Elizabeth’s note: In this accompanying piece to his column about the evolution of investment advice as a profession, Ron Rhoades give us this brief history of the intellectual shift between the brokerage model and the RIA model. This article is an addendum to his article about whether financial advisors are a true profession. Click here to read that article.

Discussion of an investment advisory profession must be understood in the context of the decline of the brokerage model and the increasing importance of financial security in the eyes of policy makers. Here are five changes that the modern era has brought to investment management. Those changes may lay the groundwork for a true investment advisory profession.

Fixed Commissions Are Eliminated. First, there were dramatic changes to broker-dealer firm revenues. From 1792, when the New York Stock Exchange fixed commission rates for brokerage transactions under the buttonwood tree in the Wall Street area, until 1975, broker-dealer firms relied upon commissions for a large part of their revenues. It was only after a private litigant alleged a violation of anti-trust laws in the mid-1960’s that this practice was deemed untenantable. Extensive SEC hearings commencing in 1968, as well as Congressional hearings in 1971, along with pressure from the U.S. Department of Justice and several pending judicial appeals, led to the SEC’s eventual 1974 decision to abolish fixed commissions, despite extensive lobbying by the Securities Industry Association (now SIFMA) and the New York Stock Exchange (as to its regulatory aspects, now FINRA).

Market Making and Price Fixing Scandals Cast Doubt on Regulators. Second, the era of computerization of trading systems has led to the substantial demise of the role of market makers – another huge source of revenue for broker-dealer firms (either directly through market making operations, or through ownership of market making firms). Another scandal on brokerage compensation practices rocked both broker-dealer firms and the NASD (now in part FINRA) in the mid-1990’s. In connection with this scandal, Arthur Levitt, then chairman of the SEC, called NASD “the cop on the beat” that “simply looked the other way.” Levitt said that the evidence showed NASD “did not fulfill its most basic responsibilities” and concluded that by NASD’s failure “American investors were hurt — large and small, sophisticated and inexperienced, institutional and individual — all were hurt by these practices.” (Statement By SEC Chairman Arthur Levitt, Press Conference Regarding The NASD, Washington, DC, August 8, 1996.) Richard Ketchum, then NASD’s COO (and now Chairman and CEO of FINRA), told the Los Angeles Times in May 1994 that the Christie and Schultz report – which raised the question of collusion among NASD-member firms in their price-fixing activities – was “irresponsible – and in fact we believe it is slanderous.” In a 1994 interview to PBS, Richard Ketchum defended NASDAQ price quotations in eighths, rather than in sixteenths, out of concern for “liquidity.” As seen by the move to decimal pricing during the last decade, Mr. Ketchum’s concerns were unfounded and, with respect to the brokers regulated by FINRA, self-serving.

3.) Traditional Brokerage Services Become a Commodity. Third, and as noted in a recent white paper by Professor Arthur Laby, the execution function of brokers has become much easier. “Changes in securities trading brought about by changes in technology have rendered brokerage a commodity, which no longer entails the level of judgment and skill required to conduct brokerage services in the bygone era of the early twentieth century.” In essence, brokerage execution services, like the other services provided by brokers (custody, arranging for the delivery of certificates – a practice which has largely been eroded, and record-keeping – a practice made more difficult with the pendency of cost basis requirements but easier with the aid of technology), have become commodities.

Investment and Financial Planning Advice Becomes Essential. Fourth, the provision of investment advice, especially of an ongoing nature, has risen in prominence. The financial world for individual Americans is far more complicated today than it was in 1940. Gone for the most part from private industry is the promise of a monthly pension check in the mailbox, replaced with defined contribution accounts and individual responsibility to save and invest for one’s own financial future.

Moreover, there exist a broader variety of investment products, including many types pooled and/or hybrid products, employing a broad range of strategies. This explosion of products has hampered the ability of individual investors to sort through the many thousands of investment products to find those very few which best fit within the investor’s portfolios. Furthermore, as such investment vehicles have proliferated, individual investors are challenged to discern an investment product’s true “total fees and costs,” investment characteristics, tax consequences, and risks. Additionally, U.S. tax laws have increasingly become more complex, presenting both opportunities for the wise through proper planning, but also traps for the unwary.

As the sophistication of our capital markets had increased, so has the knowledge gap between individual consumers and financial advisors. Investment theory continues to evolve, with new insights gained from academic research each year. In constructing an investment portfolio today a financial advisor must take into account not only the individual investor’s risk tolerance and investment time horizon, but also the investor’s tax situation (present and future) and risks to which the investor is exposed in other aspects of his or her life.

Washington Has Started Paying Attention. Fifth, the importance of investment and financial planning advice, from a public policy standpoint, has not gone unnoticed in the halls of Washington, D.C. and in the capitals of the many states. Proper financial planning is essential to encourage both an increase in household savings and in order to invest those funds more effectively. If people do not make careful, rational decisions about how to provide for their financial security over the course of their lifetimes, then the government will have to step in to save people from the consequences of their poor planning.

Ron A. Rhoades, JD, CFP® serves as Chief Compliance Officer and Director of Research for Joseph Capital Management, LLC, a registered investment adviser with offices in New York, North Carolina, Georgia and Florida. This article represents his views only, and not necessarily the views of any organization to which he may be affiliated.