By Dr. James M. Dahle, WCI Founder
Many students, residents, and physicians wonder about the process of choosing a financial advisor. In many respects, the process is similar to choosing your physician. There are no rigid guidelines, the personality fit can be key, expectations need to be realistic, you should avoid the bad apples, and by the time you know enough to choose a financial advisor properly, you may not need one at all. These 12 guidelines should help you make your decision.
#1 Consider Whether You Need a Financial Advisor at All
- You avoid paying the fees associated with paying someone else. In investing, unlike most of life, you get (to keep) what you don't pay for.
- There are fewer surprises because you are intimately involved with the process. You're not going to “Bernie Madoff” your own account.
- Since you are intimately familiar with your financial plan, taxes, and investments, you can make decisions on the fly that are most beneficial to your portfolio, rather than waiting to meet with your planner. A successful investment plan need not be complicated, as you can see from this post, The Default Portfolio.
#2 Understand How Your Financial Advisor Is Paid
This helps you understand their conflicts of interest. There are basically four models:
The first is a commission-based model. This model essentially consists of “financial salespeople masquerading as financial advisors” and is not a model I recommend you use. The “financial advisor” gets paid when they sell you a product. These commissions can be 3%-8% of the amount invested in a mutual fund (a “load”) or annuity and 50%-110% of the first year of premiums for a life insurance policy.
The obvious conflicts of interest are that the more you buy and sell, the more the advisor makes. Also, it is in the financial advisor's best interest that you pay the highest loads possible, and unfortunately, the worst investments offer the highest commissions. A financial advisor (or more typically, their company) may also get “soft money” in addition to the load to offer particular mutual funds to an investor. This, of course, all comes out of your pocket. This type of advisor also has the incentive to sell you expensive, complicated investments, such as variable annuities, privately traded REITs or Master Limited Partnerships, and cash value life insurance.
Assets Under Management Fee
The second is an assets under management (AUM) model. The financial advisor gets paid 0.25%-2% of your portfolio a year. These advisors tend not to take you on as a client until you reach a certain level of assets, usually from $100K-$1 Million.
This does you little good when you really need the advice, such as educating you in the beginning, developing a financial plan, acquiring appropriate insurance, and selecting your first few investments. Conflicts of interest are fewer than in the commission-based model, but still present.
At least the advisor is interested in seeing your portfolio grow, because as it gets bigger so does their take. The advisor, however, is more likely to recommend against anything that would decrease the size of the portfolio, such as appropriate levels of retirement spending or even alternative “investments” such as paying down your mortgage.
The other issue with this method of compensation is that it really doesn't take any more work to manage $1 Million than $100,000, so as your portfolio size goes up, your advisor should offer a break. Perhaps 1% on the first $500,000, 0.5% on the next $500,000 and 0.25% after that. However, I run into investors all the time who are paying 1% on several million dollars in assets. There is little point in paying someone $50K a year to do what you could get for $10K.
The third is an hourly-based model. The financial advisor is paid for their time, like an attorney. This is a difficult business model for an advisor because of the lack of a steadily growing stream of income and because investors don't like seeing just how much advice costs (the above models are much better at hiding it from you), and so it can often be more difficult to find an hourly fee-only advisor. This model is becoming more common, however.
Conflicts of interest include working slowly, withholding information so more visits are required, and making things overly complicated so they require more time. In addition, it introduces the factor that since each time you get advice it costs you money, you are less likely to ask questions that could save you money in the long run.
Annual Retainer or Flat Fee
The fourth model is a flat-fee model. You pay one flat fee each year for all the advice and services you need. This is a particularly uncommon model, at least used alone without being combined with one of the other models. The conflicts of interest include the advisor trying to avoid spending time on you and your account, since they get paid the same no matter how much work they do for you. This could cause them to use an overly simplistic portfolio, neglect tax-saving strategies, fail to educate you appropriately, etc.
Advisors like to use the terms fee-based and fee-only to confuse the picture. Fee-only means there are no commissions. The advisor makes money only from you, whether you pay hourly, annually, or as a percentage of AUM. Fee-based means that you pay a fee and then in addition, the advisor makes money off commissions, too. Just because an advisor collects a flat fee each year doesn't mean they are not making commissions off the recommended investments.
#3 Understand How Much the Advice Is Really Costing You
For instance, if your investment fees total 2% of your portfolio a year, that's the equivalent of your investments earning 2% less a year than they otherwise would. Thanks to the miracle of compound interest, that adds up to a lot of money over your lifetime.
Consider two investors who invest $20,000 a year over a period of 30 years. Both have investment portfolios that earn 6% after inflation a year. One pays 2% to an advisor. After 30 years, the first investor has $1.58 Million. The second investor has only $1.12 Million, 29% less. Over the years, that advice cost the second investor $460,000, or over $15,000 a year! That's almost as much as he was investing!
#4 Understand That Designations Can Mean Very Little
When it comes to credentials for a financial advisor, there are dozens and dozens of credentials, and the minimum requirements are almost nothing to get some of these letters behind your name.
Medicine can be a little confusing with designations such as MD, DO, DC, ND, PAC, RNP, etc., but that is nothing compared to financial advising. Most physicians wouldn't go searching for a doctor for their family and accept the designation of DC, but for some reason, they are just fine with a financial advisor whose only designation RIA (Registered Investment Advisor). Never mind that the chiropractor spent years learning his craft and the RIA may have spent less than a week.
So which of the hundreds of designations mean something? CFP (Certified Financial Planner), CFA (Certified Financial Analyst), ChFC (Chartered Financial Consultant, an insurance designation similar to CFP), and CPA/PFS. Each of these requires 200+ hours of studying, some experience (although it can be in sales), and usually (but not always) an exam or three to pass.
If an advisor doesn't care enough about their career to earn at least one of these designations, I worry at least a little about their commitment to the profession. Note that although one of these designations should be considered minimum adequate training, they are not sufficient to ensure quality advice.
#5 Realize That 95% of Advisors Out There Are Not Very Good, and Many Are Likely to Be Harmful to Your Financial Health
Unlike in medicine, where a basic level of competency is generally present and most doctors are very qualified, many financial advisors are crappy. If you haven't yet read my post on What Advisors Think About Doctors, you may find it eye-opening. You should also realize that many advisors, even those who carry the weighty certifications discussed above, may demonstrate an appalling lack of knowledge of what actually works in investing. If you're planning to get help, I highly recommend including a WCI recommended advisor in your search. Each is vetted initially by WCI and then continually assessed based on feedback from white coat investors. If we get concerning negative feedback, we take them off the list.
#6 Most Financial Advisors Cannot Take Care of All Your Financial Needs
There are very few financial advisors who can help you with financial planning, insurance, investments, taxes, and estate planning. Even if they do consider themselves qualified to help you in all these areas, they may be a jack-of-all-trades and a master of none. You actually might be better off having five different financial advisors:
- An hourly fee-only advisor to help you develop an overall financial plan
- An insurance specialist to help you get adequate life, disability, liability, and property insurance
- An investment manager to manage your investments
- A certified public accountant to help with your taxes and
- An estate-planning attorney to help with wills, trust, estate plans, asset protection, etc.
When you realize an advisor may only be helping you with one of these needs, you'll see just how high fees can get!
#7 Have a Realistic View of What an Advisor Actually Does
An advisor's role is not to help you beat the market or to predict the future. They cannot do this, anyway, although they may believe they can, and might even try to convince you they can. (You should avoid an advisor who claims they can through security selection or market timing.) An investment advisor's role is to help you set up an adequate investment plan, maintain the investment plan, to know when significant tweaks should be made to the plan (Hint: they should be made rarely and with a great deal of thought. Changes should generally be in reaction to differences in your life circumstances, not changes in financial markets), and mostly, to help you avoid shooting yourself in the foot.
Managing YOUR non-productive financial behavior is the biggest benefit of a financial advisor. Unfortunately, those who don't believe this don't hire advisors, and many of those who do, don't need advisors. Although 1% a year is pretty expensive for investment advice, if they can keep you from selling out at the bottom of a bear market like 2008, they'll have earned their fees. The best planners do this not just by hand-holding during crises, but by designing an appropriate plan in the first place and continually educating clients about them.
#8 It's Nice If an Advisor Has Access to DFA Funds
DFA funds are passively managed funds similar to index funds with a great long-term track record and a sound theoretical basis. They are generally not available to individual investors without an advisor. They cost a little more than typical index funds but are probably worth it. It is not clear that they are worth the additional cost of an advisor JUST TO GET THE FUNDS, but, if you are hiring an advisor anyway, you might as well get “DFA Access” at the same time.
Likewise, you don't want an advisor that is wedded to a particular company. If an advisor works for Edward Jones, guess whose investments they will recommend? Anyone managing your investments should be able to invest them with any firm, not just their own. Watch out for conflicts of interest; some advisors get paid more by their company to get you into their own funds.
#9 Interview Multiple Advisors, and Realize This Is a Business Relationship, Not Personal
Don't hire your father's advisor or your brother-in-law. It'll be much harder to fire them later. You should also check with regulatory authorities to see what kind of complaints have been filed against your advisor and his firm. You can check this out on the FINRA site, or the SEC. You might also check with state authorities and the Better Business Bureau. Just think about what you would do if an advisor screwed you. Who would you complain to? Check with them. Ask for references also.
#10 Realize That Just Because You Are a Do-It-Yourselfer, Doesn't Mean You Need to Be a Rabid DIY-er
You can always get financial advice a la carte. You can manage your own investments, but still pay a CFP to help you develop an overall financial plan and pay a CPA to do your taxes for you. You can also get a second opinion about your financial plan. You have to hire an insurance agent to buy an insurance policy, but you would be well-advised to know what you want before you walk into their office, lest you walk out with an expensive cash-value insurance/investment hybrid plan like whole life insurance.
If you set up a simple plan, you might only need financial advice every year or two. Paying 1% of your portfolio a year is an awful lot when you only need an hour of advice every 5 years.
#11 Hiring an Advisor Doesn't Absolve You from All Responsibility to Know About Financial Subjects
This is still your second job, whether you like it or not, even if you hire someone to help you with it. You'll still need to read at least a handful of books on the subject and keep up with new developments over the years. A good advisor will provide you with some education, but you still have to know how to speak their language.
#12 Being a Specialist in Advising Physicians Doesn't Mean Much
Lots of advisors “specialize” in physicians because they think, like most of America, that M.D. means mucho dinero. While there are a few unique things about the financial life of physicians (late start, lots of student loans, highly specialized, rapid increase in income upon residency completion, some asset protection issues, some retirement account issues, etc.), most financial needs are the same for them as for anyone else.
What has been the most effective way you've acquired financial advice? Comment below!