How to Choose a Financial Advisor

The reason why modern economies are so much more productive than ancient and medieval ones is because specialization is more highly developed. We don’t grow our own food, make our own clothes, build our own houses, or attend to our own medical needs. Most of us don’t even change the oil in our cars. It is not surprising, then, that so many people call upon the services of a financial advisor.

Of course, this replaces one problem with another – the problem of choosing the advisor.

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Friends and Family

Observation suggests that many people limit the range of possibilities to friends and family. Presumably, they reason as follows: How can we work with somebody we don’t like? We’re entrusting our financial secrets and well-being to the person we pick, and nobody is more trustworthy than our close friends and family members.

Personal attraction and compatibility is highly overrated as a qualification. A financial advisor will often be called upon to make dispassionate and objective evaluations of your assets and actions. Friendship and emotional ties can hinder this process and the communication that should go with it. Of course, it’s better not to hate your financial advisor, but close friendship is by no means necessary or even desirable.

Trustworthiness is an absolute prerequisite. The problem is how to gauge it. The ties of friendship and family can, indeed, sometimes serve as guarantor of good behavior – and sometimes not. Legal responsibility is a more reliable motivator.

Credentials – or Qualifications?

For years, the term “financial planner” was thrown about very loosely. Marketers of any financial product felt free to style themselves as financial planners on the slightest of pretexts. Recently, there has been a move in regulatory and financial-industry circles to restrict use of the term to those who have undergone a rigorous course of training in the subject. Typically, this involves at least a year of study and subsequent examinations. It also entails subscription to a code of ethics and behavior. Professional designations such as Certified Financial Planner (CFP), Chartered Financial Consultant (ChFC) and Personal Financial Specialist (PFS) meet these criteria.

Probably the most important element of the financial planner credential is the fiduciary responsibility it imposes. The financial planner is legally bound to place the interests of his clients first and foremost, even ahead of his or her own financial interest. This stands in stark contrast to stockbrokers and insurance agents, who are legally responsible to their companies, not to their clients. Fiduciary responsibility can’t prevent financial advisors from making honest mistakes. It does specifically forbid them from taking actions that they know to be counter to their client’s interests, and it gives clients a legal basis to act against any financial advisor who does so.

The combination of formal qualifications and fiduciary responsibility is powerful. It is possible that professionals can compensate for the lack of credentials with a record of success and experience. It is also possible that their inner standards (or company policies) will provide protection analogous that provided by fiduciary responsibility. Customers should assure themselves on both these counts before accepting any substitutes for accredited financial planners.

Active Management

Of all the reasons for selecting (or rejecting) a financial advisor, none is more overrated than the promise of higher investment returns based on the advisor’s penchant for picking stocks or forecasting economic developments. Several centuries of experience, backed by data, casts doubt on such claims. If the world’s leading portfolio managers cannot consistently improve on the performance of market averages and indices, it is wildly unlikely that any financial advisor you choose can do so. To be sure, every year some managers do better than others, but any long-term differences are almost surely due to random variation rather than ability or systematic factors.

By some lights, this might seem to vitiate the purpose of choosing a financial advisor. What is the advisor good for if not to produce superior investment returns?

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The Real Value of Financial Planning

In fact, the real value of financial planning lies elsewhere. Research pinpoints asset allocation as the prime determinant of investment returns. This means that your return is tied to the portions of your portfolio that are allocated to assets in different risk categories, such as equities (stocks, mutual funds, or variable annuities), fixed-income securities (bonds or fixed annuities), liquid assets (cash, demand deposits, money-market funds), and real assets (land, homes, gold, etc.). The financial advisor’s job is to inventory your assets, group them appropriately in categories, and insure that your portfolio is periodically reviewed and rebalanced as necessary. Because different assets will grow at different rates, rebalancing is necessary to preserve the allocation that matches your needs and risk tolerance.

Asset selection is only one of many valuable services performed by the financial planner. A financial plan is a road map to your financial future, highlighting the goals along the way to your final destination and drawing a route to them. This act of financial cartography requires a staggering amount of knowledge about finance, investments, taxes, law, and economics.

Among the assets up for consideration are stocks, bonds, mutual funds, annuities, CDs, money-market funds, savings accounts, gold, land, dwellings, and various other real assets. Saving for college requires knowledge of IRS rules and procedures, tax-advantaged accounts, and university admission and scholarship details. Planning to accommodate a home mortgage requires knowledge of real-estate law and procedure, the IRS mortgage-interest deduction, and amortization schedules. Retirement planning requires understanding of IRA, 401(k), 403(b), 457, SEP, SIMPLE and Roth accounts, as well as a working knowledge of discounted present value techniques. Mishandling of rollovers into, out of, or between tax-advantaged retirement plans can lose a substantial portion of the funds to current taxation or tax penalties. The financial advisor is trained to avoid such mistakes.

A financial advisor who never beat the S&P 500 even once might earn his or her keep merely through guiding you through the mine field of the planning process without blowing a hole in your net worth. Avoiding mistakes may not be as glamorous as earning high investment returns, but money saved is just as green as money earned.

Summary

Choosing a financial advisor is just as reasonable as choosing a doctor, lawyer, or auto-repair firm. That does not make it an easy choice. Friends and family are often chosen but sometimes lack the combination of qualifications and motivation provided by a financial-planning credential. That credential not only provides comprehensive learning but also the prod of fiduciary responsibility, which places the financial interest of the client foremost among the financial planner’s responsibilities.

Active management – the pursuit of above-average investment returns – is a dubious basis on which to choose a financial advisor or evaluate their performance. The planning process is a long, detailed journey through life, requiring a staggering amount of knowledge to negotiate successfully. Merely avoiding mistakes is sufficient justification and recommendation for choosing a financial advisor.

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