By: Frank Armstrong, CFP, AIF
Market Risk and Behavior Risk are well known and frequently discussed. However, there is another type of risk that is often overlooked; The Advisor Risk.
Investors that recognize that they dont have the time, knowledge or inclination to deal with market risk, and/or the discipline to deal with their own behavior risk may seek advice, and unwittingly run into a third level of risk: The risk that their advisors are either not working in their best interest and/or are incompetent. This third risk is little discussed or appreciated. But, advisor risk is not trivial. Countless investors that delegated their investment decisions to so-called professionals have been devastated during the recent bear market.
How to avoid advisor risk
Investors should start by asking themselves who the advisor works for. The world of investment advice is dominated by sales organizations including brokerage houses, broker-dealers, insurance companies, mutual funds, banks, etc. These firms hire sales people to sell high profit (for the firm) products. The salesmen are compensated by commissions, which are based solely on the economic interest of the firm. There is only one ethic: Sell More! Any gains realized by the investor are a pure happy coincidence. Failure to sell enough of the right stuff is a career-ending move for these captive salesmen. As my friend Bill Bernstein says: Brokerage houses service clients like Bonnie and Clyde serviced banks.
These houses offer advice worth far less than zero, and far too often operate at a level little better than common thieves in pin stripes. From top to bottom, the commission-based system is fatally flawed, hopelessly corrupt, riddled with conflicts of interest, hidden agendas and lack of disclosure. Too often, the totally predictable result is inappropriate investment recommendations, churning, proprietary products, high costs and dismal results. These problems are a direct result Wall Streets moral vacuum, and well-demonstrated inability to police themselves.
Perhaps you suffer from a lingering doubt that Wall Streets brokerages are working for you? If so, you can quickly disabuse yourself of that delusion. Simply review Henry Blodgets stomach turning email file obtained from the New York State Attorneys investigation of Merrill Lynch.
Why would any investor subject himself to the risk that his advisor is not working exclusively in his best interest? Why would you pay to obtain advice that isnt objective? Commissions introduce a totally unnecessary moral risk into the advice function.
There is a simple alternative that eliminates that problem. Just refuse to deal with any commission-based advisor. (Commission based compensation includes fee-based compensation which is a particularly evil label referring to both fees and commissions. Dont be fooled.)
Investors must insist that the advice they receive is totally objective, and exclusively in their interest. Fee-only advisors provide advice and service. Their compensation is paid directly by the client, fully disclosed, completely transparent, and product independent. With the commissions gone, there is nothing in the relationship that prevents the advisor from providing objective advice.
The investors best defense against inappropriate advice is the ironclad separation between the advice and brokerage functions. The advisor works only for the client, receives no other compensation, and as a fiduciary acts only in the best interest of the client. The NAPFA fiduciary pledge below sets the standard for advisor conduct. Ask your local used stock salesman if he can sign it. From the clients perspective, no other relationship is acceptable.
Coming up: Professional Qualifications
A pure heart and an empty head are not enough to solve the investment question. Investors must also demand professional competence. What should they look for?
The NAPFA Fiduciary Oath:
The National Association of Personal Financial Advisors is the largest professional association of comprehensive, Fee-Only financial planners in the United States. With 750+ members and affiliates, in 45 states.
The members of the National Association of Personal Financial Advisors (NAPFA) subscribe to the following fiduciary oath:
- The Advisor shall exercise his / her best efforts to act in good faith and in the best interest of the client.
- The Advisor shall provide written disclosure to the client prior to the engagement of the advisor, and thereafter throughout the term of the engagement, of any conflicts of interest, which will reasonably compromise the impartiality or independence of the advisor.
- The Advisor, or any party in which the advisor has a financial interest, does not receive any compensation or other remuneration that is contingent on any client’s purchase or sale of a financial product.
- The advisor does not receive a fee or other compensation from another party based on the referral of a client or the client’s business.