May 18, 2011

Ten Questions to Ask a Financial Advisor

The following is a guest post from Marotta Wealth Management .

The Securities and Exchange Commission recently changed the disclosure requirements for investment advisors from a checkbox format to an essay style. I wasnt convinced, however, that the new disclosure format would separate the sheep from the wolves or help consumers better understand the difference between fee-based and fee-only financial planning.

Someone asked me what disclosures I would require for financial advisors. Two years ago I wrote a long series on how to safeguard your money. You can use those principles as a checklist to evaluate investment advisors and the philosophy underlying their advice.

Ive written these principles in a yes-or-no format and reworded the questions. Yes is the best answer and no means you should seek more information or not consider that advisor at all. Although answering affirmatively to all 10 questions would be my first screen in selecting a financial advisor, it still does not guarantee the person has the competence necessary to offer comprehensive wealth management.

1. Do you use a recognized third-party custodian to hold your clients assets?

A third-party custodian such as such as Schwab or TD Ameritrade offers an extra layer of accountability and oversight. The safeguards and monitoring of advisor and custodian work mutually. The custodian sends you their own set of statements, a way for you to double-check what your financial advisor is telling you. Being defrauded is much less likely when you are receiving independent statements.

2. Is there a good chance my investments will lose money?

Remind yourself here that the correct answer is still Yes. There is no sure thing. If something sounds too good to be true, it is. I used to analyze offers to find the proverbial catch. I would scrutinize the small print to discover where they were going to make their money. In the process I learned a great deal about the dishonest methods companies use to separate fools from their money: bait and switch, allure of exclusivity, guarantee or your money back, limited time horizon and automatic charges.

Investment guarantees are an oxymoron. Certainly we hope an investment will generate income or appreciate in the future. But every attempt to ensure that hope costs some of the potential return. Thats why insurance products dont produce as much growth as market returns. My favorite Paul Volker quote: You cant hedge the world.

3. Is the daily price of everything you invest in listed in the Wall Street Journal?

Only put your money in publicly priced and traded investments. These are liquid assets. Investors undervalue liquidity 99.9% of the time. You need to be in the other 0.1%.

Liquidity refers to the ability of an asset to be easily sold without losing value in the process. Imagine starting with a pile of money, buying the asset, holding it a week and then trying to sell it again. If you get back a much smaller amount of money, the asset is illiquid.

Because illiquid investments are hard to price, its also difficult to compute what return youve received. Real estate, hedge funds and private equity deals belong in this category. Some purposefully lock up your money and prohibit sales for several years. Or a market may exist for them but with very little volume. Finally, they may have capital calls so not only cant you sell, but you are required to invest more money in them. They all may have the allure of exclusivity, but they lack liquidity. Here is the critical question: When you need to spend your money, will it be easily available?

4. Do you avoid hedging or buying options? Does everything you invest in trend upward?

Any investment that, on average, doesnt go up shouldnt be an asset class in your portfolio. A lot of so-called investments fit this description. They are best described as speculations, not investments. There is a place in specific portfolios to invest in something that doesnt go up on average. But this situation is the exception, not the rule. These decisions are warranted most commonly because a large investment needs protection. In this case, what you are really buying is insurance, not an investment.

5. Could you teach me to implement your investment strategy and let me do it on my own?

Dont trust any investment strategy you dont understand. Dont trust any advisor who wont or cant take the time to explain exactly why and how he or she operates. An advisors investment philosophy is the most important and valuable resource you are purchasing. If you dont trust your advisors knowledge and techniques, you shouldnt entrust your financial future with that person.

Distressed emerging market risk arbitrage may be a surefire way to make loads of money, but if you dont understand the process and feel at ease being part of the team that executes that move on the field, you would be better off sitting on the bench and investing in Treasury bills.

6. After selecting your investment approach, could I change my mind at any time, immediately recoup everything left of my investment and have no financial hooks to keep me from dropping your approach?

To safeguard your money, you must be able to extricate yourself quickly from any bad investment. Of course, the companies that sell mistakes dont want you to be able to do that, so they use financial hooks to hold your money captive.

Any financial product with a surrender value significantly different from the net asset value has financial hooks such as annuities, insurance products, loaded mutual funds, hedge funds and private equity.

7. Do you report a client-specific time-weighted return each quarter?

Excellent advisors work hard to cultivate certain traits. Honesty is paramount and includes communicating clearly and straightforwardly exactly how bad the markets have been and can be.

Advisors naturally want to look good, and you must overcome your own desire to have a good-looking advisor. You need the truth. Without it, you certainly cant make realistic financial plans.

8. Do you live a frugal lifestyle?

The differences between the manager of a Ponzi scheme and a model citizen are almost imperceptible, which is not surprising. Those who would perpetrate a Ponzi scheme are usually not the demons everyone makes them out to be. And they are obsessed with appearing successful.

This fixation on appearances, however, is the red flag. If you are the millionaire next door, you know that frugality is one of the marks of an effective financial advisor.

9. Is the fee I pay you the only compensation you receive?

A greater conflict of interest exists when your financial advisor gets paid by someone other than the fee you pay them. There is also a conflict when your advisor gets paid differently on one type of investment versus another or based on the performance of specific investments.

10. Do you sign a fiduciary oath?

Fiduciaries take oaths and are bound by a code of ethics. Their conduct is based on applying ethical principles. In contrast, the nonfiduciary world is based on rules rather than on principles and ethics. If an agent has followed the correct procedures, has the paperwork in order and has client signatures on the correct disclaimer forms, no rules have been broken. The behavior can be called unethical, but it is not illegal. Thus additional rules do not necessarily translate into exemplary conduct.

The differences between these two worlds are seen most clearly in the decision-making process. Fiduciaries cant simply put your money into good investments. First they must understand as much as they can about you and your goals. They must demonstrate undivided loyalty to help you meet those goals. Taking the time to understand your goals is simply part of their ethos.