5 Rules For Getting The Best Financial Advice For Your Money
Learn Five Rules For Getting The Best Financial Advice For Your Investment Dollar
Key Ideas
- Discover how a financial adviser's pay structure influences the advice you receive.
- The four different compensation plans and how each impacts your portfolio.
- Five valuable tips that will keep more money in your pocket when dealing with salespeople.
Quick – tell me the difference between a broker and a financial adviser.
If you're not really sure, then you're not alone.
Multiple studies show investors are confused – and for good reason. The formerly clear lines of demarcation have been blurred in recent years.
Both offer services that are becoming more similar than different, so why should you care?
The reason is compensation structure – how you pay for the financial advice you receive, and the conflicts of interest it causes.
How your financial adviser is compensated effects the financial advice you'll receive.
For example, back in the heady days when investment banks still called themselves investment banks, Merrill Lynch settled a $100 million dollar multi-state settlement for alleged wrongdoing and conflicts of interest regarding biased financial advice.
I mention this case not to pick on Merrill, but because it was a high profile, landmark settlement demonstrating a fundamental conflict of interest with brokerage advice.
Every year the financial periodicals report on similar problems with brokers accused of recommending stocks to the public when their firm has an investment banking relationship with the company, and recommending stocks that the analyst owns or the brokerage firm holds a large position in.
The list of wrong-doings also includes churning accounts, recommending inappropriate investment products, and much more.
“History shows that where ethics and economics come in conflict, victory is always with economics. Vested interests have never been known to have willingly divested themselves unless there was sufficient force to compel them.”– B.R. Ambedkar
The motivating cause for each ethical violation is rooted in compensation incentives. Brokerage firms wear too many hats and serve (get compensated by) multiple masters.
Related: How Your Financial Advisor is Taking 75% of Your Retirement Income (or More!) Video, PDF download, or Audio.
How can you possibly be an investment banker to a company and sell that same company's stock to your retail clients while representing your organization as an unbiased fiduciary giving impartial financial advice? Sorry, but it doesn't work that way.
It's the equivalent of your personal physician writing prescriptions for drugs while being employed by a drug wholesaler and getting paid a commission for his recommendations. Would you trust your health to a doctor with those financial incentives hiding behind his recommendations?
I doubt it, yet people do the same with their financial security every day.
I encourage you to confront every source of financial advice in your life with this question: “Is this person an adviser or a salesperson?” Nobody can be both at the same time.
If they're an adviser, then they're paid a fully disclosed, up-front fee for their time and advice. If they're a salesperson, they'll be compensated for their advice in other ways. It's just that simple.
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The Business Reality Of Financial Advice
The sad reality is most investment brokers, financial planners, financial advisers, and financial consultants are euphemisms for the word “salesperson”. They're paid to either sell investment products or investment management services.
Their business model is driven by gathering client assets under their umbrella and then selling investment products. The more assets under management, the more product that gets sold. They aren't paid for the ability to make money with money even though that's the very skill you want from them. Time spent developing investment expertise is a distraction from what puts money in their pocket: selling.
In other words, your best interest isn't the same as your adviser's best interest, and there isn't a compensation structure in existence that can motivate them to care more about your money than their own.
They make money from their business, and you make money from your investments. That's a critical, fundamental difference.
“The popularity of conspiracy theories is explained by people's desire to believe that there is some group of folks who know what they're doing.”– Damon Knight
This isn't some grand conspiracy theory against the financial adviser community; it's a natural result of division of labor in business. Brokers are in the sales department and their job is to sell. Management does the managing and research does the research.
Each department's function is specialized for business efficiency. A broker is no more responsible for investment skills than a secretary is responsible for sales calls. Each cog in the wheel has its function, and the broker's function is to sell.
This wouldn't be a problem if brokers and financial advisers represented themselves as marketing professionals with a product or service to sell, but they don't. They represent themselves as fiduciaries and investment experts, which is where the problems begin.
Anytime financial advice comes from someone with a product or service to sell, treat that advice as if it's coming from someone peddling used cars, computers, sofas, or any other product or service.
You wouldn't view a used car salesman as a fiduciary representing your interests, so why is your financial adviser any different? They're both salespeople who must get in your back pocket to fill their own back pocket.
I know that sounds harsh. There are many financial advisers furious with that statement, but it's true nonetheless. Their advice is impacted by how they get paid. It's not a grand conspiracy theory. It's the inherent nature of the business.
How Compensation Biases Your Financial Advice
The choices for compensation in the financial advice business are varied with no perfect solution. Every compensation package creates incentives that affect the quality of financial advice you receive.
Below are the four most common compensation structures and how they bias financial advice:
1. Commissioned Sales
Transaction commissions motivate the sales person to create transaction activity and to concentrate activity on high commission products.
It's all too common to hear about brokers being sued for churning accounts and selling high commission investments to their clients regardless of suitability to capitalize on graduated commission incentives.
Commissioned sales have the greatest conflict of interest of any compensation structure. The incentives created for the broker have no congruence to the client's interests and can sometimes be diametrically opposed.
“Fortunately for serious minds, a bias recognized is a bias sterilized.”– Benjamin Haydon
2. Percent of Assets Managed
An alternative pay structure for financial advice is “percent of assets” management fees. This is a superior alternative to commissions, though it's not without its own flaws.
When I ran a successful hedge fund under this compensation structure, our motivation was to maximize consistency of returns rather than profits. The reason was simple: consistent returns maximizes client retention, which maximizes the investment adviser's profits.
Volatility scares clients away, even if it might put more profit in their pockets.
3. Profit Incentive Fees
Under this arrangement, the adviser is paid a percentage of profits from your account. This sounds great on the surface because the adviser is only paid when you make money, implying congruent interests. Unfortunately, that's a half-truth.
The adviser shares only in your profits, not the losses. This motivates the adviser to take greater risks in hopes of creating larger returns so he can get paid more.
Why? Because the capital he's risking is yours – not his. However, the money he's earning is both yours and his. From the adviser's standpoint, it's a risk-free return because the loss is yours to bear, but the gain is shared.
You may or may not end up with more profit, but you'll likely get more risk with this incentive structure.
4. Fee-Only Advice
Fee-only financial advisers are paid by the hour for financial advice. They shouldn't receive any other reward such as transaction commissions, residual trailer fees, or back end revenue.
Paying by the hour is probably the closest you'll come to getting financial advice that isn't biased by compensation. However, you should be aware that your financial advice will still be biased by the limitations of the adviser's experience, education, skill, and intelligence.
Examples of fee-only financial advice include fee-only financial planners and my educational coaching services. The sole motivation of a true fee-only adviser is to give you as much valuable financial advice as possible for the dollars you spend so you'll continue to purchase more services.
But beware of people who hang their hat as “fee-only” because few are truly fee-only financial advisers (watch for back-end kickbacks!). The reason is because “fee-only” isn't the most profitable business model, so few actually operate in its true form.
In fact, that was one of the challenges I faced in becoming a financial coach. I could make more money if I sold financial products or managed money directly, but I believe the client is best served by separating the financial advice function from the investment product sales function.
“Reality leaves a lot to the imagination.”– John Lennon
In short, there's no perfect solution that motivates your adviser to stand in your shoes and want what you want with your money.
There's no compensation structure that can make someone else care about your money more than his own. I know that isn't what you want to hear, but reality is reality regardless of our desires.
More Evidence Against Biased Financial Advice
In case you might be thinking I'm Chicken Little claiming the investment adviser sky is falling, let me present you with a random selection of quotes from numerous investment periodicals.
The conflicts of interest inherent in financial advice are well-known by industry insiders. Only the investing public is generally in the dark on this issue.
For example, Smart Money magazine published an article titled “Ten Things Your Financial Planner Won't Tell You”, by Oluwasanmi. Below I'll quote several interesting points regarding biased financial advice taken directly from the article.
“Anyone can hang out a shingle and call himself a financial planner: there's no required training or experience.”
“‘The bulk of people who market themselves as financial advisers are salespeople,' says Consumer Federation of America's director of investment protection, Barbara Roper.”
“When Irvine, Calif.-based CFP Scott Dauenhauer worked as an adviser at a few big name brokerage firms during the 90's, he says he was constantly being pushed into selling the firms proprietary and often poorly performing mutual funds, variable annuities or wrap accounts. ‘We got pressured to sell them because the pay out was higher,' says Dauenhauer.”
“A 1997 survey by National Association of Personal Financial Advisers and the Consumer Federation found that three out of five ‘fee only' planners actually earn commissions or other financial rewards for their services.”
And if that weren't enough to convince you, Jane Bryant Quinn stated in a Newsweek article that “Financial planners who take commissions have a built-in conflict of interest – even with a disclosure, my choice would be a fee-only planner.”
“The most important matter is how the planner is compensated. Hire the planner who has no financial stake in (your) investments,” according to Forbes magazine.
And Money magazine stated, “Start with the general practitioner – a financial planner (whose) compensation should be from fees alone.”
Bob Veres was quoted in Financial Planning magazine: “After almost 25 years in this business, I've learned that you can usually find the worst investments by looking for those that people are paid – handsomely – to sell.”
Financial Planning also ran an article by Marshall Eckblad where he stated, “Because wirehouses manufacture and sell financial products, it's hard for their brokers to claim they're agnostic.”
Again, I'm not trying to say that all financial planners and brokers are bad.
“We're all salespeople of our wares and things look a lot different from the other side of the counter.”– Unknown
There are some very good, honest people working in this conflict ridden profession trying their best to offer quality financial advice. However, you must use common sense because the conflicts and biases exist nonetheless.
It's a well-known problem inherent in the nature of the money management business.
Five Rules To Maximize The Value You Receive From Biased Financial Advice
Since nearly all financial advice is biased, then what's a person to do?
How do you still extract value in a world of conflicted communication?
Below are several tips to sort good financial advice from the bad and the useless:
1. Understand the Incentives Hiding Behind the Financial Advice
If the source stands to profit from the investment advice offered, then trash the information because it's likely one-sided and unreliable.
2. Never Confuse Facts With Opinions in the Financial Advice You Receive
Facts are hard data and numbers. They're true and knowable right now.
Opinions are the interpretations of those facts.
Opinions are useless clutter that cloud investment decisions.
Facts are what matter.
The salesman will blend the two together.
Your job is to extract the few facts from the myriad of opinions and disregard the rest.
3. Not All Financial Advice is Created Equal
You must know the adviser's background, education, training, skill, and experience to decide if his advice has merit.
“If stock market experts were so expert, they would be buying stock, not selling advice.”– Norman Augustine
For example, a hedge fund manager who has completed many years of independent research with twenty years of real-time trading experience will provide higher quality advice from a better experience base than a business school graduate trained in product sales by a brokerage firm.
The sad reality is most financial advisers are trained by their parent company to promote the party line. Seldom do they know enough beyond official policy to question the validity of company dogma.
The result is they speak the company doctrine as if it were truth. In fact, they often believe it is truth.
They aren't bad people; they're just misinformed and don't know enough to know what they don't know.
You can't understand a person's financial advice until you know the shoes they're standing in. Their experience and training colors their advice.
There are several levels of knowledge in the financial advice business, and the unfortunate reality is the bulk of retail financial advice comes from the ground level where too many financial advisers dwell. You want top floor financial advice.
4. You Can't Understand a Person's Financial Advice Until You Know How Their Pockets Are Lined
Again, compensation creates incentives that affects the quality and bias built into the financial advice you receive.
Ask your adviser to disclose every single way he can make money from your money – exclude no revenue stream, no matter how small.
Will he make more if you invest more? Are there back-end kickbacks that you never see because they don't appear on any of your financial statements, such as 12B-1 fees and internal brokerage incentives?
5. Utilize Financial Product Salespeople as Information Gathering Tools Only
Financial salespeople are good for introducing investment products that can be used in your portfolio.
When they pitch you on their favorite “tools” it should be the beginning of an educational process, but you should never invest based on the opinions of these salespeople. Instead, separate the investment advice function from the investment execution function and pay for them separately to minimize conflicts of interest.
The bottom line is everything a financial product salesperson tells you should be taken with a grain of salt. Never invest based solely on their recommendations without completing your own due diligence and forming your own opinion based solely on facts.
Remember, there's no such thing as free financial advice. One way or another, you pay.
Whether it's upfront in fees, behind-the-scenes in commissions and kickbacks, or down the road in poor investment decisions that cost you far more than quality financial advice ever would have cost in the first place, you're going to pay the price for your advice.
True financial advice is paid for directly by you, and not by the company offering the financial products you buy.
True financial advice results from paying a disclosed fee for a service rather than having the fees embedded in the product for sale.
It's your money. You're responsible, and you're the only one that has to live with the results.
Nobody cares about your financial future more than you.
And that's financial advice you can depend on.
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