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Is the market being set up for a fall?

Published Sep. 16, 2005

Just as the stock market is taking a hit, a new study suggests that the nation's brokerage houses may inadvertently be planting the seeds of a broader stock-market setback.

The reason, says the study by Prophet Market Research & Consulting of San Francisco, is that stockbrokers have been steering novice investors pell-mell into stock mutual funds and individual stocks this year.

"Many brokers aren't profiling customers thoroughly and may be suggesting investments based on an overheated stock market rather than an individual customer's needs," the soon-to-be-released Prophet study says.

And just what is wrong with that?

"If they're not explaining the long-term nature of the investments, it's a pretty good hypothesis" that many of the stock-market amateurs "will get right back into CDs" and abandon stocks if the market tanks, says Scott Galloway, lead researcher at Prophet.

Prophet is the same outfit that has earned kudos for exposing problems at banks that sell mutual funds to unsophisticated depositors. Now it has surveyed stockbrokers, and results are sure to cause a stir, given recent plunges in the Dow Jones Industrial Average.

Prophet surveyed the sales practices of 21 of the nation's largest full-service brokerage firms, using 93 "mystery shoppers" presenting themselves as unsophisticated, first-time investors. The study was done January through May.

The survey found that brokers handed out specific investment advice to more than half of the mystery shoppers without asking even the most basic questions about their finances, such as their tax bracket or income level.

Nearly 30 percent of the brokers failed to ask about the investor's willingness to stand pat during a market correction, the study shows. And brokerages are placing more novice investors in the stock market than they were only a year ago; almost half of the shoppers were recommended stock mutual funds, and nearly a quarter were pitched individual stocks, Prophet says.

Mutual fund holders have shown little tendency to flee in past market downturns. But with a growing number of first-time investors entering the stock market through mutual funds, some market watchers wonder how long fund holders will maintain their reputation for staying cool amid market sell-offs.

Prophet's Galloway said even those firms that scored at the top of its customer-service list, such as Travelers Group's Smith Barney Inc., the nation's second-largest brokerage house, and Merrill Lynch & Co., the nation's largest brokerage firm, deserve only a C for customer service based upon how they performed.

"There's no excuse for not finding out someone's income level," Galloway says. "We're not talking about selling blenders here. This is serious stuff."

This survey's top performer, Smith Barney, declined to comment.

A Merrill Lynch spokeswoman declined to comment on Galloway's assessment but says: "Merrill Lynch takes a planning-based approach to our business, with a focus on long-term client relationships rather than individual transactions. While we can't speak to the methodology of this study, its findings seem to bear this out."

A spokesman for PaineWebber wouldn't comment about the firm's next-to-last-place showing among the nation's largest securities firms. "We don't know the methodology of the survey," the spokesman says.

But the survey's last-place finisher, A.G Edwards & Sons, said it would work harder to improve its score. The St. Louis-based brokerage firm issued a statement from its chairman and chief executive officer, Benjamin F. Edwards III saying: "Obviously we are not happy about our last-place finish, but we believe this gives us a challenge. Rather than rest on our laurels, we've got to go back to the basics."

Not all the news is bad for brokers. The survey showed that large brokerage firms generally scored higher than their smaller competitors, while those pitching mutual funds did a better job researching their clients' risk levels than those pitching individual equities.

In addition, the survey found that small-investor-oriented firms made "dramatic improvements" when it comes to treating men and women equally. In 1995, for example, females were less likely to receive key disclosures about their investments. This time, there is virtually no difference.

But there are other problems. More than 75 percent of the mystery shoppers were handed "collateral material," such as newspaper articles and fund brochures, instead of the fund's official legal document, the prospectus. Of those mystery shoppers who were urged to buy mutual funds, only 50 percent received prospectuses, which disclose such vital items as the investment policy of a mutual fund.

George Daniels, a principal at Daniels & Alldredge, a Birmingham, Ala.-based investment advisory firm, says the brokerage industry often spends too much time "pitching return" and not enough disclosing risk. Daniels should know: He has been a broker and investment adviser for the past 30 years.

"There's almost no discussion of risk," says Daniels.

Poor grades for brokers

A study by Prophet Market Research & Consulting of San Francisco surveyed sales practices at some of the nation's largest full-service brokerage firms, using 93 mystery shoppers. The firms were ranked by customer service, sales presentation skills and compliance. A perfect score is 100.

Firm Score

1. Smith Barney 75.1

2. Merrill Lynch 74.7

3. Prudential Securities 74.6

4. Dean Witter Reynolds 73.7

National average 73.5

5. Paine Webber 71.8

6. A.G. Edwards and Sons 71.2

Source: Prophet Market Research & Consulting