What Can You Withstand: Why Risk Tolerance Questionnaires Don’t Always Tell the Full Story

by Maximilian Viski-Hanka

Above-average. Above-average is my “apparent” risk tolerance as determined by an investor risk tolerance quiz developed by Dr. Ruth Lytton at Virginia Tech and Dr. John Grable at the University of Georgia. This quiz is just one of many that any investor could take to have someone, or better yet, an algorithm, determine their risk tolerance. But what really is our own individual risk tolerance? How can something as abstract as a quiz or questionnaire determine what my risk tolerance really is? For example, I was labeled as having an above-average risk tolerance, yet I can’t even bet $5 on a roulette table for fear of losing that meager five dollars. This great fear of losing money, even though I have an above average risk tolerance, is common among investors throughout the world.

When creating an investor’s portfolio, financial advisors are expected to determine their client’s risk tolerance through the use of various assessments and questionnaires. However, when faced with tangible, rather than abstract losses, many investors realize that they habitually over-estimated their own risk tolerance.

These risk assessment questionnaires typically ask questions relating to individual’s behavior in bull or bear markets, years until retirement, age, income, marital status, etc. Unfortunately, these questionnaires don’t cover the full story. As Allan Roth, a Financial Planning Contributing writer and founder of the firm Wealth Logic in Colorado Springs, CO., stated, “the problem is that we are emotional beings rather than logical ones.” As the famous Jim Valvano once said, “If you laugh, you think, and you cry, that’s a full day. That’s a heck of a day.” When investors fill out these questionnaires, their confidence level, mood, atmosphere, and a whole range of other emotions can, and usually do, influence their answers. For example, on a really good day an investor may want to be very aggressive in his investments, whereas on a different day that same investor might feel risk averse due to the emotional turmoil of a death in the family. Emotions and the impact that day-to-day occurrences have on an investor’s investment objectives are highly undervalued when it comes to their risk assessment.

During the credit crises and market drop of 2008 and 2009, many investors discovered that they could not withstand the substantial drop in the market; these events made many investors incredibly risk-averse for fear of losing their livelihood. Mr. Roth, however, feels that such aversion is now a thing of the past because many investors seem to have already forgotten the 2008 crises, and because the high stock prices have instilled renewed confidence in these previously hesitant investors. But what happens if the market experiences a severe pull back? Will people deny the fact that they were risk tolerant? Why can’t questionnaires foresee these fluctuations in risk tolerance?

Several renowned financial analysts believe that questionnaires are unable to accurately determine the “behavioral facets of risk,” As two of these analysts, Brad Klontz, an associate professor in personal financial planning at Kansas State University, and Ron Sages, a wealth management advisor and personal financial planning researcher in Greenwhich, Conn., believe that questionnaires cannot cut to true willingness of a client’s ability to accept loss and risk. To rectify the problem, Mr. Klontz suggests a variety of attributes that should be taken into account when determining a client’s risk tolerance: client gender, planner gender, risk perception, risk composure, anchoring, previous financial loss, etc.

Ultimately, the goal is to figure out what can one do when trying to accurately determine their risk tolerance? In addition to Mr. Klontz’s suggested attributes, investors should thoroughly discuss their risk tolerance with their financial advisors, rather than leaving it up to a questionnaire; investors should only use these questionnaires as general indicators to determine whether any changes need to be made to their perception of risk. Most importantly, instead of determining at the first couple meetings what one’s risk tolerance might be, investors should wait and take some time to contemplate their risk profile. Accordingly, financial advisors should take the necessary steps to ensure that they get the most accurate depiction of their client’s risk tolerance. Finally, advisors should check-in on their clients throughout their time together and make sure that their investment objectives and risk tolerance have not changed. Making sure this information is accurate is crucial and beneficial to all parties involved.

To find out more please visit: Why Risk Tolerance Questionnaires Don’t Work

Crowdfunding: A New Way To Ask Friends For Money

by Jamey R. Campellone

On Wednesday, October 23, 2013, the Securities and Exchange Commission (“SEC”) voted unanimously to propose rules under the Jumpstart Our Business Startups (JOBS) Act that would permit and regulate companies to offer and sell securities through crowdfunding. The SEC allows a 90-day public comment period before reviewing the comments and finally approving the proposed rules.

Crowdfunding is a term used to describe a growing method of raising capital though the Internet. This funding method has been used to generate financial support for such things as artistic endeavors like films and music recordings, typically through small individual contributions from a large number of people. In exchange for a pledge to the project, contributors usually receive some token of appreciation related to the project they are funding. However, crowdfunded projects are not selling ownership in the projects to their contributors.

It is clear that crowdfunding can be used to raise funds for many things. However, before recently it generally fell outside the securities arena. That is because offering a share of the financial returns or profits from business activities could trigger the application of the federal securities laws, and an offer or sale of securities must be registered with the SEC unless an exemption is available.

Titles III of the JOBS Act created an exemption under the securities law so that this type of funding method can be easily used to offer and sell securities as well. SEC Chair Mary Jo White noted that the intent of the JOBS Act is to make it easier for startups and small business to raise capital from a wide range of potential investors and provide additional investment opportunities for investors.

Consistent with the JOBS Act, the proposed rules would among other things permit individuals to invest subject to certain thresholds, limit the amount of money a company can raise, require companies to disclose certain information about their offers, and create a regulatory framework for the intermediaries that would facilitate the crowdfunding transactions. The crowdfunding sites would be required to provide investor education materials, and they would be prohibited from offering investment advice or making recommendations. This proposal would give portals some flexibility on how they make money, including on commissions based on the deals done on their sites.

Opponents of the prosed rules argue that this still creates a complex, costly regulatory framework, and complying with this new framework is likely to be intimidating and cost-prohibitive for exactly the sort of small businesses and entrepreneurs conventional crowdfunding often attracts. Additionally, crowdfunding may pose some dangers to mom-and-pop investors. But really, the biggest threat of crowdfunding may be to venture capitalists.

The SEC’s aim is to help startups and small businesses raise low-dollar-value capital more easily, without facing the current regulations on venture capital investments. If the rule passes, startups will not be forced to beg them for money anymore. Thanks to both general solicitation and now crowdfunding, entrepreneurs will be able to ask everyone for monies. From the vantage point of a past small business owner, this is a step in the right direction. The opportunities to get funding without having to go hat-in-hand to a bank or to a venture capitalist are enormous. Crowdfunding could prove to be a benefit for entrepreneurs across the country. And this is a good thing.

To read more about the new crowdfunding rules, please click here

Five Red Flags That Every Investor Should Know About

by Frank Wehr

When it comes to picking an investment advisor or individual investments in today’s market, it can be very difficult to decide, “What is right for me?”  Many novice investors find themselves in a financial position to make investments, but are simply afraid to take the advice of brokers or take a chance on an investment.  It is easy to see why people are so hesitant when it comes to trusting the advice of a broker.  There is certainly no shortage of stories in the news today about crooked brokers and their brokerage firms and the investors that lost everything on an investment that was supposed to be a “sure thing.”

But it’s not all bad.  Believe it or not, most brokers are smart, professional financial advisors who put investors’ interests first.  Nevertheless, it is important for investors to know what to keep an eye out for when deciding to invest with a particular broker.  The following is a list of 5 red flags that should put every investor on alert.

Note – just because you have experienced one of these red flags does not necessarily mean you have fallen victim to a crooked broker.  However, if you have experienced any of these red flags, it might be time to have a conversation with your broker or perhaps consult another advisor for a second opinion.

1. No Risk Of Principal

Many investors find themselves looking for a way to make higher returns than they would if they left their money in savings accounts, but do not want to risk their principal.  While there are many low-risk options, such as various government bonds and some mutual funds, there is simply no such thing as a totally risk-free return.  Any assurance by a broker that an investment or product offers a totally risk-free return should put the investor on immediate alert.  If your broker tells you a product offers a risk-free return, ask her to guarantee in writing that you will not lose your principal.  That leads me to my next point….

2. Guarantees

FINRA (Financial Industry Regulatory Authority), which oversees all brokers and firms, explicitly prohibits brokers from making guarantees about the performance of an investment.  Every investor wants assurances that they will make money or that they will not lose money.  But, if your broker is making promises against losses, she is also putting her broker license at risk.  Investors should always ask their brokers for explanations of the risks involved in an investment and the reasons why the broker thinks an investment might perform a certain way instead of counting on guarantees.  If the only way a broker can sell you an investment is by making promises about it, you probably do not want anything to do with the product… or the broker.

3. Repayment of Losses

This applies to investors who have already taken some losses and their broker or investment advisor wants to cut them a personal check to repay them for those losses.  Seems like you might have a real stand-up broker who genuinely feels bad about the losses you have taken, right? WRONG! This is highly unethical and would be grounds for termination of any broker caught doing so by their firm.  FINRA rule 2150(c) and every brokerage firm, which is governed by FINRA, prohibit brokers from personally repaying clients for their losses.  If you find yourself holding a check for your losses with “Sorry” in the memo line, it is time to talk to a supervisor.

4. An Investment You Don’t Understand

With the amount of complex investment products and technical jargon that get thrown around by finance professionals, it is easy to see how so many investors can get confused.  For this reason, many investors put their full faith in their broker and purchase recommended products they do not fully understand.  They figure, “I do not really need to understand these products as long as my advisor does.”  Even if your broker is a friend or family member, this is an extremely risky strategy.  If you purchase a product you do not truly understand, chances are you also will not understand your broker’s explanation of why you lost a quarter of your principal investment over a 3-month period either.  When it comes to the more complicated investment products—i.e. UITs, REITs, etc.—the devil is really in the details and often times so is the risk. Furthermore, many of the more complex products, are more expensive to own due to maintenance fees—fees you might not understand without a fulsome understanding of the product itself. But, you do not need to pass the Series 7 to understand what’s in your portfolio.  You should feel comfortable asking your broker to explain how a particular investment functions and why it is appropriate for you.  Put more simply, if you do not understand it, ask your broker to explain it again.  And if you still do not understand it, ask for something else.

5. Penny Stocks

Penny stocks are equities that trade for less than $5 per share.  Penny stocks seem appealing to some investors as they can offer the opportunity to purchase a considerable number of cheap shares early on in a company’s life.  When a penny stock company hits it big—like Monster Energy Drinks, True Religion Jeans and Pier 1 Imports all did—holders of their penny stock stand to make huge returns.  But, most people don’t realize just how speculative penny stocks are and how rarely they make money for their investors.  Most penny stocks are offered by young, small, unproven companies without sufficient capital to run their business. As a result, many penny stock companies go bankrupt and lose all the money invested by their shareholders. Not to mention, penny stocks are a favorite vehicle among financial criminals to defraud and steal from investors.  According to FINRA, penny stock fraud is one of the top 5 most common types of financial scams out there.  The point here is that your broker should NEVER recommend penny stocks unless you specifically ask for something speculative and you are willing to lose all the money you invest in them.  In most cases, you would be better off putting your money on the craps table than in a penny stock.  At least in the casino you get to roll the dice.

PIABA Issues Report: Expungement Relief Granted in High Number of Settlement Cases

by Lauren Gonzalez

On Wednesday, October 16, 2013, the Public Investors Arbitration Bar Association (“PIABA”) released the findings of a study which raises the notion that investors relying on the public brokerage background reports on FINRA’s website are unlikely to be getting the complete picture.

When an investor lodges a complaint against his or her broker, the complaint moves through FINRA, the Financial Industry Regulatory Authority. Easily accessible on FINRA’s website is its BrokerCheck® tool, which allows for investors to research a member firm or broker and learn about the broker’s employment history, educational background, certifications, and importantly, whether a customer has ever filed a dispute against that broker or brokerage firm.

PIABA’s five-year study of more than 1,600 arbitration cases showed that in cases filed between January 1, 2007 and mid-May 2009, expungement was granted in 89% of the cases resolved by stipulated awards, commonly the result of settlements. For the time period beginning mid-May 2009 through the end of 2011, 96.9% of the cases resolved by stipulated award also granted expungement relief. One financial professional was granted expungement 35 times out of the 40 times he requested it. To have a record expunged means to have any record of a complaint made by investors removed from a broker’s public regulatory record.

The idea that an investor or an arbitrator deciding a case is not receiving a complete picture of a broker’s complaint record can be a scary thought. President of PIABA, Scott Ilgenfritz, commented that “[t]he result is that investors who are diligent enough to seek out information about brokers may be getting a woefully incomplete picture of the individual to whom they will entrust all or most of their nest egg … [W]hat is supposed to be an extraordinary relief measure is now being sought and granted in roughly nine out of 10 settled cases that we studied.”

An investor who sees that a broker has a myriad of customer disputes may be less likely to elect that person as his or her broker. Also, the number and type of customer disputes filed against a broker can influence an arbitrator’s decision in later cases filed against that broker. For instance, think about a broker who has had 10 previous customer complaints of churning an account with nine of those complaints expunged. An arbitrator making a decision on a churning case involving that particular broker would be more likely to grant an award in favor of the investor in a churning case if the nine expunged records still existed on the broker’s record. Similarly, the arbitrator would be less likely to grant an award in favor of the investor in a churning case if the broker’s report only showed one prior customer complaint. The unfortunate truth is that the broker still has those ten complaints; however, under the current rules investors, and eventually arbitrators may not be able to fully see the entire picture. When an arbitrator is making this decision, the arbitrator often times holding the investor’s entire life savings in his hands. Full disclosure of any and all prior complaints and disclosures would make for a more fluid relationship between investor and broker prior to the arbitration process.

As per the PIABA report, the SEC and FINRA intended for expungement to be an extraordinary remedy, not one that is freely given. Several recommendations that the report makes include more thorough training for arbitrators regarding motions seeking expungement relief, FINRA proposition of rule changes with respect to respondents bargaining for settlement negotiations upon an agreement to expunge, and changes to the procedural application in motions for expungement relief.

This report indicates an eye-opening realization of the need for change. Allowing for complaints to be expunged so easily is a detriment to investors who are attempting to do their due diligence in selecting an appropriate broker to entrust their hard-earned money with. This report means that investors cannot rely on FINRA’s BrokerCheck® reports and investors must be more creative in their background checks on potential brokers. One solution would be for investors to look at all awards involving that broker through FINRA’s website.

FINRA has already sent a notice to its arbitrators on expanded expungement guidance. In its notice, FINRA attached mandatory reading for all FINRA arbitrators. FINRA also mentioned in its notice that the organization planned to issue follow-up communications including revisions to its expungement arbitrator online training course, an “Arbitrator Audio Workshop”, an article in an upcoming issue of its arbitrator newsletter, and revisions to the “Expungement Page” on its website.

It will be interesting to see how this report and raw data will impact FINRA’s rules and regulations in the near future.

For Arbitration Award Payment, Insurance is No Easy Fix

by Nicholas Kulik

Hedging against catastrophic occurrences through products such as life, car and home owners insurance have been staples for years. But what about “errors and omissions” insurance for broker-dealers? In response to a growing problem of brokerage firms going bankrupt after losing securities arbitration cases, the FINRA (Financial Industry Regulatory Authority), Wall Street’s industry-funded regulator, is floating the idea of requiring brokerages to carry insurance for the payment of arbitration awards to investors.

A total of $51 million of arbitration awards were granted in 2011, or 11% of total awards, have not been paid due to many small brokerage firms closing up shop after they could not afford awards levied against them. This insurance requirement could allow customers to recoup some of their losses that would otherwise go unpaid.

Sounds like a great idea, right? While insurance may provide some financial relief to investors who may otherwise be out of luck, the policies can also be riddled with exceptions and coverage limitations. These may include allegations of fraud and problems stemming from risky investments. Additionally, many insurance underwriters may not want to cover small brokerages, which they often view as high-risk. Other issues FINRA will have to consider in developing an insurance mandate includes how much coverage to require firms to buy and the effect of this directive on the financial industry as a whole.

Even if requiring insurance is not the solution, lawyers for investors and consumer advocates have no shortage of alternative proposals. The following are four more possible solutions to FINRA’s problem of unpaid awards and the hurdles experts say regulators would have to overcome to make them viable.

S.E.C. (Securities Exchange Commission) regulation calls for all brokerages to keep funds on hand to pay liabilities known as net capital requirements. However, this can be as little as $5,000. At a recent conference of securities lawyers, the question was posed, “Why don’t we just hike up that amount?” Several problems arise from this potential plan. First, changes in SEC regulation could take years to implement, leaving harmed investors waiting in the meantime. Second, even a substantial requirement of $500,000 could still leave investors stranded when they win arbitration awards exceeding that amount.

If individual brokers cannot afford awards, why not require all 630,000 brokers under FINRA governance to contribute annual dues to a newly created recovery fund? The dues would not be steep and could create around $126 million annually to cover potential unpaid awards. Problems may arise despite the funds size, by encouraging small firms to pursue risky investments and then close up shop when things go south knowing investors can recover from the fund.

If creating a new fund is not ideal, FINRA could look to an organization that exists with a large sustainable fund already in place. The Securities Investor Protection Corporation is a non-profit organization that provides insurance coverage in cases where brokerages close and customers’ assets go missing. SIPC, which is funded by the brokerage industry, accumulates annual interest of $1.6 billion which could potentially be enough to pay such unpaid awards. Issues arise with this reform measure because the proposal would likely be tied up in Washington D.C. for years with debate of the dangers of making the good actors cover the bad actors.

For more information, see Arbitration Award Insurance

Finding a Solution to Unpaid Arbitration Awards

By Nate Irvine

Going to an arbitration proceeding can seem like rolling the dice. Arbitrators may be biased, expert witnesses can be persuading, and attorneys might be overconfident or less than stellar. However, in extreme cases an X-factor exists. The broker could go belly up and leave the claimant penniless. In fact, this is a growing concern for smaller brokers and FINRA is searching for an answer.

The following represents a sample of alternatives:

New Insurance Requirements

Force brokers to purchase insurance that provides coverage for arbitration awards. The premiums would most likely be very expensive. Most firms in the industry whether big, or small, would probably not support the increased expense. Furthermore, the last thing anyone wants to do in the current economy is choke off small business growth with excessive regulation.

Raise Capital Requirements

FINRA has no power to raise the capital requirement because that power belongs to the Securities and Exchange Commission (“SEC”). The SEC already requires every brokerage firm to maintain certain capital requirements to cover liabilities, which includes arbitration awards. It would take the SEC years to raise its requirements because of the powerful brokerage lobbyists. Besides, such a solution is not all encompassing because it would not provide adequate protection for investors whose brokers close up shop regardless of increased requirements.

Industry Insurance Fund

Another potential option is for FINRA to create a fund that every broker is required to make an annual contribution to. There are about 630,000 brokers that FINRA regulates, so such a fund could be created by forcing brokers to pay minimal contributions. However, some attorneys believe this solution would cause brokers to take unnecessary risks, leading to an increase in bad business practices. Yet the risk might be mitigated by capping the amount investors could recover.

Extend SIPC Coverage

The Securities Investor Protection Corporation (SIPC) provides insurance for customers when brokerages fail. However, they do not cover arbitration awards. Some believe that SIPC coverage should be extended to include arbitration awards. However, the biggest brokers in the industry are unlikely to support such an idea because they already pay their arbitration claims.


In order to be competitive in the industry, smaller brokers utilize a variety of enticing sales tactics to gain new clients. However, greater rewards equal greater risk, which includes the possibility of forfeiting arbitration awards. Buyer beware in the short term, there is no clear solution to the problem at hand and most seem skeptical of solutions proposed to mitigate damages produced by smaller brokers that fail.

For more information on this article can be found at: Solutions to Unpaid Arbitration Awards

Should FINRA Expand the Fiduciary Duties of Brokers to Include the Duty of Loyalty?

By Kent Crocker

FINRA recently issued a report on observations made while analyzing brokerage firms that suggests a broker’s accountability and compensation may need to be altered in order to protect the “best interests” of customers. More specifically, FINRA recently modified the suitability rule when it added more duty of care elements, but is now raising the possibility of implementing the duty of loyalty standard. Holding a broker to the duty of loyalty standard may help prevent conflicts of interest, which often arise from how the broker is compensated. For instance, a broker can be compensated more favorably based on what investments he sells to customers. The broker could also be under the direction of the firm to sell only certain investments to customers in cases where the firm is motivated to generate the revenue from investments that more favorably compensate the firm.

Implementing a duty of care standard helps guide brokers in a few respects. The duty of care standard creates the requirement that the broker be well-informed in the investment a customer is being placed in. If the broker breaches the duty of care, then the broker can be found liable for negligence and entitle the customer to damages. Under this rationale, it is quite obvious why FINRA decided to include the duty of care in the suitability standard, as brokers should be aware of the consequences of not finding the correct investment for each customer. However, the duty of care standard draws into question the compensation platforms that some brokerage firms may use and suggests that caps should be placed on the amount of fees a broker or brokerage firm is allowed to receive or charge. The logic behind this rationale is simple: Brokers and firms are motivated and driven to make a profit, which can create a conflict of interest where the customer’s “best interests” are not considered to the extent FINRA would like.

FINRA is now hinting at implementing the duty of loyalty in order to offset the amount of influence profit and compensation can have on both the firm and broker’s decision making process. Again, the manner in which brokers and firms are compensated would have to be altered in order for the amount of claims being brought to decrease. However, if the duty of loyalty were to be enacted, then it would run contrary to how the duty of loyalty is applied in corporate settings. For instance, a board of director for a corporation has the fiduciary duty of loyalty to always make decisions that are in the best interests of the corporation. Here, the brokers and firms would have a duty of loyalty to the client’s best interests and would be prevented from making decisions based on the best interests of the firm.

In order to help firms and brokers evolve towards a greater concern for the “best interests” of the customer, FINRA and the Securities and Exchange Commission (“SEC”) could tighten the standards for brokers and firms by intensifying the fiduciary duties owed to clients. In the view of the regulators, the financial industry is often driven by sales and profits, which suggests the motivation behind the duty of loyalty discussion. FINRA and the SEC are regulating the industry to ensure the rights of investors are protected, but overregulation can be just as devastating in the opposite respect. Unsurprisingly, many in the financial industry do not want brokers to be subject to a duty of loyalty by FINRA, the SEC, or any other regulatory agency. It will be interesting to see how far regulation can go. The duty of loyalty appears reasonable on its face, but its application in the current compensation structure for firms and brokers may prove difficult.