I was just listening to CNBC and heard an investment expert recommend a dud stock in Wind Energy space for investment. Consider this, the stock is one of the worst wealth destroyers in recent times, the underlying asset is still loaded with debt and there is no visible signs of a turnover story. Atleast not yet. It is almost a penny stock now. God help those who listen to his advice.
This must make you wonder sometimes ‘Aren’t these guys the so called experts? Then why they make these worthless recommendation’. And that is what we will discuss today.You must have had some recommendations from your brokers which have worked tremendously well or awesomely bad for you. So , are they good enough to listen from now on. Let’s see…
Why broker recommendations don’t work for retail investors
The job of a broker is to interact with management of a company and provide unbiased advice to a client. The client is usually a retail investor or financial institution. But that part called ‘unbiased advice’ seldom happens. Let us discuss why recommendation from these experts mostly fail.
1) ‘Buy’ recommendations are always majority
Remember a broking house runs on commission. Every time you buy a stock and sell it they make a commission. The more you buy the more commission they make.
And if you buy a stock, you are likely to sell it at later date. So this ensures there is atleast two transactions from which commission can be earned. So there is always a flood of ‘Buy’ recommendations.
Relevant read: How to choose good stocks for investments
2) They have to keep recommending every month
Just imagine this scenario where your broker sends a newsletter or make a recommendation only once or twice in the whole year. You will start to think like “I’m paying you so much for your recommendations. You hardly send any”.
Remember, such a broker might turn out to be good if he ensures he only recommends good stocks. Because of this compulsion, most brokers have to send out a monthly list and so they have to make some new recommendations.
In order to do this, rather than suggest a stock based on its merit , they choose a stock and search reasons to justify that. that is surely the best approach for disaster stock selection.
3) Brokers are afraid to make ‘Sell’ recommendation
Remember the broking analyst has to deal with a company management. His bread and butter depends on that. He is researching the company and needs to get information from them. He does not want to have the embarrassment when meeting a company after recommending to sell their shares.
So you will always see that there is very rare ‘Sell’ calls but merely hold or reduce recommendation. As a shrewd investor you must always be ready to sell a stock if its fundamental aspects change.
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4) Brokers have investment banking relation with companies
Unfortunately, broking firms have increased investment banking and advisory roll with companies. They also want a share of the lucrative investment banking pie. This creates a conflict of interest. So they are forced to recommend these stocks to their clients to whom they must actually give unbiased advice.
This is a huge conflict of interest. But, who gives a damn. As long as my pocket is filled, there is no reason to complain.
5) Analysts have to obey the ‘house view’
Assume you’re an analyst. You think a stock is worthless but it is on your employer’s(broking house) buy list. Will you dare to make a ‘Sell’ recommendation. Typically in India, broking house has a list of good stocks and its analysts usually provide recommendation only from that list.
This is typically true in large firms. Even if he thinks the recommendation may turn out wrong, he rarely takes that risk.
6) The more recommendations made, the less likely you will remember a bad recommendation
You must know this by now. Having seen the experts stock recommendation every week, I often wonder how they make up this list. They have to keep recommending. Do you remember what stocks they recommended last month and month before that and how they have performed. Highly unlikely.
This is a master strategy by flooding you with recommendations. So they can always show that “this recommendation failed but see stock A & B have gained 30, 40%”. One fails to understand that these 2 stocks that performed would be among a basket of 30 stocks recommended over 2-3 months. Atleast few are expected to perform well and they have their escape route.
So what are we trying to accomplish with all this? Are all brokers wrong? Should we not listen to them?
Also read: How to choose your financial advisor
Best way to use a stock broker
1) The best way is to not read his Buy or Sell strategy. Look at the information he provides. Sadly, many brokers get this wrong even. But good brokers provide this information correct.
The numbers are from management and published to exchanges every quarter. This is hard data. Sit down and analyze their(the company you plan to invest) balance sheet, profit/loss statement.If you are happy, then invest. Else walk away.
2) Take responsibility for your action. There is no use in saying I lost money because of his recommendation. It is your money. So the responsibility is yours. Be aware and be awake.
3) Treat recommendations with a pinch of doubt. Analyze what the broker house gets from that. Where does their money come from. Do they have any conflict of interest.
4) See if the investment matches your philosophy and goals. There is no use investing in a share recommended by a broker if it does not match your investment style or what you want to establish by investing in shares. Be Objective and ruthlessly rational.
5) Stop buying just because it was recommended. They will suggest 100 stocks over a year. Don’t be tempted to invest in all of them. A common man’s stock portfolio is ideal with 10-30 stocks max. Less than 10 and it is not diversified and more than 30 is too diversified.
6) Allot some time for finance. At SmartMoneyGoal we always say, no one is more interested in your financial well being than yourself. Educate yourself. If you don;t have time to invest yourself, you must have time to atleast select good mutual funds. That is bare minimum. You must also review it every 6 months.
It is your money. Be ruthlessly careful. Remember Warren Buffet’s two rules of investing. Rule1: Never lose money. Rule 2: Never forget Rule1. Happy investing.
What is your opinion? How much do you depend on your broker for stock recommendation? How has the results been so far? We would love to hear your opinion/experience.