Buying stocks that your broker says you should? You might just lose

Have you lately bought an existing stock or IPO on your broker’s recommendation and then seen its price fall substantially some time later? Well, chances are that your stock broker may have offered you the recommendation just before he wanted to sell out his own position on the same stock. Surprised? Read on.

Most stock brokers, other than buying and selling stocks for their clients, also buy and sell stocks on their own account. At times, they might decide to build positions in a not-so-great stock and then start recommending it around. First, they go to their bigger clients (mutual funds, foreign investors, high networth individuals, etc) and make a sales pitch for that stock. Selling the stock to their bigger clients helps them jig up its price. Till this point, the recommendation on a particular stock goes exclusively to their bigger clients. Along with bidding up the price of the stock, the brokers make commissions on the way as well for buying stock for their clients.

In the next phase, the recommendation through newspapers and television channels reaches the so called ‘small investor’. Influenced by the recommendations, he starts buying up. And when this happens, it is time for the brokerage house and its bigger clients to sell the stock to those who want to buy. The broker now makes money on two counts: a) by charging you a commission for buying stock b) by selling out on the proprietary position it has built up. So, the small investor is the sucker in the entire game.

For a broker, it makes sense that investors keep buying and selling all the time. No broker has ever made money with an investor holding on to his stock investments.

As Adam Smith (not to be confused with Adam Smith the famous economist) writes in The Money Game, “They could put you in some stock that would go up ten times, but then they would starve to death, they only get commissions when you buy and sell. So they keep you moving.”

Logically, the retail investor should be able to figure out the goings on after a while. But, that does not seem to be the case.

As Smith writes, “…the investors who really follow the market, the ones who call up all the time, ninety percent of them really don’t care whether they make money or not….If they make a little money, they’re happy, if they lose a little money, they’re not too unhappy. What they want to do is to call you up. They want to say, ‘How’s my stock? Is it up? Is it down? What about the earnings? What about the merger? What’s going on? And they want to do this every day, they want a friend, they want someone on the telephone, they want to be a part of what’s going on.”

And to all the questions investors have, brokers always seem to have an answer. Very few brokers seem to be in the habit of saying ‘I don’t know’.

The IPO game, though, works a little differently. Most brokerages also have investment banking divisions, which help bring these IPOs to the market. Technically, there are supposed to be Chinese walls between the brokerage and the investment banking decisions. But, that is rarely the case.

As Andy Kessler writes in Wall Street Meat, in reference to a particular IPO, “The burning question was where to price the stock. There is always tension in an investment banking firm when it comes to pricing IPOs. The banker who is charging a 7% fee to do the IPO wants the deal priced as high as possible.”

If an investment bank is handling an IPO, then its brokerage division usually writes out a positive recommendation on the stock. Given this scenario, brokerage analysts write research reports that their investment banking clients would like investors to read, which may or may not give the real picture. This ensures that this client and other clients keep coming back to the brokerage. Nobody likes firms whose analysts give negative coverage to a company and this can lead to the investment banking business going to other firms.

Like Mitch Zacks points out in his book, Ahead of the Market, “Hell hath no fury like a CEO who has lost several million dollars due to some smart-aleck analyst. You can bet that for the next several years - and perhaps for as long as that CEO is in power - that the aggrieved company is not going to do any business where the pessimistic analyst works (and it’s also possible that the analyst will be fired). While most investors may forget about the sell recommendation in a couple of months, corporate management tends to have a much longer memory. When you lose several million dollars worth of stock options - as the CEO of a downgraded firm will attest - you tend to take it very personally.”

A negative recommendation also has an impact on the portfolio that the brokerage firm has built on its own account. A sell recommendation can also have an impact on the portfolio that the stock brokerage has built up on its own account. So, you rarely get a sell recommendation on any stock from a brokerage house.

As Adam Smith points out in his book, The Money Game, “And take selling. You think they tell you when to sell? Never. First they sell themselves, then you watch the stock going down day after day, you can’t get them on the phone, finally you get them, they say, ‘While the outlook near term is uncertain, long term holdings need not be disturbed.’

“That means, ‘I sold last Tuesday, Charlie, and I forgot you were still in that dog.’ You know how long the long term they talk about is? Five hundred years. May be seven hundred years. But whatever happens, they make it, coming and going. You make money, they take those commissions. You lose money, they take commissions. You leave your account alone, they call you up and tout you, they don’t make money when it’s sitting still.”

DNA