Market Timing and Legal Liability: What Really Matters

People always ask me how I can be a securities attorney and sue stockbrokers and other financial advisers and also be an RIA compliance consultant. My answer is that by combining the two, ultimate goal is promote a win-win situation. I help advisers by showing them how to protect their practices and achieve good results for their clients. Those that refuse to promote such goals learn the hard way.

In an earlier post, “The RIA’s Achilles’ Heel, I mentioned that I felt that one of the most common errors I see among investment advisors is a failure to develop an effective risk management program to protect their practices. In some cases this is due to a failure to separate investment theory from legal reality.

A perfect example of this is the concept of market timing. Mention the term and people usually react strongly one way or the other. Opponents of market timing claim that it does not work and simply increases risk, has adverse tax consequences and increases overall costs. Proponent of market timing claim that it helps reduce overall risk and can reduce unnecessary and significant financial loss.

One of the main problems with the concept of market timing is that there are various beliefs as to what market timing actual entails. The classic definition of market timing is shifting 100 percent of one’s investment either into the stock market or 100 percent out of the stock market, no middle ground.

The there are those, like investment legend Benjamin Graham, that view market timing as a more flexible and defensive concept, allowing for gradual reallocating of assets in response to changes in the stock market or the economy. Graham’s model called for an initial 50/50 split between stocks and bonds. Graham then suggested that an investor could make changes in the allocation, with the proviso that the allocation to either stocks or bonds never drop below 25 percent or exceed 75 percent. Interestingly enough, Henry Markowitz, Nobel Laureate and the father of Modern Portfolio Theory, admitted that this was the model he used to manage his own investment portfolio.

Then there is yet another camp that believes that any reallocation or rebalancing of asset constitutes market timing. This camp chooses to completely ignore the proven cyclical nature of  the stock market.

Then there is a faction that support the notion of periodic re-balancing to restore a pre-set allocation model. Re-balancing is OK because it is not deemed to be market timing, simply re-balancing.  The first thing I do when I depose an investment adviser is to ask him to describe his approach to investment management. If he/she indicates that they use re-balancing, I ask them why they do so. The I ask them their definition and opinion on market timing.

Come into my parlor said the spider to the fly. I’m leading you into what I call the “Market Timing Gotcha.” Why would you shift assets from a profitable investment and reallocate it to a poorer performing investment? That would seem to be contra to the duty of prudence, would it not? Are you shifting assets to the poorer performing asset in anticipation of a change in performance? Would that not constitute market timing?

To me, from a legal liability perspective, the argument over market timing is a waste of time. Investment advisers are going to be evaluated from a standpoint of the prudence of their management of a client’s portfolio. The key is the effective management of a client’s portfolio so as to prevent significant losses and unnecessary costs.

History has shown that the market is cyclical in terms or performance. Argue all you want, you lose.  Therefore, a simplistic static, or buy-and-hold, portfolio makes no sense from a liability perspective. Simply no way to justify allowing a client to absorb such losses. Want to throw in periodic re-balancing? Fine, but be prepared to explain why you chose to re-balance, as opposed to possibly re-allocating some of the assets (a la Graham), if the re-balancing does not properly protect the client.

There are those predicting a bond bubble based upon the Federal Reserve’s suggestion of increasing interest rates. While long-term bonds are generally considered a better investment when interest rates are low, long-terms take a greater hits when interest rates are rising, when short-term bonds are the preferred bond investment. Would it be prudent for an investment adviser not to re-allocate any assets invested in long-term bonds to avoid the risk of loss due to rising interest rates?

Again, from a liability perspective, an investment adviser is going to be evaluated in terms of the prudence of their investment decisions. Arguing over semantics is a waste of time. The key questions are going to be whether an advisor took steps to minimize a client’s investment risks.

My focus is always on what steps the advisor took to provide a client with upside potential while minimizing downside risks. I’ll reverse engineer the client’s portfolio and analyze the efficiency of the advisor’s actions, both in terms of costs and risk management, including my proprietary metric, the Active Management Value Ratio™. Regardless of whether you call it re-balancing, market timing or whatever, did an advisor manage the client’s portfolio in such a way to preserve the client’s wealth by avoiding significant financial loss. If not, the claim will be breach of fiduciary duty of prudence.

I often have stockbrokers tell me they are not worried since they are not held to a fiduciary duty to their customers. As ESPN analyst Lee Corso would say, “not so fast my friend. In FINRA notices 11-02, 11-25 and 12-25, FINRA warned registered representatives that they do have an obligation to always act in a client’s best interests, which is the exactly required under the fiduciary duty of loyalty, as well as the fiduciary duty of prudence.

Case law also supports the imposition of a fiduciary duty upon stockbrokers and other financial advisors when it is determined that the stockbroker or financial advisor had “de facto” control over a customer’s account.

The courts look at various factors in determining whether an adviser had de facto control over an account. As the courts have stated,

[t]he touchstone is whether or not the customer the intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.(1)

the issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions.(2)

If the answer to these questions is in the negative, then the likelihood is that the adviser will be deemed to have had de facto over the customer’s account and they will be held to a fiduciary standard in their dealings with the customer and the account. For more information on the issue of fiduciary duty based on de facto control, see my post, “Upon Further Review: Do We Already Have a Universal Fiduciary Standard.”

My advice to my RIA clients and others has, and always will be, forget the semantic of whether something is or isn’t “market timing.” Instead, focus on doing the right thing for the client. If there are potential tax implications, discuss possible strategies with the client if possible. Just because a client provides a financial adviser with discretion does not mean an advisor should be proactive and consult with a client on certain issues. And remember, document the discussion to better yourself.

One of the biggest, most common mistakes I see are situations where an investment adviser allows the tax “tail” to wag the investment “dog.” I have yet to talk to one investor who has said that they were more comfortable taking the investment losses they suffered in the 2000-2002 and 2008 bear markets rather than pay some taxes and preserve more of their wealth. Advisors who blindly ignored the multiple signs and failed to act prudently and proactively to protect their clients are paying the price now.

Another area ripe for discussions with clients involves wealth preservation, including the use of effective hedging strategies. Fiduciary law states that a fiduciary is required to diversify a client’s portfolio unless there is good cause not to do so. In some cases, hedging strategies such as the use of alternative investments, protective puts and inverse index funds/ETFs may be prudent. At least one case has suggested that, at the least, a financial advisor has an obligation to disclose and discuss such strategies with client’s as necessary to avoid potential losses.(3)

There are plenty of consultants who can advise investment advisers on how to set up an RIA and prepare all the required manuals required by the regulators. However, having all the required RIA manuals is not going to save an RIA’s practice if the RIA breaches its fiduciary duties to their clients.

The typical response of an RIA to a breach of fiduciary duty claim is that they did not know what the law required or that they did not intend to break the law or hurt the client. Neither excuse is an acceptable, for as one court stated, “a pure heart and an empty head is no defense.”

The sad truth is that it is relatively easy to win or settle a breach of duty case. Be proactive and learn, and stay updated on, the applicable law or consult with an attorney experienced and knowledgable in investment/RIA law. And finally, focus on being proactive and doing whatever is necessary to truly protect client’s against significant losses without regard to semantics or other irrelevant concerns.


1. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9th Cir. 1982)

2. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975)

3. Levy v. Bessemer Trust, 1997 U.S. District LEXIS 11056 (S.D.N.Y. 1997)

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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