And what do you WANT that job to be?
Before you decide to hire and work with a financial advisor, it’s a good idea to get an idea what they will be doing for you. And know what your alternatives are. Financial advisors come in various flavors. The flavors relate to their relationship regarding their status as an employee vs independent businessperson, how you pay them for their work, and the work they actually do.
What is their relationship to you? Somebody else’s employee or your Independent Advisor?
Employee: As an employee of a financial firm (e.g. Edward Jones, Merrill Lynch or Morgan Stanley Smith Barney, the ones I’m most familiar with), your advisor is required to follow the policies of their employer. Like any employee, your advisor can be fired by their employer. So although you may trust your financial advisor and even feel close to him/her, your relationship is not entirely in your hands. No matter how personal your relationship feels, your relationship is not in fact with the advisor; legally, you have a relationship with the financial firm, their employer. If the advisor is fired or resigns, the first you may hear of it is when you get a call from the new advisor the firm has assigned your account to.
Independent Advisor: Advisors can also be in business independently. As an independent businessperson, your financial advisor can still be fired. But it would be you doing the firing, since he/she doesn’t have an employer. You are in a client relationship with him/her as a professional. And you can always change your mind and take your business elsewhere. On the other side, the advisor can also decide that your account is not what they want to do and sever the relationship from their side. Just like any other client/professional relationship.
How do you pay them?
Commissions: This is how everything used to be. When you trade a security, you pay a commission for each transaction. Today, you can still invest this way with stocks, bonds, mutual funds and exchange traded funds (ETFs). Commissions used to be quite large, varying with the size of the trade, the price of the assets, and whether you traded in “round lots” (100 shares = 1 round lot). Mutual funds are different; commissions differ by share class. https://www.gobankingrates.com/investing/funds/mutual-fund-fees/
For A shares, cheapest in the long run if you stay in the fund family you have paid, you pay a commission up front to buy shares in a fund within a fund family; after which, you can transfer your investments to other funds within that family of funds with no charge. When you sell out of the fund family, there is no commission. With C shares, you don’t pay a commission up-front or when you sell, unless you sell within one year. If you sell within that first year, you pay 1% on the way out. (This is by no means an exhaustive explanation of commissions; it is a representative summary. The variations are endless and complicated. I wonder why that is…)
Although this is complex and confusing, IF how much money you are paying to your advisor is the major criterion influencing your decisions, THIS IS THE CHEAPEST WAY TO INVEST – IF you follow a strategy of keeping your money in the mutual fund family you choose for the long term ( so you don’t pay any more to move to a new mutual fund family) and perhaps holding a small portion (e.g. 10-20%) in the highest quality stocks at cheap prices for the long term (e.g. 10-20+ years). Again, this is so you pay the absolute minimum in commissions. Any additional trading of stocks of mutual fund families will increase the payments to the advisor.
Fees for assets under management: Under this model, there are no commissions for trading; transactions are free. Instead, you pay a fee – typically a percentage of the assets you hand over to be under management. (NB: if you follow the same strategy as above – high quality mutual fund families, high quality stocks held for the long term (in other words, little trading of investments)– you will pay over 2X – see the section footnote below – what you would pay under a commission-based arrangement for the same investment results! In other words, the rest of the fees above the commissions you avoid go into the pocket of advisor and his/her employer.)
For that additional fee, you get to feel reassured that your advisor is NOT making recommendations that would make more money for him/her, since the fee remains the same no matter what you’re invested in or what trades you make. If your portfolio value goes up, the advisor makes more income; if it goes down, they make less income. (Note there are no circumstances in which they make NO money; the fee is based on your “assets under management,” however large. For more on this, see my future blog on what it means to be a fiduciary.)
Section Footnote: 2X? That seems high… Okay, let’s run the numbers: https://www.gobankingrates.com/investing/funds/mutual-fund-fees/ gives you the average mutual fund commissions. Let’s assume for this illustration that you have $120,000 to invest when you move your 401K to an IRA with an advisor. This advisor recommends you put $100,000 into American Funds and buy $20,000 of 10 high quality individual stocks. American Funds has a “breakpoint” at $100,000 (a discount from the full price for smaller investments), so you pay 3.5% out of the $100,000 one time to own a portfolio of American Funds. At any time, you can move -for no additional cost – to a different portfolio of funds from within the American Funds family. Every year after that, you will pay 0.25% of your asset value, in what are called 12B-1 fees, as sort of a service fee to the advisor. The commission of the stocks will be about 2.5%, and we’ll assume you will hold all these investments for the next 20 years. Total up from cost is $3500 for mutual funds and $500 for the stocks = $4000. For simplicity’s sake, let’s assume the portfolio only grows over the next 20 years enough to maintain the $100,000 (a totally ridiculous assumption…), the 12B-1 fees will total $5000. So the total of all payments to the advisor over 20 years is $9000.
Compare this to the alternative of C-shares or fee-based compensation: Your $120,000 is in your account and you start paying 1% per year. Assume for the sake of this argument that you hold the exact same portfolio – of American Funds and 10 stocks for the next 20 years. Again, for simplicity’s sake, let’s assume the portfolio does NOT grow: so total fees will be $24,000. 2.67X what you would pay for commissions to hold the same portfolio.
Conclusion: If you are paying fees and your advisor is not actively managing your investments, you may want to reconsider your arrangements.
Other: Believe it or not, you can hire a financial advisor by the hour! I don’t know of any, but I’ve heard that they’re out there. And I don’t know what anyone could do for you in an hour…
How do they spend their work time?
Different advisors define their jobs in different ways. But there are three basic job activities they all have to consider and balance in some way:
- Client acquisition/asset gathering,
- Client relationship management
- Portfolio strategy and design: Investment research, decision making, and management.
Let’s consider each one.
Client acquisition/asset gathering:
Notice how the terms suggest different emphases? What matters here: the clients? Or their assets? In one sense, it doesn’t matter: every advisor has to have at least a certain number of clients/amount of assets, or they won’t earn enough to stay in business. This area encompasses sales and marketing, advertising, cold calling, networking activities, speaking engagements and seminars, websites, and asking for referrals.
Everybody does this. The question is how much. If you are paid by commission, you are forced to spend most of your time finding clients/assets, because you can’t earn a commission without transactions and in order to make transactions, you have to have a client with a funded, open account. Similarly, if you are psychologically driven to maximize your income and you are paid by fees, you will spend lots of time and effort to add to your assets under management, since that is the basis for your fees. Time prospecting takes time away from client relationship management and anything to do with investments, but it has to be done or the advisor is out of work. Few if any advisors are independently wealthy, so we have to find other people’s money to work with.
Client relationship management:
Clients expect at least a minimum of attention. That minimum is occasional or regular phone calls as well as some regular schedule of account performance reviews. Regular statements, either mailed or online, are also part of minimal expectations, but typically the custodian firm takes care of this. Above that minimum, the sky’s the limit, including advice and updates, either on the phone or in person, financial planning from primitive to sophisticated, etc. Many advisors will send you birthday cards for yourself and your family members, season’s greetings cards, etc. Quite a few will take you out to eat, play golf with you, take you fishing on their boat, etc. All of these are considered managing your relationship.
How much you want of this beyond the minimum expectation is a matter for you to decide. You might want this to be the core service your advisor provides. Or you might be more focused on your investments.
Portfolio strategy and design: Investment research, decision making, and management:
This includes the complex and intellectually challenging part of the work of an advisor. And not all advisors are prepared for it or interested in doing it. Some firms do the work and hand out formulas to their advisors; and independent advisors can always find formulas to use. This allows advisors without a lot of expertise in investing to claim that their recommendations are designed by the finest experts.
Four Decision Levels:
Portfolio management encompasses four broad decision levels:
Overall allocations to broad categories: The first is the allocation of investments across categories, primarily between bonds and stocks, fixed income and equities, and what part of the portfolio should be international.
Type of holding within each category: Second, having arrived at the proportions of those major categories, then, within each category, the designer must select what type of security to hold, whether that’s specific stocks and bonds individually, or mutual funds, or exchange traded funds, whatever. Each of these is a different method of holding the investments. And each way of holding investments has implications for the costs and outcomes you will experience.
Specific securities within each type: Third, within each type of security which is within each category, specific selections may be made. So, which specific stock within which specific industry? Which specific mutual fund and what mutual fund strategy would fit within each of those targets?
When to change: Fourth, for an adaptive advisor, the question is when would you change any of those decisions? At the most granular, detailed level, when would you change a specific stock or mutual fund? out of one stock into another stock? out of one mutual fund into another mutual fund? Or within a category. When would you move from mutual funds into unit investment trusts or into exchange traded funds, or perhaps decide to not do mutual funds or exchange traded funds at all and just do individual stocks and bonds? And last and most radical of all is when would you change the categories? Or change the percentage allocated to stocks or to bonds, or the percentage international within a portfolio. When would you shift a portfolio, change the portfolio allocation from more conservative to more expensive?
Who’s doing the driving?
Overriding all four of those chunks is the question of who’s doing the driving? Who is making the decisions at each of those decision points? At each of those decision points, it could be anybody. It could be you, it could be a panel of Chartered Financial Analysts at the Home Office who make recommendations of various standard allocations or various standard model portfolios. It could be your advisor selecting a stock from a list provided by their firm or some other expert source or doing their own screening research to find stocks or mutual fund or other alternatives. It could be almost anybody, but it’s important to know who. If your portfolio is a vehicle that your future depends on, it’s probably important to know: who’s doing the driving?
Your Alternatives
You have choices to make about what kind of advisor you want to work with. And the decisions are not easy.
(DIY: one alternative is to do it yourself. If you’re reading an article about advisors, you may already have considered this and dismissed it. The probabilities are stacked against your success, but although unlikely, you can succeed with this. It just takes a lot of study and work. The average investor without an advisor underperforms those with an advisor by several percentage points over almost any time period.)
Here are two alternatives to consider: one is the most common, the other is quite different. These two are not exhaustive; you could find other models.
The Industry Standard:
What you will be offered when you walk into most financial advisor’s office is a discussion and a risk tolerance questionnaire. The result of that discussion and your answers to the questions on your risk tolerance will be a recommendation for an appropriate portfolio allocation. You will also have a discussion of how the advisor is a “fiduciary”, which means that legally you can sue them if they act in some way that puts their interests ahead of yours. (For more on the concept of fiduciary, please read my – as yet unwritten – article on what it means to be a fiduciary.)
The advisor may go to the trouble of doing an extensive information gathering of your situation and your goals, plug it into his firm’s software along with a substantial list of assumptions, and create a “financial plan” that feeds into the portfolio design and informs the regular discussions of whether you are “on track” to meet your goals.
When you and your advisor have agreed upon an allocation, they will come up with a package of specific investments, designed either by themselves or by a group of CFAs (Chartered Financial Analysts) hired by their firm; it will be composed mostly of a very, very diversified list of mutual funds and perhaps some individual stocks. This will be invested and you’ll have a regular scheduled discussion, on the phone or in person, in at least a year and perhaps every 3 months.
A different advisor model:
I can only discuss my own model in any detail. I’m certainly not the only alternative! And the way I work is certainly not for every investor!
I am highly qualified to do what I do. I have very extensive education and experience. Furthermore, I continue to study and explore my own ignorance and push against the limits of my knowledge. My mission is to share what I know for the benefit of my clients. The most important and useful thing I know is that there are cycles in the economy and market that are regular enough and slow enough that portfolios can be adjusted to be more or less in tune with the market and economic conditions.
The people who follow the standard model disparage the kind of work I do as “market timing” and try to make it sound scary. I reply that there are times when standard indicators and conditions strongly suggest that the market is too risky for almost anyone, certainly for anyone who is relying on their investments for their financial future in their old age! And those times can be identified with an enormous amount of data. I certainly don’t espouse anything like day trading!
What I aim for is to be in the market when the economic and market data indicate the economy is starting to grow and companies are starting to profit, and scaling out of the market when the economy is slowing down and companies’ profits are beginning to suffer. Being out of the stock market when it collapses is very fortunate for people’s financial health! As is being in for long bull markets.
To be specific, for the most part, I am the person doing the analysis and selecting the investments that go into my clients’ portfolios.
- I monitor the economy and the markets to identify approximately what stage the cycle is in currently. This suggests, if it doesn’t completely determine, what the appropriate allocation should be for stocks vs bonds, for specific sectors and industries, for specific fixed income maturities, as well as an appropriate international allocation.
- Within those large categories, I compare the relative performances, advantages and disadvantages of various types of holdings: mutual funds vs ETFs vs UITs vs individual stocks and bonds.
- Within those more specific categories, I monitor which specific holdings are showing relative strength, outperforming the competing offerings. What we’re searching for are the best performing stocks in the best performing industries/sectors; the best mutual funds or ETFs in the relevant categories. These are then assigned to what we’re trying to create: an “optimum” portfolio adapted to the current and expected conditions.
- Last, I monitor the investments in the portfolio for underperformance relative to expectations. Underperformance is an indication of an error, so unless there is some compelling argument for holding on, that investment is sold. And then this procedure repeats.
I’m ready, willing and able to discuss a broad overview of what I’m doing and why and delve into the specifics of what and why with anyone who’s interested. This is one of the benefits of working with an active investment manager like me: you get to discuss your investments in detail.
For the rest, like any good advisor, I stand ready to discuss any financial issue or need for some specific planning, retirement, education, estate, whatever. And I’m always ready to have a conversation about any questions or concerns you may have.
FULL DISCLOSURE: The discussion of the three approaches to investing above has not clearly and emphatically outlined the advantages, disadvantages, benefits and risks of each approach. Clearly, I favor my own approach, but – just as with DIY and Buy-and-Hold – there are disadvantages and risks that you should consider before deciding to work with me, or any other advisor. None of these approaches is perfect for everybody! I wrote this piece because in my estimation the Buy-and-Hold alternative is rarely criticized or questioned – nor are other alternatives fairly considered — to the detriment of investors’ interest! Do yourself a favor and do a thorough and diligent comparison of all the relevant issues before you make your decision.