One of our newer clients asked a question a while back that comes up occasionally, “How do I know if you are doing a good job?” It is a great question. I’m not sure I have a great answer, but this is my attempt at it. First, I will give eight tips for finding an advisor in the first place, followed by eight tips for evaluating the advisor once you have hired them, and finally I will comment on the obvious factor that oddly (or so it would seem) didn’t make either list.
Consumer advocates who advise individuals searching for an advisor generally recommend finding one who:
- is a fee-only (not “fee-based” or “fee-oriented” – these terms are designed to confuse the investor) registered investment advisor. This means that they are legally a fiduciary and are required to put their client’s interests first. In addition, since the advisor is only getting paid by the client, potential conflicts of interest are minimized (though not eliminated).
- is credentialed. At a minimum the advisor should be a Certified Financial Planner (CFP) and, if your portfolio is larger, a Chartered Financial Analyst (CFA). There are hundreds of credentials, but a great many are simply marketing tools that can be obtained by paying a fee and taking a short true/false test. The CFP (for financial planning) and the CFA (for investment management) are widely considered the gold standards.
- has a clean regulatory record.
- takes a holistic view of your finances. A good advisor will make sure your overall house is in order (insurance, estate planning, etc.) before addressing your investment portfolio. Even when addressing the portfolio, the rest of your situation should influence it. To give just a few examples, a retiree with a mortgage and an entrepreneur both should have a lower risk portfolio, an investor with a long-term fixed-rate mortgage needs less inflation hedging than a pensioner, etc. A good test of this is to note whether the advisor recommends things they don’t offer (such as an umbrella liability policy, or updated wills) and reviews your tax return for opportunities even though they don’t do tax preparation. These are signs they truly have your interests at heart.
- is willing to provide references. This isn’t fool-proof of course. An advisor is unlikely to provide a reference that won’t say positive things, but it can still shed some light on their level of service among other things.
- doesn’t talk about beating the market or potential returns, but rather about how to reduce risks and make reasonably sure you can reach your financial goals.
- is experienced. It does help to have been around the block a time or two. (I believe vicarious experience from studying market history is probably even more important, but it is hard to know whether the advisor has that.)
- has low fees. The industry standard is one percent of assets under management (per year) or less for larger accounts.
All of those items are good when selecting an advisor initially, but still don’t answer the original question. After the advisor is hired, how do you know if they are doing a good job? Your advisor is probably doing a good job if he or she:
- is always happy to explain why they are doing what they are doing.
- generally uses inexpensive investment vehicles (primarily index funds and other passive-type funds).
- doesn’t make many changes to the portfolio once it is initially invested. Most activity – even by professionals – removes value rather than adds it. A cautious, even, temperament is crucial to long-term success.
- proactively contacts you about changes to income, gift, and estate taxes, etc. and is responsive when you reach out to them.
- doesn’t tell you what you want to hear. This may seem odd, but good salespeople tend to agree with you and want you to be happy above all. Thus if you are worried about the stock market (2008), they will agree with you about lowering your risk level. If you are excited about the stock market they will agree with you about raising your stock exposure (1998). Similarly, a good advisor generally won’t be investing in whatever the latest fad is. A good advisor is frequently pushing back against the reigning emotion of the time – even yours.
- is focused on the long-term and provides a long-term perspective. For example, permitting (or even encouraging) a client to spend more than their portfolio can realistically support will be just fine – for a decade or two. A good advisor is planning for, and cautioning you about, the consequences in the very long run.
- doesn’t pretend they can predict the direction of the market in the short run. No one can reliably do this, but even if they could they certainly wouldn’t be working as your advisor. (They would either be an extremely wealthy retiree or be running a hedge fund.)
- broadly diversifies your investment portfolio. As an expert witness I have testified for clients who were put into portfolios almost exclusively composed of high yield (junk) bond funds or REITs. While many things can have a place, items such as these should be a very small part of a portfolio.
The astute reader who has gotten this far (who, first of all, should be commended for their endurance) may have noticed that I have not put a seemingly obvious item on either list above – returns. Why would I leave out past performance in selecting an advisor, or current performance for an existing advisor? There are a few reasons:
- You will never have a long enough track record. I have explained this at length elsewhere but to know a portfolio manager who has been beating the market by 2% annually (which is enormous) actually has skill would require a track record 56 years long. (This is a difference of means test assuming 2% alpha, 20% standard deviation, and 90% correlation with the benchmark.) Thus, realistically, you will never know with any high degree of confidence whether a portfolio manager is skillful. I wish it were otherwise, but it simply isn’t.
- Good performance may just mean extra risk. An advisor who placed a client in an inappropriately risky portfolio will nonetheless look like a genius when the market is going up. There is an old Wall Street saying, “don’t confuse brains with a bull market.”
- Underperformance may just mean prudence. Good investment advisors had their clients appropriately diversified in the late 1990’s and thus trailed the market (remember “irrational exuberance?”) by a wide margin. While those advisors were vindicated in the early 2000’s many had already lost a significant number of clients – who frequently returned to them with much diminished portfolios.
So, while it is somewhat counter-intuitive, there are many factors that are useful in evaluating your financial advisor, but performance isn’t one of them.