professional financial advice contents · choosing an investment advisor by dennis waldron january...

Professional Financial Advice

Contents

Page 2 Choosing an Investment Advisor, by Dennis Waldron

0 Advisor Notes

Page 13 A special report on the rich

Page 19 Do financial advisors improve portfolio performance?

Page 23 How to Check Out a Financial Advisor by Chuck Jaffe

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CHOOSING AN INVESTMENT ADVISOR

By Dennis Waldron

January 24, 2012

At Kodak

Technical-Electrical Tech/Imaging Science/Statistics

Quality Manager and Process Engineer at EK

6 Sigma Black Belt Training

Compliance

After Kodak

Certified Financial Planner Courses

H&R Block Income Tax training and employment

Financial Back Room Assistant

Financial Advisor at AXA

FINANCIAL SERVIVCES WAS/IS MY PASSION BUT NOT MY CAREER

I HAD THE LUXURY OF WATCHING AND LEARNING, AND TO BE OBJECTIVE!

FINANCIAL/INVESTMENT ADVISOR DEFINITIONS

Fee-Only Financial Advisor

Can receive fees paid directly by the client.

Fixed dollar amount or a percentage of the portfolio or per/hour basis

Fee-Based Financial Advisor

Can receive fees paid by you

Can receive commissions paid by a brokerage firm, mutual fund company, insurance company or investment partnership.

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Commission-Based Financial Advisor

Can receive commissions paid to them by a brokerage firm, mutual fund company, insurance company or investment partnership

IDEAL ADVISOR KNOWLEDGE BASE

Manage investments in his platform (Their broker Dealer-LPL/Cataray Grant)

Several strategies-Buy and Hold, Tactical, Strategic

Manage investments in other platforms-Fidelity, TD Ameritrade, T. Rowe Price, Scottrade etc.

Financial planning

Pension decisions i.e., lump vs. annuity etc.

College savings

IRAs

Roth conversion

Periodic reviews

Tax advice

Withdrawal strategy

Medicare and Medicaid

Social Security

Long Term Care

Trusts

Estate taxes

Gifting Strategies

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REALITIES OF THE BUSINESS

ADVISOR MUSTS

Make Enough Money To Stay In Business

Keep Clients Who Generate Money or Referrals

Acquire New Clients(ASSETS)

ADVISOR WANTS

Help The Client

Have Enough Time To Service The Client

Make More Money

FINANCIAL ADVISOR PAY

Fee Only 100-250 dollars per hour

Cannot sell products i.e., Advice Only.

In some cases you need to have enough knowledge to ask the right questions

You will need your own accounts and to make your own moves

How often will you go to them for investment advice?

Full-Service i.e., Pay from Assets Under Mgmt and selling annuities/life insurance

Brokerage Account 1-2% upfront, but little payout to advisor. Pay comes from fund company

Little to no incentive to service.

No tracking of Long Term or Short Term gains

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Full-Service Managed Account Fee of 1% per Year of your Account

Fee shows up on statements.

Advisor is paid monthly.

No tracking of Long Term or Short Term gains

Annuity: 3-5% to advisor

Paid by company

Possible annual payout

Proprietary investment choices

EXAMPLE

Managed Account of $500,000

1% per Year = $5,000

Approximately $400 per month

Annuity of $500,000

5% upfront = $25,000

$400 per month vs. $25,000 payment

PAY for Full-Service

Life Insurance

50% of first year premium goes to agent

Annual payout on insurance other than term

Little incentive to service except to sell more

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GENERAL

Everyone wants an advisor who will act as a fiduciary. However, the system of pay for advisors makes conflict of interest inevitable.

WHAT ATTRIBUTES DO YOU WANT IN AN ADVISOR?

Knowledgeable

Fiduciary

Time to work with you..

Knowledgeable in Behavioral Science

Responsive to communication

Able to pull the trigger on investments

Accessibility

WHAT ADVISOR TYPE (Financial vs. Investment) IS RIGHT FOR YOU?

“Know Thyself”

What do you know?

What can you do yourself?

How much do you want to do?

Are you disciplined?

What do you want the advisor to accomplish? You should have a measureable objective.

WHAT, SPECIFICALLY, WILL AN INVESTMENT ADVISOR DO FOR YOU?

Determine risk tolerance-questions and interview

Assess financial goals (income needs, rate of return). Your advisor should create a plan for you; not an assistant or secretary.

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Determine asset allocation to supply needed income or rate of return

Implement allocation with appropriate products based on risk tolerance and financial goals

Review plan and fine tune; periodically assess income need with a financial plan.

Your advisor should create a plan for you; not an assistant or secretary.

DECIDE IF YOU WANT A FINANCIAL ADVISOR OR AN INVESTMENT MANAGER

IF YOU WANT AN INVESTMENT ADVISOR

Ask What Investment Strategy He Uses

Almost all advisors use Buy & Hold with enough movement in the portfolio to make you think it is being actively managed

Rebalancing is a form Active management

HOW TO FIND THE BEST ADVISOR FOR YOURSELF

Talk to your friends, but only those who are very knowledgeable in investing

No one will admit they made a mistake with an advisor

Everyone lies about their investments and how they are doing

Performance is important but impossible to measure

Ability to redo financial plans and reassess goals

Routine reviews w/o requesting them

Does he return calls or is it an assistant?

Does he routinely answer questions or does he refer you to a specialist?

Who actually knows your account?

How old is the advisor? DO NOT GET AN ADVISOR UNDER 30-35

Does he have a partner or relative he works with?

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What is his succession plan-who takes over for him?

How many clients does he have? (This will never be verified.)

People think if an advisor has a small number of clients they will get personal attention. An advisor seeks out those clients who are making him money. An advisor with no clients is new in the business and will be spending his time working on new clients; not on your account.

All advisors want a small number of high net worth clients: $10 million+

Go to an advisor with some pre-conceived parameters i.e., low internal fees, low trading costs, Buy & Hold, Timing, downside protection. Give him some parameters.

Does the advisor do his own “investing” or is there a group “expert” devoted to investing?

Does he help with taxes/withdrawal strategy or does he send you to high priced experts for general advice?

Will he manage you children’s accounts /spouses accounts?

COMMON MISCONCEPTIONS

He will tell you he beats the market routinely, but ask for data.

The performance Data will be Selective and imprecise.

It is difficult to get this data and compare apples to apples.

Advisor payment type does not ensure he/she will act in your best interests.

Securities law provides no guarantee i.e., Mutual Fund Class and Risk Assessment.

Credentials do not guarantee competence i.e., CFP example/Series 7&66/63/65

Hidden pressures on advisors-office expenses, Health Care, continued employment, etc.

The only skill is acting like he has a skill.

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WHAT EVERYONE REALLY WANTS

BEAT THE MARKET!

ASSUME THE PRESSURE OF MANAGING FINANCES

DO IT WITH LESS RISK AND LESS VARIABILITY

KNOW EVERYTHING THERE IS TO KNOW ABOUT ANY FINANCIAL or TAX or INVESTMENT ISSUE, AND KNOW WHERE THE MARKET IS GOING

ANSWER ALL QUESTIONS

DO IT FOR FREE!

IF THE ADVISOR DOES NOT WORK OUT

Find a new advisor

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These notes were started sometime after 2001 by Henry Wirth as part of a Financial Planning SIG project. They were last revised on June 2, 2011. The original project participants were reasonably knowledgeable investors who volunteered to interview financial advisors. Here's what we learned.

Fee-Based vs. Fee-Only vs. Commission Based Financial Advisor

A Fee-Based Financial Advisor can receive fees paid by you, and commissions paid to them by a brokerage firm, mutual fund company, insurance company, or investment partnership.

A Fee-Only Financial Advisor receives fees paid directly by their clients. These fees can be fixed dollar amounts OR they can be a percentage of the portfolio. Fee-Only Financial Advisors have a fiduciary responsibility to choose investments that are in your best interest. They typically use investments that have low internal expenses such as no load mutual funds and investments that have no 12B-1 fees.

A Commission-Based Financial Advisor receives a commission paid to them by a brokerage firm, mutual fund company, insurance company, or investment partnership for products they sell to customers.

Sourceshttp://en.wikipedia.org/wiki/Financial_adviserhttp://www.investopedia.com/articles/basics/04/022704.asphttp://money.cnn.com/magazines/moneymag/money101/lesson15/ Top things to know; Item 5

Before you interview an advisor, determine EXACTLY what you want the advisor to accomplish. Do NOT sign a contract unless the objective is included in the contract. Remuneration should be dependant on satisfying the measurable objective.

A Fee-Only Financial Advisor is probably the best choice. Furthermore, the fee should be a fixed dollar amount rather than a percentage of the portfolio so you know exactly what you're paying. The National Association of Personal Financial Advisors website is www.napfa.org. The organization’s members are almost all CFPs and all work as fee-only planners.

Any specific financial questions I had were always answered for free by Vanguard. See Pg 3, Item 4. Experts are also available on-line to answer specific questions for as little as $10. http://www.bidawiz.com/ is one of many sites where you don't pay until you're satisfied with the answer. Fee-Only Financial Advisors are also available on an hourly basis to give your portfolio an annual check up, answer questions etc.

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http://www.bidawiz.com/

http://www.napfa.org/

http://money.cnn.com/magazines/moneymag/money101/lesson15/

http://www.investopedia.com/articles/basics/04/022704.asp

http://en.wikipedia.org/wiki/Financial_adviser


What will a professional financial manager do for you?

1. You are the boss. If you know what you want and if you're not a complete idiot, then almost anyone will do anything you want. Let's face it: If they didn't do what you wanted them to do, you'd fire them. But be prepared to pay more if you have special needs and a moderate portfolio. If you don't know what you want and if you don’t have special needs, then almost every investment advisor in the world is going to say their investing style is whatever worked well in the last ten or so years. But what are they really gonna do?

A. They will try to determine your risk tolerance i.e., they will try to determine how much of a loss you can tolerate before you panic and fire them.

B. They will try to determine how much income you need.C. Based on your answers to questions A and B they're going to determine a

stock/bond allocation for you. The stock allocation will probably be 85% US large cap stocks or mutual funds designed to mimic the S&P 500 as closely as possible and a combination of US small and mid cap stocks or stock funds and international stocks or stock funds designed to mimic appropriate indexes. Note that a combination of 15% US extended market and foreign stocks isn't going to help or hurt your portfolio regardless of how well or poorly these asset classes perform. The advisor/manager is doing this simply to say, "I was there" if they out-perform and, "I avoided over-exposure" if they under-perform. The bond portfolio will consist primarily of laddered intermediate term US bonds with some short and long term bonds and cash thrown in for the same reason.

The paragraph above was originally written shortly after 2001. The portfolio that was described worked reasonably well during the ten-years thru 2000, but it did NOT work as well during the ten-years thru 2010. As a consequence, most advisors are now recommending more small and mid cap exposure, more international exposure, and perhaps some emerging market and international bond exposure for more daring investors. Hindsight is wonderful.

Can you do all this yourself? In theory you can do anything yourself IF you understand why the stock/bond allocation that was originally determined should be maintained OR changed, AND IF you have the intestinal fortitude to do it. Two BIG IFs. If you can say yes unconditionally to both IFs then you can be your own manager; if NOT, then you need a manager.

2. Relatively few investment advisors in this world will have exceeded the risk adjusted return of an appropriate index and, if they did, you won’t know if they were smart or if they were lucky; nor will you know if their luck or brains are going to prevail once they start managing your portfolio. If you're searching for a guru or a savior then try to remember what happened when our Mutual Fund Special Interest Group tried to identify out performing mutual funds before the fact. If you settle for the returns of an index then you’ll get whatever the index yields minus some modest transaction costs. If you chase performance then you may out perform, but the chances are far greater that you’ll under perform by 4% or more per year.

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3. Management fees are generally 1% of your entire portfolio, but this is a competitive business so it is fairly easy to negotiate lower fees or, better yet, fixed fees, especially if you have a portfolio greater than $500K. If your advisor is trailing an appropriate index by 1% (and most of them will trail for a variety of reasons) then factor that into the total cost. Consulting fees and co-fiduciary fees can easily add 1% or more. All things considered, professional management will probably cost about $20,000 PER YEAR if you have a $1 million portfolio and if you don't have any special needs; $30,000 if you're a PITA (Pain in the Ass). Is professional management worth the price? Only you can decide if the management or companionship you're buying is worth the money you're paying, but recognize that if you lack discipline and intestinal fortitude then you could benefit from professional management.

4. Vanguard will analyze your portfolio and create an individualized financial plan for a one-time fee of $250 if you have between $50K to $500K with them. If you have more than $500K, then their plan is free and you are entitled to "more sophisticated" support. If you have $1 Million or more, then the perks are even better. If you have the discipline and intestinal fortitude to follow their plan then you don't need a manager; if NOT, then you may benefit from professional management.

5. I have not commented on our impressions of any of the advisors whom the project volunteers interviewed because it’s subjective and irrelevant i.e., the advisors have been trained to make a good impression. However, in my opinion, an overwhelming percentage of advisors are simply salesmen who want to sell a financial product that has been manufactured by their organization. Most of the products they're selling have high fees and/or expenses that usually subtract value from an appropriate index.

6. The best advisor you're likely to meet is the person who stares at you when you look into a mirror IF you're willing and able to educate yourself. If you're not willing and able to educate yourself, then you're a fool, and the advisor you choose is likely to be a charlatan. A fool and his money are soon parted.

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http://www.economist.com/node/13356628?story_id=E1_TPPVGGNR

A special report on the rich

Show them the money

The rich have become disillusioned with the people who look after their fortunes

Apr 2nd 2009 | from the print edition of The Economist

ONE of the problems with being rich is that you cannot just leave your money to sit

there: you have to do something with it. Few people feel confident enough to throw

themselves into the hurly-burly of financial markets on their own. The wealth-

management industry exists to take that problem off their hands, for a pretty hefty fee.

Unfortunately for all concerned, the industry tends to promise more than it can deliver.

Last year was disastrous for financial markets, with the MSCI World index of equities

falling 42%. Moreover, many clients, having been persuaded of the benefits of

diversification in recent years, had bought alternative assets, such as hedge funds and

private equity, which supposedly offered absolute (positive) returns uncorrelated with

the stock market. But when the crisis came, those assets turned out to be highly

correlated to the mainstream and lost value as well.

The final straw came at the end of last year when the extent of the Madoff scandal was

revealed. Bernard Madoff pleaded guilty to running a Ponzi scheme in which he was

paying early investors consistent returns by taking the money from later ones, with

potential losses in the tens of billions of dollars. Just what were wealth managers doing

to earn their fees if they could not spot the scam?

So there is now fairly widespread dissatisfaction with the industry. “The old wealth-

management universe is not just broken, it’s been broken and tossed away,” says Russ

Prince of Prince & Associates, a market-research firm. “Nobody believes anything

anybody is saying any more.” A survey by his company showed that 15% of the wealthy

had left their main adviser last year and a further 70% had pulled some of their money

away.

A survey of rich Americans by Harrison Group found that 63% had lost faith in financial

institutions. And Caroline Garnham of Lawrence Graham, a London law firm, says that

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http://www.economist.com/node/13356628?story_id=E1_TPPVGGNR


half of her clients do not use private wealth management at all, and half of the

remainder are dissatisfied with the advice they received.

The private wealth-management business has always been rather murky. Ask for

performance figures, and the best you will get is the record of some model portfolio;

clients are all different, managers say, and have different attitudes to risk. Besides, they

argue, looking after a client is not just about performance, it is also about tax

management, family structures and all manner of other things. Some clients have strong

opinions and will want a say in how the portfolio is run; others will have long-standing

positions in particular businesses or properties that they may be unwilling or unable to

sell. So a private-client portfolio will normally look quite different from a pension-fund

version with its careful mix of equities, bonds and property.

These constraints are real enough, but they make it very hard to measure the “success”

of a private-client manager. A lot may depend on the trust between the individual client

and the relationship manager at the bank; if the bond is strong, then a bad year such as

2008 can be explained away. This can be an advantage to private banks once clients

are on the books; inertia may keep them there, if only because clients can rarely be

sure that they would be better off elsewhere.

Who rates as rich?

How much money do you need to count as wealthy in the first place? For a wealth

manager, it depends on how big a portfolio you can give him to manage. For example,

Merrill Lynch’s wealth-management report starts counting at $1m in “investible assets”.

That excludes people’s main homes, which may seem reasonable. But it means that a

Londoner who sells his home and decides to rent can suddenly find himself “rich”.

In fact, a lot of wealth managers will not bother with anyone who has less than about

$10m in assets. After all, a portfolio of $1m these days would generate an income of

only $30,000 if invested in Treasury bonds, which does not leave much scope for the

playboy lifestyle.

Putting performance to one side, another big issue for the industry is the quality of

advice on offer, and whether it is sufficiently impartial. In many cases private banks may

be part of larger groups that see an advantage in having a captive client base for their

other activities. This link is made explicit in a recent report on the wealth-management

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industry by Boston Consulting Group (BCG). “Some players position their private banks

within their corporate or investment banks,” the report says. “This approach aims to

keep the client’s wealth in a single institution and tap product-development synergies.”

These synergies often turn out to benefit the banks a lot more than the clients. As

Stefan Jaecklin of Oliver Wyman puts it, “in the integrated banking model there are

limited benefits for the private bank from having an investment bank attached; the

benefits mainly flow the other way round. A lot of private banking has not been about

advice but about pushing products. Often bankers will be rewarded not just on the basis

of assets under management but on product sales.”

Jacques de Saussure of Pictet, a Swiss wealth-management group, agrees. “We have

avoided having an investment bank within the Pictet group because it creates lots of

conflicts of interest,” he explains. “The wealth-management business can become a

distribution channel.”

An important development in recent years has been the use of so-called structured

products. Like the toxic versions that were undone by the collapse in the American

housing market, these products involve the use of derivatives. That makes them a

tempting sales opportunity for investment banks with derivative expertise. An enthusiast

would say that these products often have tax advantages and can be used to manage

an investor’s risk profile; a cynic would say that the structures can disguise a lot of fees

and charges.

A gamble by another name

Some structured products may be a reasonable way of enticing investors to take a bit

more risk; for example, with an investment that offers 90% of the growth in an equity

index but with a guaranteed return of capital if the market falls. But others, particularly

those involving commodities, may be a vehicle for gambling. “A lot of structured

products were speculative in nature, with questionable purpose in a private-banking

context,” says Mr. Jaecklin.

These structured products can quickly turn into dead money if markets move against

them, with clients locked in for years or able to redeem only at fire-sale prices.

“Structured products can become illiquid and pricing can be at the mercy of the issuer,”

says Pictet’s Mr. de Saussure.

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Another issue emerged from the collapse of Lehman Brothers. In some cases the

guarantee on a structured product was provided by the failed investment bank; this

meant that clients did not get their promised money back after all.

But the bigger problem has been investment losses. During the boom years some Asian

private-banking clients were sold a toxic product known as an accumulator. The

structure sounded simple. If shares in a company, say General Electric, stayed above a

given level, investors received a high yield; if the shares dropped below that level, they

ended up owning the stock. In effect, the clients had written a put option on the share

price. That was fine in rising markets but proved to be a disaster in 2008 when clients

ended up owning shares that were falling rapidly.

Asian clients may have been sold more of these products because they were generally

seen as being willing to take rather more risk. As one observer remarks, many of these

clients were people who were earning 25% a year from their own businesses; they

found it hard to understand why private banks were offering much lower returns. Raj

Parmar of HSBC Wealth Management says there was “little doubt that the Asian

wealthy did exceptionally well in the past five to seven years and better than their

counterparts around the world. However, a lot of institutions were knocking on their door

and outbidding each other on returns, often using leverage. By late 2008 many Asian

investors gave away a substantial proportion of the profits they made in those five to

seven years.”

Many Asian clients will have been caught out by the sharp falls in local markets last

year, with the Shanghai A share market dropping by 65%. Even so, the industry sees

the region as a promising area for expansion. According to BCG, assets under

management in China grew at a compound annual rate of 25% between 2002 and

2007, though the figure will have taken a big hit in 2008. Another growth area was

central and eastern Europe, which had four of the ten fastest-growing wealth markets in

2002-07: Poland, Slovakia, Hungary and the Czech Republic.

Wherever the clients are based, they are likely to have been chastened by the

experience of the past 18 months. Like everyone else, rich people want the impossible:

high returns with no risk. But their biggest fear, naturally enough, is losing a chunk of

their wealth so large that they would have to adjust their lifestyles to live on a smaller

income. So at times of trouble they will retreat from risky assets such as hedge funds

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and into cash and government bonds. Some have called it the “back to basics” market.

“For the next 18 months to two years, investors will be a little cautious,” says HSBC’s

Mr. Parmar. “They are going to demand more explanation of what is in their portfolios. It

is hard to sell a black-box product today.”

Golden glow

Indeed, there is considerable demand for that most ancient of financial products, gold.

According to the World Gold Council, investment demand for bullion between 2007 and

2008 rose by 64%. Pictet, the wealth-management group, decided some time ago to

take physical delivery of gold (rather than get exposure via the derivatives market), and

has had to find extra space in its vaults.

This change in behavior is, in itself, a challenge for the private-banking sector. Oliver

Wyman suggests that the shift from equities and structured products into cash and fixed

income will reduce private-bank revenues by around 20%.

Moreover, the Madoff scandal and the controversy surrounding Sir Allen Stanford, a rich

Texan accused of an $8 billion investment fraud, raises a lot of questions about what

private wealth managers actually do with their clients’ money. How could such groups

pass due-diligence tests when they used obscure auditing firms and kept their

investment processes so secret? According to Jérôme de Lavenère Lussan of Laven

Partners, a company that specializes in due diligence, “there has been a degree of

complacency and laxness about how people choose investments.”

There may well be some consolidation in the fund-of-hedge-funds industry, where many

people have been amazed to find that managers charged 1% or 1.5% of the sums

invested a year for their supposed skill in scanning the industry, only to send clients’

money to Mr. Madoff. With the sector already losing money after suffering unexpected

losses in 2008, many funds-of-funds may be forced to close. “We expect that firms

which suffered from exposure to Madoff (almost regardless of the scale) will see

material redemptions as investors react to perceived lapses in the due-diligence

process,” says Huw van Steenis, a finance-sector analyst at Morgan Stanley.

The rest of the wealth-management industry may also have to change. Fees have not

been transparent, with clients getting charged for a whole range of services and some

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managers taking “retrocessions” or kickbacks from outside funds with which they place

money. “The industry needs to move to a model where advice is being charged for and

money flows are transparent,” says Mr. Jaecklin.

Downward pressure on fees seems inevitable. In the 1990s, when investors were

earning 20% a year, fees seemed a trivial issue; but when cash is yielding 1-2% and

government bonds 3-4%, they take a much bigger chunk of total return.

Given their losses in 2008, clients may also be attracted to banks which they believe to

have weathered the crisis better than others; Credit Suisse and JPMorgan are both

reporting significant inflows. Another section of the market that may do well is private

family offices, which deal with the wealth of a single dynasty or a small group. Their

main drawback is that they require considerable resources to set up, so may not be

worthwhile unless a family has around $1 billion. Multi-family offices, such as the

London-based Fleming Family & Partners, are another option.

There is a natural inertia about wealth management. Clients may want to believe that

they made the right choice of adviser in the first place, or will “cling to nurse, for fear of

finding something worse”. They may also feel they lack the expertise to evaluate the

service they are getting. “Private clients don’t know enough about the industry to be

able to demand what they need,” says Ms Garnham. But the financial crisis will have

shaken many clients out of their lethargy. The next few years will see big changes in the

wealth-management industry. In future, firms will have to deliver as well as promise.

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http://www.voxeu.org/index.php?q=node/4014

Do financial advisors improve portfolio performance?

Andreas Hackethal Michalis Haliassos Tullio Jappelli

24 September 2009

Do financial advisors aid their clients in making wise investments? This column shows

that investors who delegate their portfolio management achieve better results. But that’s

due to the fact that advisors tend to be matched with richer, older investors. In fact,

financial advisors tend to lower returns and raise risk relative to clients who

manage their own investment.

The recent stock market crash makes clear the dangers of financial risk exposure,

particularly for households lacking financial sophistication and the means to handle

market downturns. Household exposure to financial risks has been promoted in the last

decade, partly as a deliberate move towards greater investment in the stock market and

partly through policy shifts aimed at promoting retirement financing through individual

retirement accounts. These developments may have important distributional

consequences, as unsophisticated investors become more exposed to financial market

fluctuations and less able than others to buffer financial risks.

Trusting the professionals

In principle, financial advisors could ameliorate consequences of differential ability to

handle finances by improving returns and ensuring greater risk diversification among

less sophisticated investors. Indeed, delegation of portfolio decisions to advisors opens

up economies of scale in portfolio management, because advisors can spread

information acquisition costs among many investors. Such economies of scale, as well

as possibly superior financial practices of advisors, create the potential for individual

investors to improve their portfolio performance by delegating financial decisions.

Well trained financial advisors might also be able to ameliorate behavioral biases of

their clients and moderate trading activity. Barber and Odean (2000) show that some

investors trade excessively in brokerage accounts, suffering transactions costs that

result in significantly lower returns; such behavior is often attributed to overconfidence.

Other behavioral biases have been found to influence some individual investors, such

as trading on the basis of past returns, reference prices, or the size of gain or loss over

the holding period (Grinblatt and Keloharju, 2001). But delegation entails costs in terms

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http://www.voxeu.org/index.php?q=node/4014


of commissions and fees and gives rise to conflicts of interest between advisors and

customers, as shown by Inderst and Ottaviani (forthcoming). On the one hand, financial

advisors need to sell financial products, and, on the other, they need to advise

customers on what is best for them to do.

New evidence on advisors’ impact

The budding literature on financial advice and its regulation is usually based on the

premise that advisors know what is good for individual customers but have an incentive

to misrepresent this and take advantage of their typically uninformed customers. In

recent research (Hacketal, Haliasso, and Jappelli, 2009), we ask:

•How do brokerage accounts run by individuals without financial advisors actually

perform compared to accounts run by (or in consultation with) financial advisors?

•Are financial advisors are indeed matched with poorer, uninformed investors or with

richer, experienced but presumably busy investors?

•Is the contribution of financial advisors to the accounts that they do run actually positive

relative to what investors with the characteristics of their clients tend to obtain on their

own?

Our analysis is made possible by a unique administrative data set from a large German

brokerage firm that allows its clients to choose whether to run their accounts themselves

or with the guidance of an independent financial advisor. The answers we obtain

provide quite a different perspective on financial advice. We track accounts of 32,751

randomly selected individual customers over six years.

Our unconditional findings would likely find their way into marketing brochures and to

shape perceptions of the public – they paint a very positive picture. Investors who

delegate portfolio management to a financial advisor achieve on average greater

returns, lower risk, lower probabilities of losses and of substantial losses, and greater

diversification through investments in mutual funds.

However, one cannot view the advisor-investor pairing as random. Our econometric

analysis suggests that advisors tend to be matched with richer, older investors rather

than with poorer, younger ones. Taking account of this sample selection bias yields the

opposite result. Once we control for different characteristics of investors using financial

advisors, we discover that advisors actually tend to lower returns, raise portfolio risk,

increase the probabilities of losses, and increase trading frequency and portfolio

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turnover relative to what account owners of given characteristics tend to achieve on

their own.

These results provide a new perspective on the role of financial advisors that could

prompt further scientific research and policy analysis of their conflicting incentives, their

likely effects, and the need to regulate them.

Based on the findings, it should not be taken for granted that financial advisors provide

their services to small, young investors typically identified as in need of investment

guidance. Indeed, the opposite is true. Even if advisors add value to the account, they

collect more in fees and commissions than they contribute.

Policy issues

One interpretation could be that advisors overcharge for their services. If they do,

should they be regulated? Or should we be content with the idea that they do not tend

to serve those lacking sophistication but those lacking time to make money on the

market? But then, why do rich, older people pay so much for advice? Could part of it

arise because these individuals would not have undertaken the investment themselves

if it were not for the help of advisors?

A further policy issue is whether, in light of varying financial sophistication across

households, financial advice can be used to ameliorate the consequences of such

differences. The findings suggest that we are two steps removed from such a

conclusion. First, we have not found financial advice to actually improve performance

relative to what households tend to achieve on their own. Second, we have not found

that the naïve and unsophisticated are those who tend to use financial advisors. Other

alternatives, such as simpler products and carefully designed default options, may be

more promising than financial advice in averting negative distributional consequences.

Finally, the analysis raises some issues for evaluating the recent implementation of the

EU’s Markets in Financial Instruments Directive aimed at increasing financial markets

transparency and competition. The directive requires financial institutions to elicit and

rate investors' financial abilities through simple questionnaires that ask investors to

report knowledge of specific assets (such as stocks or mutual funds) or whether they

consider themselves financially sophisticated. The directive seeks to reduce conflicts of

interest between individual investors and financial institutions and advisors. But

ensuring high investor quality does not necessarily eliminate the need to monitor quality

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of services by financial advisors, especially since there are negative performance

effects even for older clients with larger accounts.

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http://www.aaii.com/journal/article/how-to-check-out-a-financial-advisor

Financial Planning

How to Check Out a Financial Advisor by Chuck Jaffe

AAII Journal April 2011

Portions of this article were excerpted from “Getting Started in Finding a Financial

Advisor,” by Chuck Jaffe. Copyright 2010 by Chuck Jaffe.

You would think figuring out who to turn to when you need financial help would be as

simple as telling yourself, “I’m having trouble figuring out the tax code, so I need an

accountant.”

It doesn’t work that way. That’s because financial advisors often wear a lot of hats and

do a lot of different chores. There are tax attorneys and accountants who do financial

planning, and stockbrokers who also sell insurance. Throw in confusing titles—where

you need to discern between a “financial planner” and a “wealth advisor”—as well as

mind-numbing professional credentials, and it’s hard to find the right mix of skills in a

person you want to work with.

To find the right match, first come up with the financial chores and tasks you want help

with, and then match your needs to an advisor. And if an advisor does more than one

job—a financial planner who also is a lawyer doing estate planning, for example—

qualify them for each task separately. Don’t assume that because an advisor is best for

one task that he is great for all.

Here are some questions that will help you determine which advisors in each specialty

are right for you.

Financial Planners

For most people, a financial planner is their quarterback and coach all rolled into one,

calling the plays and designing the strategy that will help them reach their financial

goals, and then executing the plan.

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http://www.aaii.com/journal/article/how-to-check-out-a-financial-advisor


You are looking for a mix of technical expertise and skill with bedside manner and

personality. Remember, a lot of what a good planner gives you is “emotional discipline,”

the ability to stick to the plan at the times when doing the right things are most difficult. If

you don’t like your financial planner, that’s not possible, no matter how much investment

skill the planner has.

Here are questions to ask financial planner candidates.

What is your educational and professional background?

Look at a planner’s background to see if he has a stable employment history. You want

an advisor who will be there for you in the years ahead, as well as one who does not

have a history of bouncing from job to job because his work did not satisfy previous

employers. If necessary, call the previous employer for a reference check.

What credentials do you have? Are there areas in which you specialize?

Consumers (and advisors too) sometimes place too much emphasis on credentials and

not enough on chemistry, but there’s no denying that you want someone who has the

expertise to handle your situation. Just as telling for the future of your relationship may

be the credentials the planner doesn’t have. A financial planner who lacks insurance

credentials probably will pass you on to an insurance agent or consultant and will focus

his efforts on your more liquid assets. That’s a smart move, and it’s the right thing to do,

but it may disappoint you if your hope is to hire one advisor who can handle all of your

current needs.

There are also some amazing specialties that may be worth asking about, depending on

your personal situation. If you have what you think is a unique situation, you at least

want to know if the advisor is prepared to handle it or willing to learn about it

What continuing education classes have you taken? What certifications, if any, do you

have?

Finding out what an advisor has been learning recently is a good way to know what is

on his mind. It also shows where his practice is headed. If you hear that he has used his

educational credits on some esoteric subject that will never come up in your finances,

you should wonder about the scope of the practice and whether you’re a great fit.

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Can I have your Central Registration Depository (CRD) number or Investment Advisor

Registration Depository (IARD )number?

When you do your background checks, you want to make sure you get the right person.

By having the appropriate registration depository identification number, you are certain

to get the right guy in the right place. Advisors may not know their CRD/IARD number—

and it can be just one even if a financial planner is in both databases—off the top of

their heads, but they can find it easily enough. If the financial planner sold securities in

the past, separate from being a registered investment advisor, get his CRD number so

you can make sure disciplinary problems did not lead to the career change.

By asking this question, the advisor should know you are going to check him out; if he

doesn’t get you the numbers, he’s trying to hide something.

Can I have a copy of your complete Form ADV?

Form ADV is an investment advisor’s registration form. They’re required by law to give

you a copy, which you would think would make this question unnecessary, but it’s not.

Specifically, you are asking for a complete ADV, when the law only requires them to

provide Part II.

Some advisors—mostly those who are brokers providing some measure of financial

planning service—will not have an ADV, but instead will have a U-4 registration form for

you to review.

Yes, you can get this form on your own, but you shouldn’t have to. In fact, ask the

advisor if there is anything he thinks you should discuss about the information in the

form, anything he thinks will raise a red flag with you. If he tells you there are no red

flags and your subsequent review of the document shows you otherwise, you know he

tried to sweep trouble under the rug

Brokers

Many stockbrokers act like financial planners, so the difference is not always obvious.

That said, a broker typically is selling you investments, where the planner is selling

advice and counsel. A broker is executing trades that are “suitable” for you, while a

planner must provide counsel that is “in your best interest.” There is a difference.

Here are a couple resources for checking out a broker’s background.

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Check FINRA

Stockbrokers typically file a Form U-4 to register with the Financial Industry Regulatory

Authority FINRA, which covers the details on the advisor’s past.

Because brokers, account executives, and whatever else you want to call a “registered

representative” are regulated by FINRA, start your background check by using the

agency’s BrokerCheck service (www.finra.org/investors/toolscalculators/brokercheck). It

provides information on an advisor’s previous employers, disciplinary actions, and

customer disputes filed against him, states he is licensed to do business in, industry

exams he has passed, outside business affiliations (which may show conflicts of

interest), and more.

The service is free and takes just minutes. If you can get the broker’s Central

Registration Depository (CRD) number, you can go directly to his record, which is

helpful if the broker has a common name.

Your second background check stop should be your state securities commissioner’s

office, for which contact details are available at www.nasaa.org.

Check With Your State

If your broker candidate also functions as an investment advisor, he will be a registered

investment advisor, meaning he files a Form ADV with either the state regulator or the

Securities and Exchange Commission. To check out the Investment Advisor

Registration Depository (IARD), which you can access through the SEC’s Investment

Advisor Public Disclosure program, go to www.investor.gov to find an easy link.

Some brokers also sell insurance products. If your candidate does, be sure to check the

insurance license—and to look for disciplinary problems—with your state insurance

commissioner. Find your state insurance commissioner’s office by looking at the “states

and jurisdictions map” on www.naic.org, the website of the National Association of

Insurance Commissioners.

Insurance Agents

Most people think of insurance agents as the guy selling them home or auto insurance,

but many agents go far beyond that, using insurance as an investment-, estate- and

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financial-planning tool. What’s more, many consumers go to agents thinking they want

basic protection, but quickly learn they want something more. While consumers can buy

stripped-down insurance or keep it simple, a good agent is likely to offer solutions that

the average customer would not come up with on their own.

Here are questions to ask insurance agents you are considering.

Can I have your insurance license number?

Ask this one early in the process and you could save some time. It’s a deal-breaker.

Insurance agents are licensed by the state. Getting the license number speeds up your

background check with the state insurance commissioner; it sends a clear message to

the agent that you intend to do a background check.

You can laugh it off as being precautionary and being a waste of a phone call if that

gets the agent to show you a license, but you should make it clear that you won’t hire an

agent who can’t prove that he is currently licensed. Some states give agents a card to

show, others a certificate for the wall. It doesn’t matter; ask for proof, look at the

document, check the names and dates.

An agent without the license on the wall may not remember the number and may not

have it handy—you should be able to search for the records based on his name—but

that person can look it up. Refusing to give you the license number is as good as an

admission of trouble. Without a problem past, there is nothing to hide.

There is no substitute for checking in with your state insurance commissioner to see if

there have been complaints, disciplinary problems, or licensing actions taken against an

agent. You can find your state insurance commissioner’s office by looking at the “states

and jurisdictions map” on www.naic.org, the website of the National Association of

Insurance Commissioners.

What credentials do you hold and what is your background?

If the agent’s credentials impress you, make sure they are real. Contact the agency that

awards the credential to make sure the advisor is in good standing and without any

disciplinary actions.

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And since many insurance agents come to the business from financial planning—or

they practice in several specialties—be sure to check out their background in those

areas too. There have been plenty of cases where someone wears out his welcome as

a broker or planner and turns to insurance because it uses the same skill set but allows

him to dodge his troubled past.

If the agent ever functioned as a broker, check his record by using the Financial

Industry Regulatory Authority’s BrokerCheck service

(www.finra.org/investors/toolscalculators/brokercheck). If he acted as a financial

planner, you can get his history from the Investment Advisor Registration Depository via

www.investor.gov.

Finally, while insurance agents typically fall under the eye of the state insurance

commissioner, it’s not a bad idea to contact your state securities administrator,

especially if the agent has a history of selling investments and not just insurance. You

can get contact details for your state securities administrator from the North American

Securities Administrators Association website, www.nasaa.org.

Lawyers

Your lawyer will make sure you have proper legal representation and that you have

handled the nuts-and-bolts financial chores correctly. It’s important to match your needs

to the right skill set, because most lawyers have specialties, and you don’t want your

needs to fall outside of their area of expertise.

The Martindale-Hubbell Law Directory (www.martindale.com) is a complete listing of

domestic and international lawyers by state and specialty. It is available in most public

libraries and provides background information on how long a lawyer has been in

practice and where and when he got degrees.

Unfortunately, it’s still just a surface measure of an attorney’s background; you will not

find out whether an advisor has had complaints and malpractice suits filed against him.

In fact, that kind of crucial information about lawyers is lacking almost everywhere you

turn. Few states make all complaints available to the public from the time allegations

were filed. Most states will reveal grievance filings, but only around the time when the

state bar association’s grievance committee has decided to issue charges against the

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attorney. Those committees can take ages to make a decision, and those charges can

end in “admonitions” or “private reprimands,” where only the lawyer and the aggrieved

client know what happened.

Regardless of those shortcomings, call your state or local bar association’s grievance

committee for any records it can provide pertaining to your prospective attorney. In

addition, check with your local Better Business Bureau (www.bbb.org) to see if there are

complaints filed there.

Many lawyers offer a free initial consultation, although some charge a nominal fee for

their time; find this out before you set up the interview. If you plan to interview several

candidates, anyone who charges for that first consultation should be scheduled last.

As with every other type of financial advisor, you are shopping for trust, integrity, and

ability, all of which are hard to judge in an initial interview.

Here are the questions that will help you get a sense of the lawyers you interview.

How long have you been practicing and in what areas of the law do you specialize?

In all financial relationships, you don’t want to be a guinea pig. That’s particularly true of

law, where one misstep could put you on the wrong side of a judgment. Find out the

scope of the practice, whether your current needs are a good fit either for the individual

lawyer or the firm. It’s not that a patent attorney can’t write up a good will, but you might

have regrets when someday you discover what years of practicing intellectual property

law have done to his skills as an estate-planning attorney.

If a lawyer has several specialties, ask how his workload is divided between those areas

of the law. A lawyer might do real estate contracts and estate planning, for example, but

his business may be heavily weighted toward the former; if you come in with a complex

estate situation, he may not have the depth of experience you want, even though estate

planning is supposed to be one of his specialties.

Be sure to find out how long a lawyer has had each specialty. Make sure he passes

muster in your area of need.

Beyond a law degree, what professional credentials do you have?

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Law is not an area where you must see specific credentials to feel comfortable with a

practitioner. The law degree and license speak volumes about someone having

achieved the minimum standards for competency.

Still, there are some legal specialties, such as a “certified tax lawyer” or “certified civil

trial lawyer.” While there are major trade groups like the American Trial Lawyers

Association that have developed credentials, most national specialty law groups are

membership organizations, rather than education/credentialing institutions. Thus, you

need to distinguish between whether the lawyer is a member or a certificate holder.

You are looking for someone who is experienced in the kind of matters you need help

with; if you are presented with a credential, find out the educational and experience

requirements and ask to see a code of ethics, if there is one

Conclusion

In the end, you are looking for the right mix of expertise, skill and personality. Rules,

regulations and investment products are constantly changing; while your advisor might

have a great-looking diploma on the wall, it’s important to make sure they are staying

current, taking continuing education seriously so that you get the best, most current

counsel.

Remember that many of Bernie Madoff’s victims thought they were getting a great

money manager, and they took the word of others rather than doing any background

checks or questioning on their own.

By qualifying an advisor yourself, you can develop the personal and professional

comfort to feel safe and secure that you are getting your money’s worth in a financial

advisor.

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professional financial advice contents · choosing an investment advisor by dennis waldron january...

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