You don't have to look too far to find a news story about an unscrupulous financial adviser who took advantage of his client(s) and stole their money. It's shocking and sad when it happens, but those stories are the exceptions, not the rule. Very few advisers are so brazen as to outright steal from their clients' accounts. There are, however, some common ways in which many financial advisers mislead their clients with subtle, but much more pervasive lies. Hopefully this article will shed some light on these myths.
#3. Bigger is Better
This is the theory that the large, well-known firms provide the best value. Probably based on the perception that Fidelity, TD Ameritrade, Northwest Mutual, USAA, etc. offer better security and/or the best price. Neither is true. The large firms actively try to reinforce the idea that their size gives them strength and stability. They know many investors are nervous about putting their money at risk in the securities markets, and they exploit that fear by representing themselves as powerful enough to protect their clients from market volatility. They also use the perception of their stability to charge the highest prices they can get.
In reality, their size plays no part in protecting your assets. All investments, even those well-diversified to mitigate risk, are subject to the volatility of the securities markets. The size of the company helping you select your investments doesn't matter. What matters is having an appropriate asset allocation for your situation and goals. Firm size plays no part in that process.
Their size does, however, influence their ability to provide the one thing most investors want more of – personalized service. Most clients seeking financial planning and investment advice want to work with an adviser who has a real interest in their values, goals, needs, and desires. They want an adviser who will take the time to get to know and understand them. Clients are more likely to have this type of personal experience with a smaller firm than a larger firm.
The largest financial firms also tend to have their own proprietary products; mutual funds and/or ETFs that they have created. Advisers at these large firms are strongly encouraged to recommend these products to clients above all others, compensating those advisers when they sell them and sometimes even punishing them when they don't.
#2. Fees Based on a Percentage of the Portfolio Put the Adviser and Client 'on the Same Side of the Table'
This is the theory that by charging a percentage (1% being common) of the client’s portfolio as his or her fee, the adviser’s primary incentive is the same as the client’s – to grow the portfolio. This is not true, and it isn’t true for several reasons.
If the adviser is paid based on a percentage of assets under management, then his or her goal would be to have more assets under management. How does an adviser accomplish that?
One way – the one that led to the recent Department of Labor Fiduciary Rule – is to convince clients to move all their assets under the management of the adviser. Frankly, if you have a good employee-sponsored retirement plan, such as the Federal TSP, it would not be in your best interests to move your assets out of that plan and into an account managed by your adviser. Yet, the charging of fees based on portfolio size makes it attractive to the adviser to gain control over all the client’s assets - even the ones already being managed well.
There are also risk management issues to consider. The client’s goal is to grow the portfolio while taking the minimum amount of risk necessary to achieve their desired financial state. When greater financial risks can equal greater financial rewards, the adviser receiving a percentage is incentivized to take greater risks than may be necessary to achieve the client’s desired financial state.
An adviser who gets paid based on a percentage of assets under management is also more likely to resist a client’s efforts to try to spend their own money. It’s only natural. If my compensation was based on the amount of your money I was managing it would be contrary to my economic interests for you to take money out of your account. That attitude is not going to be helpful in providing the best advice to a retiree who needs to start drawing down their savings to pay for their retirement. It certainly doesn’t put the adviser ‘on the same side of the table’ as the client.
Finally, acquiring more assets under management is much more easily done by acquiring more clients than it is by growing the portfolios of existing clients. Not that I think there is anything wrong with advisers seeking to acquire more clients. My retainer fee model incentivizes the same thing. The more clients paying retainer fees I can acquire; the more profitable PIM Financial Partners will be. I just don’t like it when advisers try to hide the true nature of their compensation by making the claim that it puts the adviser and the client on “the same side of the table”. It’s misleading. Although, to be fair, I think some advisers honestly believe it.
#1. A Financial Adviser Can Predict the Future
This is the implied theme of active portfolio management. The adviser and his or her team is smart. They are smarter than everyone else. They know things no one else knows. They can read economic tea leaves and accurately predict which securities, sectors, and/or geographic regions are going to be the best and worst for investments in the upcoming quarter or year. They know when to get into the markets and when to get out. Or so they would have you believe.
Numerous academic studies have shown this is not true. The reality is that those who try to predict the markets are wrong more often than they are right. In fact, one study showed that a cat was better at picking stocks than a group of so-called stock-picking experts.
I would love to be able to predict the future. I would make mind-boggling amounts of money in all kinds of markets. Unfortunately, I cannot. What I can do is remain focused on the investment strategies over which I can exercise influence – appropriate asset allocation, maximum tax efficiency, and the lowest possible fees. Doing these things well is both valuable and attainable.
I can assure you of something, however. If I ever develop the ability to predict the future I will not sell that priceless skill to you for my currently affordable retainer fee. I won’t even sell it to you for 1% of your assets under management. The ability to predict the future would be worth much, much more than that. Anyone who claims they are willing to sell the ability to predict the future to you for a 1% cut is deceiving you.
Don’t be fooled by advisers who try to use one of these myths to influence you into becoming (or remaining) a client. If your adviser (or a prospective adviser) is propagating one of these myths, run! (And keep your hand on your wallet on your way out the door!)