher returns.

The financial services industry exists in large part because of trust. When we complete a transaction we trust that it will go through as agreed to and the funds will transfer accordingly. If we had re-verify each and every calculation or transaction the industry would grind to a halt.

That is not to say that mistakes, both large and small, are not made. Of course they are. Every firm out there (and investor, for that matter) makes mistakes. Where the best firms excel is in how they rectify those mistakes.

On the other hand, these “cash sweep” policies are not a mistake, but a deliberate policy to maximize brokerage profits at the expense of their customers. These plans are not illegal, in that they are properly disclosed, but they certainly are cynical. Life is too short to deal with providers who do not value you as a customer.

In short, if you cannot trust your current bank, broker or investment advisor to do the right thing (the vast majority of the time) you should be looking elsewhere for a firm that will.

*We had thought about titling this post “Know what you own” until we realized we had used that title for an earlier post on the importance of understanding how long-only commodity funds operated.

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