Should I Use a Financial Advisor?

People often ask us if our emphasis on asset allocation and indexing means that we think they don't need to use the services offered by financial planners. The answer, with a couple of important reservations, is a resounding NO. The right planner/adviser, used in the right way, can add a lot of value to a person's life, just like the right doctor, dentist, lawyer and accountant can (not to mention the baby sitters, car mechanics, and everyone else who makes modern life possible). We are, in short, very strong supporters of financial planners and advisors.

Unfortunately, there are a lot of people out there who call themselves financial advisors, consultants, planners and similar terms. And, of course, there is the obligatory alphabet soup of different qualifications after their names (CFA, CFP, ChFC, CPA etc.) So how do you find the one who is right for you? In our experience, the right planner or advisor to use is someone you like, someone you trust (listen to your instincts!), someone who comes recommended by people whose acumen you respect, and someone who is well qualified. With respect to the latter, the National Association of Securities Dealers has a website which translates various acronyms into plain English.

Beyond these criteria, we prefer planners who are compensated via an explicit hourly fees for their services. We like to pay financial advisors the same way we pay lawyers, accountants, doctors, and other professionals. When financial advisors are compensated using other approaches, it can create what are called "agency problems" or, to put it another way, a misalignment between their short term incentives and your long term financial goals. Let's look at three types of compensation arrangements, and the agency problems they can create.

The first situation is one where the financial planner appears to be giving you advice for free. As with other things in life, if something sounds too good to be true, it is. In fact, advisors in this category are typically (and sometimes quite well) compensated via commissions paid to them by the companies whose products they sell to you. As much as they protest that it isn't the case, common sense tells you that this can sometimes create conflicts of interest between you and your supposed "advisor." One of the most common conflicts (e.g., it has come up in the recent mutual fund scandals) is a situation where the prospect for a high commission affects the product an advisor recommends to a client. Another problem is called "churning", and refers to excessive trading in a client's account in order to earn more commissions for the advisor. If you are thinking about using a commission-based advisor, ask ahead of time for disclosure of the commission arrangements on all the products the advisor has considered in putting together his or her solution for you (including the ones he or she rejected). Also ask for the total amount of commissions the advisor will earn over the next five years (many products have delayed payouts) on the products sold to you. Many people are shocked when they see the size of this number. Finally, think long and hard before giving an advisor the discretionary authority to execute buy and sell transactions on your behalf.

The second type of advisor is one who, instead of commissions, charges you a fee that is equal to a percentage of the total value of the assets the adviser is helping you to manage. When confronted with this type of arrangement, some people question whether the work actually performed by the advisor scales linearly with the fees you pay to him or her. A good analogy is to the six percent commission charged by real estate agents when a house is sold. More than a few sellers have questioned whether it takes three times as much work to sell a $600,000 house as it does to sell a $200,000 house. Think about two clients, one with a $200,000 portfolio, and one with a $500,000 portfolio. Assuming they have similar needs (e.g., for tax, estate, and insurance planning, etc.), and they both go to the same advisor who charges a fee equal to one percent of assets, it is logical to ask what additional benefits the latter client is getting for the additional $3,000 per year in fees that he or she is paying (of course, it may also be the case that, with rising portfolio values, needs also change).

However, to be fair to planners and advisors, there is another side to this issue, which brings us to the third type of compensation arrangement. This is one where the advisor's fees are tied (at least in part) to the underlying performance of some or all of your investments. A fee tied to the value of assets under management is a variant of this approach, as is the 20% of profits typically charged by hedge fund managers. Intuitively, this usually strikes people as an attractive deal -- the advisor will only earn high returns if you earn high returns. The potential downside, however, lies in what happens if your investments lose money (or have returns below a minimum threshold). If terrible performance only means that the advisor loses his or her job, then agency problems (i.e., conflicts between your interests and those of the advisor) may still exist. Years ago, a friend who was then a trader at a large Wall Street investment bank told us he had the greatest job in the world. Why? Because if, by risking the firm's capital, he made the firm a lot of money, he would get a big bonus. But if, in taking risks that could result in those high returns, he instead lost a lot of that capital, he would only lose his job, and could always get another one. Given this mismatch between personal upside and downside potential, do you think the trader had an incentive to take risks with the firm's capital that he wouldn't have with his own money? The moral of the story is this: fees tied to investment performance only make sense if the advisor has exposure on the downside as well as the upside, and will also feel pain and regret if the future returns on on your portfolio are negative.

On balance, here is where we come down: we like fee based planners, we believe that the right performance based compensation structure can also benefit clients, and we prefer commission based compensation least of all.

Finally, we reiterate the value that a good planner or advisor can add. Beyond helping clients to identify their long term liabilities and develop an appropriate asset allocation policy (e.g., the right mix of exposure to beta and alpha risks and returns), an advisor can help a client to adjust it in light of prevailing market conditions, as well as determine the savings levels needed to achieve their goals, how to manage their taxes, hedge their risks (which includes, but isn't limited to buying insurance to cover them), borrow wisely, and plan for the eventual distribution of their estate. Planners can also sometimes help clients to manage their emotional response to the normal ups and downs experienced by different asset classes in their portfolio. Helping you with all of these tasks, and integrating them into an effective plan, is the real value added you get from a good financial planner. For that reason, we strongly support their use.

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