Many people want to be thought of as a "sophisticated" investor. This designation means you are capable of evaluating the risk and rewards of investments presented to you.
Brokers love sophisticated investors. They qualify for high commission products like hedge funds and other complex, alternative investments. Being "sophisticated" usually means you have a high net worth. More funds to invest means more fees. That's why "sophisticated" investors are wined, dined, and otherwise actively pursued by brokers.
No wonder investors wear "sophisticated" as a badge of honor. They are offered private equity and other deals that "ordinary" investors will never see. Wealth has its privileges.
Unfortunately, there's a little-known dark side to the "sophisticated" label. I experienced it many times as a lawyer representing investors whose savings were pillaged due to the misconduct of their brokers. If the aggrieved investor had achieved any success in life, his "sophistication" was raised as a defense, no matter how egregious the misconduct. I had cases where the broker engaged in such excessive trading (known as "churning") that the account would have had to earn in excess of 20 percent annually, just to break-even. The defense was predictable. The "sophisticated" investor received monthly statements and should have put a stop to this activity.
In an article in the New York Times, financial journalist Ron Lieber tells the tale of a Wells Fargo broker who engaged in a convoluted scheme to defraud his clients by misappropriating profits belonging to them. The broker pleaded guilty and is seeking to avoid prison time. What's his defense? His clients included a lawyer and retired executives. They were "sophisticated." They didn't catch the problem. Wells Fargo's lawyer pointedly noted in a court hearing that no client ever complained to the company, even though every improper trade was reflected on their confirmation slips.
When I was first confronted with this defense, I brushed it off as nonsensical. Surely, no unbiased judge or arbitration panel would buy it. If an industrialist is the victim of legal or medical malpractice, would it be a defense that she was wealthy and sophisticated and should have been able to detect it?
How wrong I was. I lost many cases because the attorney for the broker attached the "sophisticated" label to my client as firmly as a leech sucks blood from its host. It was hurled derisively as a weapon, with none of the refinement used to entice the client to do business with the broker in the courting stage. If you could be characterized as a "sophisticated" investor, you need to understand this label could become a get out of jail free card for your broker. He can pillage your accounts almost with impunity, and blame you for not catching his misdeeds.
I caution all investors to avoid brokers who claim to be able to "beat the markets" (which includes almost all of them). I can find no credible, peer-reviewed evidence they have the expertise (as contrasted with luck) to pick stocks, time the market, or pick outperforming mutual funds, despite their claims to the contrary. If you are looking for another reason to avoid them, being considered a "sophisticated" investor and understanding how that designation could come back to haunt you may give you the final nudge to escape their clutches.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.
The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information, and content on this blog is for information purposes only and should not be construed as an offer of advisory services.
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