Beware Of Conflicts Of Interest

If you read a newspaper, watch television or read research reports from brokerage firms, you will find investment advice. Of course, that’s just for starters. Nowadays, the Internet is full of people and outfits telling you how to make money and which stocks to buy.

Some of these recommendations are well-meaning. Some may turn out to be profitable. But investors need to be aware that a huge chunk of the financial landscape is littered with advice that is woefully conflicted. As a result, you may not be hearing the unvarnished truth.

Conflicted advice comes in all shapes and sizes, so let’s take a look at how it manifests itself.

Perhaps you read in the paper one day that a brokerage firm has rated a stock a buy, and put a juicy target price on it for the next twelve months. All this seems very enticing. But what you may not realize is that the same brokerage house has benefited from providing investment banking services to the company they are now recommending. They may have participated in a stock or bond offering for the company, or maybe they advised it on a merger or acquisition. Regardless, they have a vested interest in promoting the stock so as to be considered for future business. Brokerage firms don’t tend to bite the hands that feed them.

Conflicts extend to recommendations on big picture things like the outlook for currencies or commodities. For example, if a large investment bank publicly says you should bet against the gold price, you might be inclined to take them at their word. Yet there’s always the chance they have not disclosed that they have a vested interest in which way the market moves.

The investment bank’s conflict could come about in a couple ways. On one hand, they might already be short the market for their own account, hoping the price will fall. In this case, it’s possible they are trying to entice other investors to join in on the bearish side, thus helping make their position more profitable. On the other hand, if they think the price is likely to rise, the bank might be looking for investors to take the other side of the trade. If this is the case, the bank which is publicly bearish might actually be building up a bullish position for itself.

Conflicts of interest happen with even the tiniest of stocks. In fact, that’s often where they happen. Many (though not all) newsletter writers who cover junior mining stocks are compensated in some way by the companies they recommend. This can take the form of either a monthly retainer for promotional services, the granting of stock options or the ability to participate in private placements. All of these conflicts provide a clear incentive for a supposedly independent analyst to be biased.

It’s important to note that conflicts of interest extend beyond the investing world. When it comes to the outlook for real estate, for example, it’s near impossible to find a realtor who will admit prices for houses are in a bubble. And it’s easy to understand why this is: real estate agents are in the business of selling properties. They benefit from higher prices. It’s completely against their interests to tell you the market is dangerously overvalued. Again, this is not to paint all realtors with the same brush, but as a general rule, they won’t tell you the sky is about to fall.

Many of the conflicts we’ve looked at are disclosed. Brokerage firms, for instance, are required to tell you if they’ve done work for a company whose stock they cover. Problem is, it’s in the fine print so most people won’t recognize it. And it may not be mentioned if all you’re reading is a newspaper article. The same goes for newsletter writers who are paid by the firms they recommend. Unless you look, you may not spot the glaring potential for bias.

So what should investors do, given all of these conflicts of interest?

One approach is to adopt a healthy level of skepticism. That doesn’t mean you completely ignore what someone says about a stock, currency or commodity, but you shouldn’t buy or sell something just based on their opinion if you have reason to believe they are conflicted. It also helps to do some research on your own. Particularly if you’re an active investor, you’ll benefit from formulating your own opinions rather than making decisions based on someone else’s.

There are many good people in the investment world. And many who are just trying to give you the best advice. But there are also many conflicts of interest out there. Some are hidden, while others are in plain sight. At the very least, being aware of them empowers an individual so they can invest in their own interest, rather than for the benefit of someone else.

 Andrew Hepburn is a freelance writer based in Toronto. He specializes in economic and financial issues. From 2006 to 2009 Andrew was a Research Associate with Sprott Asset Management in Toronto focusing on commodity markets. He is a graduate of Queen's University. Reach him at ahepburn20@hotmail.com.