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 wasn't 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.

I've 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 client's 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. That's why insurance products don't produce as much growth as market returns. My favorite Paul Volker quote: "You can't 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, it's also difficult to compute what return you've 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 can't 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, doesn't go up shouldn't 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 doesn't 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?

Don't trust any investment strategy you don't understand. Don't trust any advisor who won't or can't take the time to explain exactly why and how he or she operates. An advisor's investment philosophy is the most important and valuable resource you are purchasing. If you don't trust your advisor's knowledge and techniques, you shouldn't 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 don't 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 don't 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 can't 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 can't 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.

Comments

[jim]

This is a very good list of questions.

[tom]

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

Disagree - the FA can explain his investment strategy, but why would he/she ever teach you the details behind that strategy? That is not a value-added question for either of you.

You, as a novice investor, could never replicate that same strategy, that is why you hire an FA in the first place.

Actually, as I write this, I have another thought. Is this post referring more to investment managers? What do you see is the difference between a FA and an investment manager?

[Old Limey]

Over the years I have taught myself how to become a very successful investor and it isn't easy and isn't for everyone.

I have these words of wisdom in full view on my desk:

"Good judgment comes from experience,
and experience ..............
well that comes from poor judgment"

You basically have to pay your tuition at Wall St. University and learn from your mistakes.

[Apex]

#8 is a key indicator for me in dealing with people. People who have a need to show evidence of success will often do anything necessary to maintain that appearance. Now if they truly are successful they might not need to do anything shady to continue the appearance, but how would you know? I mean after all, they appear successful right.

CNBC's American greed recounts the stories of countless money manager and ponzi scheme rip off artists. There is not one of them who was not attempting to live a lavish lifestyle while doing it. What is the point of committing fraud if you can't enjoy it.

I have also personally seen people chase the trappings of wealth. The desire to look successful and rub elbows with those who are is a huge motivating factor.

When watching American Greed, all the people who get taken by the crooks always talk about how the person seemed so successful so they never would have suspected anything. I must be idiosyncratic because whenever I see someone spreading money like cream cheese on a bagel I have buzzers and repulsion warning signals going off in my head, my gut, and all the way down to my little toe.

To me someone who is displaying success is putting on a show and most shows are fiction. If I wanted to see a show I would go to the theater. When it comes to my money, I want boring and bland. No one tries to fake that.

[DIY Investor]

I or one like question #5. The evidence as I see it (along with Warren Buffett, Burton Malkiel, Dan Solin, Charles Ellis and many others) is that a really easy investment system involving well diversified, low cost exchange traded funds beats 80% of the professional managers out there on a longer term basis after all costs are accounted for. It is why the country's largest pension funds have so much money indexed.
The system can be learned by reading any number of excellent books including "the Elements of Investing" by Malkiel and Ellis.
A weekend reading the book along with some time spent with an investment professional who believes in the approach is doable.
Questions 1 and 3 are also excellent IMHO.

[Derrik Hubbard, CFP]

As an investment adviser myself, I really love these questions and think they will definitely serve those who are seeking out an investment adviser.

I'm not sure that a good investment strategy necessarily can be replicated by a retail investor. Understood, yes, but replication might involve complicated research and proprietary software tools not accessible to the retail investor.

Derrik Hubbard, CFP

[MBTN]

Derrik:

I have a different take on the whole issue of whether or not a "good" investment strategy can be replicated by a retail investor. In my opinion. most good investment strategies are pretty darn simple: invest X% in this asset class, Y% in that asset class, and rebalance every Z months. Sure you can make some refinements around the edges. Do I rebalance every 4 months or every 12 months? Do I invest 5% in emerging markets or 7.5%? However, the basic premise is something that anybody can do through one of the big mutual fund companies. There are plenty of freely available examples of reasonble asset allocations for various risk tolerances and life stages.

The area where people need help isn't the technical aspects of investing; it's the psychological aspects. People start off with a good plan but after the first market correction, they panic. They throw their plan out the window and buy and sell in a panic. They end up selling their declining assets and buying overpriced ones, which is the exact opposite of what you should be doing but it is exactly what most people do.

This is where a financial advisor earns their money in my opinion. They don't earn their money with "complicated research and proprietary software tools". They earn their money by helping their clients to stay the course when times are bad (and when times are good and people are thinking of moving all of their money into a hot bubble stock of the month).

[Old Limey]

How about asking this question to the prospective financial advisor? "Could you please show me your complete track record for each of the last 5 years?"

I have never used a financial advisor, and never will, but that would be my very first question. My second question would be "Please show me your complete fee structure?"

Question #1 of 10 is a No Brainer unless you want to be a Bernard Madoff type of victim.

[ACS]

Another question could be "Do you track your own net worth? Can you show me your net worth history over the past X years?" I don't know if many advisors would be willing to share this info, of course. But I would personally be much more likely to pay for financial advice from someone who was already very successful with their own finances.

[Jack-of-all-Trades]

When speaking with the financial professionals that you are considering,you should treat the initial conversation as a mutual interview. The professional should ask you about your goals, your current financial situation, your plans for the future and your personality as it relates to saving and investing. By learning about you, the professional can begin to formulate an appropriate investing strategy. At the same time, you should be prepared to ask questions that will allow you to judge the professional's ability to manage your finances appropriately.