Sound Investing 11: Advice

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Get good financial advice

Do you need a financial advisor?

In their book Why Smart People Make Big Money Mistakes, Gary Belsky and Thomas Gilovich talk about the “ego trap,” their term for the overconfidence people often display in financial matters. Research shows that people are very likely both to overestimate their financial knowledge and to think that they are in better financial shape than they really are. Smart people shouldn’t be embarrassed to admit that they need financial advice. Part of the price we pay for our advanced economy is that our finances have become very complicated. Financial firms offer us a bewildering variety of investment products. The federal tax code imposes a complicated set of rules for taxing different kinds of investment returns. Employers present their workers with a confusing set of savings options instead of protecting them with traditional pensions. Very few people have the time and knowledge to evaluate all the alternatives by themselves.

Unfortunately, financial mistakes can be costly, especially if the results are compounded over many years. Here are some of the most common ones:

  • underestimating future financial needs, such as by underestimating how long one may live in retirement
  • saving too low a percentage of income
  • carrying debt at exorbitant rates of interest (especially credit card debt)
  • putting too much money into one kind of investment
  • risking too much money on trying to beat the market, instead of planning for an average market return
  • investing money needed in the near future too aggressively, or investing money not needed for a long time too conservatively
  • accepting high investment fees and expenses that are not justified by superior returns
  • paying too much to buy “hot” stocks or mutual funds, while overlooking more reasonably priced alternatives
  • failing to take full advantage of tax-sheltered savings plans, especially by passing up employer matching contributions

Investors who should know better often make these mistakes unwittingly, just by not giving enough attention to each financial decision. A good financial advisor should spot such problems very quickly and recommend solutions. In addition, professional advisors have technical tools for analyzing a client’s financial data and projecting long-term consequences of present choices. For example, a “Monte Carlo” simulation can forecast future returns, taking into account not only historically average rates of return for different investments, but also reasonably likely deviations from the historical averages. This approach can estimate the probability of achieving a financial goal by means of a particular investment strategy. Advisors cannot guarantee positive financial results, but they can help improve the odds.

What kind of advisor do you need?

The financial services industry has gotten very large, and investment advice is now available from many sources, such as brokers, mutual fund companies, insurance companies, accounting firms, and banks. Any of these could be a source of good advice. In order to avoid paying too much for too little, you should consider what kind of advice you need and how you will be charged for it. Beware of “free” advice that isn’t really free, because it steers you into unnecessarily costly investment options.

Ideally, your financial advisor should be someone with your best interests at heart. The term for such a person is “fiduciary.” According to the Certified Financial Planners Board of Standards, that’s “one who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client.” The danger is that people who call themselves financial advisors will put their own financial interests ahead of yours. That’s one reason Congress passed the Investment Advisers Act of 1940, which required those giving financial advice for compensation to register as investment advisors and adhere to a fiduciary standard. The Securities and Exchange Commission, however, made an exception for those whose primary business is trading securities, but who also give some advice to their customers. In recent years, brokers and other sellers of financial products have expanded their financial advising functions and often receive compensation for them. Nevertheless, the SEC continued to maintain that they did not have to register as investment advisors nor adhere to a fiduciary standard because their advice was “incidental” to their job as brokers. So two types of advisors, those obligated to put their clients’ interests first and those without such obligation, have co-existed in the financial services industry, with the general public often unable to tell the difference. Brokers and insurance agents have been able to call themselves financial advisors, without being obligated to recommend the products that are best for their customers.

On March 30, 2007, the U.S. Court of Appeals for the D.C. Circuit struck down the SEC rule that exempted brokers providing financial advice for compensation from the 1940 law. In the aftermath of the 2008 financial crisis, the Obama administration also proposed bringing brokers under a fiduciary standard. The Wall Street Reform and Consumer Protection Act of 2010 stopped short of imposing such a standard, but it did give the SEC the explicit authority to do so. In January 2011 the SEC released the findings from its study of the issue. It concluded: “The standard of conduct for all brokers, dealers and investment advisors, when providing personalized investment advice about securities to retail customers…shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer or investment advisor providing the advice.” Whether the specific rules issued by the SEC will be strong enough to enforce that standard remains to be seen. Resistance to the fiduciary standard remains strong, especially from the insurance industry and Republican lawmakers.

[Note: A more recent post on the battle over the fiduciary rule is here.]

If you are looking for someone with a strong commitment to a fiduciary standard, you may want to limit your choice to Registered Investment Advisors. RIAs must be able to provide a copy of the disclosure Form ADV they file when registering, and you can also check their registration online at You may also want to look for a Certified Financial Planner, because CFPs must meet rigorous standards of education and experience.

How will you pay?

A related decision concerns how you want to pay for advice. The options include sales commissions, asset management fees, hourly fees, flat fees for preparing financial plans, or some combination of these.

Sales representatives of financial services companies can advise you on how to invest your money without charging you a specific fee. They make their money from salaries or commissions on the products they market. The disadvantage for the consumer is that these representatives may steer customers toward the products they sell rather than informing them of the full range of investment choices. Brokers often recommend mutual funds with high commissions and fees, and insurance agents recommend costly insurance products such as annuities. Investment author Burton Malkiel says that investors often make unwise choices because “most individuals get ‘sold’ financial products. Brokers and advisors don’t make any money if they put you in a Vanguard index fund, but they do get paid for selling you a hot, actively managed fund” (Journal of Financial Planning, 4/05). These products often generate inferior returns once costs are factored in, while more cost-effective products are overlooked.

“Fee-only” advisors accept no commissions for what they sell, which leaves them free to recommend whatever products they view as best for the client. Some of them give advice for an hourly fee, or charge a flat rate to prepare a financial plan. Others are asset managers who manage your portfolio on a continuing basis. (Not all asset managers are fee-only however; some sell securities on commission too.) Asset managers charge an annual management fee, usually a percentage of your total invested assets. This appeals to people who don’t want to have to deal with a lot of everyday financial tasks and decisions. It can be very costly however, since you are paying all the time. A 1% fee on a $500,000 account is $5,000 a year, and many managers won’t accept smaller accounts.

What kind of advising you get depends a lot on what you are able to pay. Low-income households may have to settle for “free” advice, even though it may sometimes steer them toward products with poor trade-offs of costs and returns. High-income households may prefer to hire asset managers, despite their high fees. What about all the people in between? How to deliver financial planning services to middle-income households is a much-discussed issue, since they can afford to pay something, but often not enough to be desirable clients for asset managers. Occasional financial consultations for a flat rate or hourly fee may work best for such clients. Websites like and offer inexpensive financial consultations online. No-load mutual fund companies like Vanguard offer various levels of assistance to their customers, some of which is free.

The good news from considering the principles of sound investing is that you can be a successful investor without making a large number of difficult decisions requiring frequent and costly advice. The main things you need to do–save regularly, maintain a diversified portfolio, take advantage of tax shelters, avoid unnecessary expenses, and so forth–are not fancy financial moves but just good habits. Once adopted, they can be practiced with a small amount of effort, like tending a well-planned garden. Small investors who take the right approach ought to be able to manage their investments themselves with only occasional input from a professional advisor.

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