Three Steps to Choosing a Financial Adviser

The following is excerpted with permission from The 1-2-3 Money Plan: The Three Most Important Steps to Saving and Spending Smartby Gregory Karp.

Americans today are forced to make a dizzying array of financial decisions, including many we've talked about in this book: how to build a retirement nest egg, save for kids' college expenses, and deal with debt and insurance.

For help, you might consider hiring a personal financial adviser. That can be a great idea or a bad one. The main advice: Buyer beware.

Choosing a Financial Adviser, 1-2-3

1. Interview three fee-only planners.

2. Ask questions and listen to your gut

3. Never agree to an investment you don't understand.

The title "financial adviser" is not regulated. No government body dictates who can call themselves one. So, anybody can print up business cards and call himself or herself a financial adviser. It's up to you to weed out bad advisers from good. To do that, you'll need to know the insider secrets of the financial planning industry.

The first thing to know is that you shouldn't abdicate responsibility and turn over your financial life to someone else, no matter how good the adviser is. Hiring a financial adviser is not like hiring a lawn service to cut your grass. In that case, you're hiring the lawn service to perform a specific task so you don't have to. A financial adviser should be different. It's like asking a landscaper for advice on how best to cut your grass. He might pull-start the mower for you and walk alongside. But ultimately, you'll guide the mower and navigate around the yard. And you'll have to live with the result.

So, hiring an adviser should be a partnership or coaching relationship, rather than work-for-hire. A good adviser will help identify problems, set goals, suggest strategies, and provide objective opinions.

1. Interview Three Fee-Only Planners

The biggest problem with most financial advisers is they have divided loyalties. On one hand, they might truly want to help you achieve your goals and get you the best returns on investments. However, that can be in direct conflict with other goals, which are to keep their job, feed their own family, and provide themselves a good income. That brings us to this unfortunate fact:

Financial advisers make more money if they put you in bad investments.

Why? Because many get commissions—call them kickbacks, if you like—from the investment companies where they put your money. Sometimes, the worst investments offer the biggest kickbacks. Advisers at insurers and brokerages might be good and decent people, but their first and foremost job is to sell you financial products.

A similar conflict would be going to a doctor who doesn't charge for office visits but is paid by drug companies for selling you pills. Any chance his prescription pad would be a little busier, whether you really needed drugs or not?

The solution? Use a fee-only planner.

A fee-only planner is paid only by you, not financial companies. Beware that the term "fee-based" is entirely different. That means the adviser is compensated by both fees and commissions. Fee-only advisers often charge by the hour or by a percentage of your assets that the adviser manages. Ideally, you would pay for advice and implement the recommendations yourself. But if the adviser will manage your money, a management fee amounting to 1 percent of your assets is reasonable, while 2.5 percent is too much. Either way, be sure the planner is using the right tools—our good friends, no-load index funds.

Two good online sources for finding fee-only planners are NAPFA.org and GarrettPlanningNetwork.com. Each of these Web sites has a "find-a-planner" option to help you locate an adviser near you.

This is important: All that said, there are many good commission-based financial advisers that would do a fantastic job for you. I just think the built-in conflict of interest is too important to overlook. Conversely, just because an adviser is fee-only doesn't mean he or she is any good.

Once you have a short list of fee-only advisers, schedule an in-person interview, which should be free of charge. That might seem time consuming, but it's worthwhile. Come prepared with your financial information, such as how much income you have and all your investment balances.

As you set out to choose an adviser, think about what specific help you need. Do you feel helpless in choosing mutual funds? Don't know what to do with stock options you received at work? Are you worried you don't have the right insurances or financial documents, such as a will, living will, and medical power of attorney? Do you need advice on spending an inheritance? Do you want a comprehensive plan to cover all aspects of your money life?

Before setting up the interview, make sure the planner hasn't been in trouble. Find out about disciplinary actions by going to the U.S. Securities and Exchange Commission Web site at www.sec.gov or calling 1-800-SEC-0330. Look for a link like "Check Out Brokers & Advisers." You can also contact your state agency that oversees investment advisers. For advisers who sell investments, otherwise known as stockbrokers, you can conduct a BrokerCheck at the FINRA Web site, brokercheck.finra.org, or call 1-800-289-9999.

2. Ask Questions and Listen to Your Gut

Choosing the right adviser breaks down into three basic tasks: Assessing the adviser's technical competence, trustworthiness, and compatibility with you. Here are six questions that will help you judge an adviser, whether they are fee-only or not:

• How are you paid? This might be an uncomfortable question to ask. But it is fundamental and important. If you're using a fee-only planner, the answers should be straightforward. Ask the planner for his or her Form ADV, a document that describes the fee structure.

• What are your qualifications? Choose a planner who has been in the business for several years and has a certification, such as Certified Financial Planner or CFP. (See sidebar for other certifications.) Ask about work history.

• What is your financial planning philosophy? Here, you're fishing for a comfort level. The adviser should talk about his or her planning process and not about hot stocks or unusual investments. If a prospective financial adviser says he or she can beat the market and promises big investment returns, end the meeting. Nobody can predict market movements. The adviser is either a fool or a liar, and probably a cheat. A good financial adviser will make sure you're well-diversified, so you can limit risk and maximize returns.

• As the adviser explains his or her philosophy, ask yourself: Are you being coached or sold to? And get a feel for how rushed the adviser is. If he or she doesn't have time to attract you as a client, the adviser might not have time for you after you become one. Finally, note the words and tone the adviser uses. Is he or she speaking in financial jargon, knowing you won't understand? It actually takes greater skill and knowledge to explain things simply. Is the tone condescending or supportive?

• What services do you offer? If you need a broad spectrum of advice, make sure the planner can help with insurance, tax planning, investments, estate planning, and retirement planning. This is the time to ask whether the adviser will be the only person you deal with, or whether you'll be shuffled off to a junior associate. And ask about how the adviser will communicate, by e-mail or phone, for example. Will you receive regular reports and periodic reviews about your financial status?

• Tell me about your typical client. You want an adviser accustomed to working with people like you. If the adviser typically works with multimillionaires and you have total assets of $100,000, how much attention do you think you'll get? You should also ask for a sample financial plan for a client in similar circumstances to yours—with the client's name removed, of course.

• Can I contact referrals? Granted, an adviser is only going to refer you to his happy clients. Ask the client, "If you had to do it again, would you pick this planner?" and "What is the downside of working with this planner?"

You want to gather factual information, but trust your gut, too. That doesn't mean you should judge whether you like the adviser as a person or whether you hit it off in idle chitchat. That's irrelevant. This is a business relationship, not a personal one.

Although some people are more gullible than others, your gut should guide you, especially if you go into the meeting with a bit of skepticism. It will tell you if the adviser is being evasive or is snowing you.

3. Never Agree to an Investment You Don't Understand

If you can't explain it to your teenager or your elderly mother, don't do it.

This is a great rule because it can keep you out of harm's way. For example, there are few average Americans who can thoroughly and accurately explain what a variable annuity is. They're wildly complicated. And that works out fine. They're not good investments for most people anyway.

That's not to say you shouldn't endeavor to learn more about finance basics. You shouldn't shy away from stock mutual funds because you're not quite certain what they are.

There are many good resources for investing basics, including books and Web sites. One free resource is at the Los Angeles Times newspaper Web site. It has a "Money Library" with a host of finance topics, including investing. It's at www.latimes.com.

All this due diligence in hiring a financial planner might seem daunting, but don't let it deter you from getting the help you need. Starting on the right financial track, even using a mediocre but ethical planner, is better than doing nothing. And remember, you can always switch financial advisers later.

Comments

[neal@Wealth Pilgrim]

I think a great question is "why did the last person who fired you do so?"

[Andy]

This is great information, stuff that I wish I had before I got involved with a commission based firm that caters to(some might say targets) the military a few years back. After a couple years of learning and a few eye opening conversations with coworkers, I realized that my wife and I had high load, high expense mutual funds and whole life insurance policies that were just not the best use of our money. I've since changed to a fee only advisor that I use as more of an instructor and mentor than anything else. Luckily, I'm still in my twenties and learned the lesson early, but not everyone has time on their side.

The problem, I think, is the high hourly wages that are charged by fee only advisors, regardless of portfolio size. I just topped 100K in investments, so before that, 4 hours at 250/hr was more than 1% of my investments...early on it was much more. I'm sure this scares many people with smaller portfolios away, since they can go to a commission based firm, where they probably pay just as much if not more in the long run, only it's hidden in fees and limited investment options. The funny thing is, fee only advisors shouldn't have to spend as much time with young adults as their problems are fairly basic and could benefit from following general rules, unlike the more established investors, so they should be able to reduce their fees and get more business in the door.

[Old Limey]

If you have good mathematical skills, are very computer literate, can either write a computer program or are very proficient with a spreadsheet, and don't mind spending the time to educate yourself about managing your own money I believe that you can be your own financial advisor. It has worked perfectly for me. I now also manage my children's accounts and am responsible for a total amount that has now reached 10 figures. I have saved a bundle in investment management fees over sixteen years and during that time have used only no-load mutual funds.

My largest investment while I was working was my 401K and for many years employees could only select one of three allocations. Consequently the great majority of my investment decisions have been made during the sixteen years I have been retired. Upon retirement I subscribed to a database service that originally came with only mutual funds plus some charting and analysis software. The database now also contains end of day prices for many stocks and is kept up-to-date by a daily download. This particular database has prices that are fully adjusted for all distributions - this is particularly essential when ranking income funds.

There are plenty of good books on technical analysis and most of the analyses are fairly simple to program. I was also fortunate that my data provider was willing to make the database formats available so that I was able to write a comprehensive program with which I could do my own analysis. I also was able to sell my software to a lot of other users of the same database.

What I have found is that if you want to obtain excellent returns you cannot use Buy and Hold. It is essential to only ride an investment UP, when it is in a downtrend you have to get out. I am not talking about short term trading, rather just avoiding Bear markets. It isn't that hard to do if you have the time to study what is happening and share my aversion for losing money. I call myself a "Momentum" investor and in whatever sector I am looking to invest I search for funds with good returns but low volatility and low drawdowns. High volatility investments are a lot harder to work with.

[Guru]

I think the nest question to ask, is if your most beloved aunt asked you to invest her nest-egg - would you put it with this advisor and in the investments he recommended?

[financial advisor]

Another important item is to find a financial advisor who has experience working with other people who are in your same financial situation. Did you realize there are advisors who focus on doctors, airline pilots, business owners, teachers, socially responsible investing and hundreds of other specialties? You will get better advice if the advisor is an expert in your situation.