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Are brokers and financial advisors ripping you off?

With more than three decades’ worth of his annual letters to Berkshire Hathaway (NYSE: BRK-A, BRK-B ) shareholders posted on Berkshire’s website, there are plenty of great Warren Buffett stories to choose from. But one of my personal favorites from the Buffett archives is his parable of the Gotrocks family.

Meet the Gotrocks

Buffett first told the Gotrocks story in the 2005 shareholders’ letter under the heading “How to Minimize Investment Returns.” And who, exactly, are the Gotrocks? They’re a fictional family that owns every American corporation — thousands of companies that annually earn (as of 2005) around US$700 billion. It’s a pretty sweet setup for the Gotrocks clan.

But the Gotrocks family’s investment life doesn’t remain tranquil. Here’s Buffett:

[L]et’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

The problems don’t end there, because soon a second class of Helpers enters the picture:

“Hire a manager — yes, us — and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

It doesn’t end there. The hapless Gotrocks are inundated with one layer of Helpers after another, each taking their cut. The joke, of course, is on the Gotrocks, because the maximum income they can receive will always be the total income of all the companies that they own, but they end up further and further from that maximum as they pay ever more fees to the Helpers.

Helping is big business

Helping (in Buffett’s sense) is a massive industry. Thanks in large part to the acquisition of Merrill Lynch and its “thundering herd” of brokers, Bank of America’s (NYSE: BAC) wealth management division alone is gigantic. It brought in more than US$17 billion in total revenue in 2011 and earned the bank US$1.6 billion in net income. Wells Fargo’s (NYSE: WFC) brokerage clients house US$1.1 trillion at the bank and it ended up with US$1.3 billion in profits from that division in 2011 on US$12.2 billion in revenue.

And those are just a couple of the big boys. They’re joined by other giants such as UBS and Morgan Stanley Smith Barney, as well as legions of smaller companies and independent advisors. And don’t think we escape – Australia has its own herd of helpers.

Take, take, take?

In a technical sense, Buffett is 100% correct — for every penny that brokers and financial advisors take, we, as a whole, earn less. (You got that we’re the Gotrocks, right?)

But does the story end there? Are brokers and financial advisors simply fast-talking financial-industry leeches, eagerly sucking the green out of our portfolios? Or is there legitimate value being added by brokers and advisors?

Hopefully you already know the answer. You wouldn’t pay a hairdresser for ‘doing her best’ to cut your hair. Or if you made the mistake once, you wouldn’t go back. You’d only pay for the result you wanted.

Foolish take-away

An investor can mirror the S&P / ASX 200 index with a commission not far from half of one per cent., by buying an index fund. So if you’re paying an advisor for performance that is less than the market performance, you’re paying someone to do worse than you can do yourself. Doesn’t make much sense, does it?

Even better, we think with a little education, individual investors can outperform the market without those fees that can often run into the thousands of dollars per year.

I was given some career advice once – ‘no-one cares more about your career than you do’. The same can be said for your investing returns.

Bottom line: take an interest, take control – join the investor revolution.

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Scott Phillips is a Motley Fool investment analyst. Scott owns shares in Berkshire Hathaway. You can follow him on Twitter @TMFGilla. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).

A version of this article, written by Matt Koppenheffer, originally appeared on fool.com

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