There are good reasons for investors to be skeptical of a broker’s model portfolios. Here are the main causes for concern
Watch out for broker “model portfolios”
Some of the most misleading ads from brokers you’ll see concern so-called “model portfolios.” These are presented as examples of the returns you could realize if you were to invest in a portfolio made up of that brokerage’s recommendations. All too many brokers use these model portfolios to build their businesses.
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The big problem with model portfolios is that, as the ads explain in the fine print, these calculations don’t reflect trading that actually happened. Nobody really turned $100,000 into $1.7 million. Instead, the fine print explains that the results show “hypothetical or simulated performance” and are “not meant to represent actual performance results.”
Hypothetical model-portfolios have a great advantage over real-world portfolios. For one thing, it’s safe to manage them much more aggressively than when you are playing with real money. This hyper-aggressive management gives the hypothetical account great returns when it succeeds. It runs up much steeper losses when it fails, of course. Still, the losses are only hypothetical, and easily disposed of.
When the losses reach embarrassing levels, the broker can simply forget the old hypothetical account—“take it out back and shoot it,” as brokers say. It can then start a new hypothetical account that may do better.
Brokers may start up several hypothetical portfolio accounts, and eliminate all but the top performers over a period of years until they are left with just one hypothetical account that makes them look brilliant. Mutual-fund companies do the same. Fund company employees refer to the start-ups as “incubator funds.” These funds have little money in them, so it’s inexpensive to treat them in such a way that they build a great record. It’s even easier for a broker to build a top performance record for a hypothetical account where there’s no money involved.
Unlike a real-money account, a hypothetical account can legally profit from front-running. When a broker’s research department plans to issue a strong buy recommendation and a thick research report in a rising market, it will generally add the stock to the model portfolio and issue the report simultaneously. That means the model portfolio will “buy” the stock instantly, but the firm’s brokers will need time to scan the report and call their clients. (They generally start by calling their institutional clients, by the way, and only then go on to individual accounts.)
Over the course of a week, a $10 stock can rise to $10.50 or even $11 in a situation like that. These near risk-free 5% to 10% gains can have an enormous impact on the model portfolio’s hypothetical profit, especially when they compound over 10 or 15 years.
Some model portfolios have an even more blatant advantage over the real world: buys and sells in the portfolio are calculated as if they took place at the closing price of the previous day. This alone gives you the magic wand you need to claim extraordinary results without any investment analysis.
All you need to do is simply check the market just before the close every day for stocks that have risen 5% or more since the previous day. Then you “buy” the ones that went up, and “sell” any you own that went down, in each case at the closing price of the previous day.
That way, you can claim credit for as many risk-free 5% gains as you need, and create whatever hypothetical profits you dare to advertise.
Watch out for brokers’ “model accounts” as well
Similarly, a number of brokerage firms publish the results of what they refer to as “model accounts.” These hypothetical accounts supposedly measure the results you might enjoy by following the broker’s best research picks. In reality, the hypothetical account does much better than the broker’s clients, because it enjoys advantages that are unavailable in real life.
Successful Investors should be skeptical of investment performance scores that companies calculate for themselves using the examples of their picks. This includes calculations by brokers, money managers and newsletter publishers. There are just too many ways to manipulate or “fudge” the numbers.
Why “model account” results may not be what they seem
I already mentioned above how the results of a model account (or model portfolio) can be inflated by posting new buys and sells after the close of trading.
Other model accounts are calculated as if the account holder could get an unlimited ration of any hot new stock issue that soars as soon as it comes to market. In reality, brokers apportion “hot new issues” only to their biggest and most profitable clients.
Successful Investors should also be alert for what you might call “selective amnesia”. For instance, you’ll find mutual fund companies and portfolio managers that have been in business for decades, but who only advertise the performance of their most recent funds and accounts. They don’t mention older accounts or funds that have so-so records. They also disregard more recent investment products that they eliminated early on, because they got off to a poor start.
This is all perfectly legal, mind you, provided that it meets fine-print disclosure requirements.
Practice accounts are not the best tool for Successful Investors either
The online brokerage industry is winning a lot of attention and goodwill by offering “practice accounts.” A practice account is supposed to be identical to a real account in all but one respect: you buy stocks online with imaginary or “play” money rather than the real thing.
A practice account that lets you buy stocks of your own choosing online without real money may seem to be a convenient way to learn investing. But the big risk with practice accounts is that you’ll try out a risky and ultimately unwinnable investment approach, like day trading or options trading, and hit a lucky streak. This could embolden you to put serious money at risk just when your results are about to regress to the mean and deliver losses instead of profits.
Model accounts are a great marketing tool, but they can lead to some heavy losses if you aren’t careful. What is your experience with a broker using one of these model accounts?
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