No advisor is perfect, but there are a few rough indicators (also see The Quality Advisor’s Alpha/Gamma/Sigma and How to Evaluate an Investment Advisor) that I use to recognize the quality of another advisor. Below are three examples in each category (this is not an exhaustive list), with my favorite simple indicators in bold:
- Does the advisor help the client address things that are important, but that another professional will get paid for rather than the advisor? If not, that tells me they are more interested in a paycheck than in helping the client. Does the financial advisor:
- recommend an umbrella policy? (Most advisors don’t sell P&C insurance.)
- make sure the client’s estate planning is up-to-date and adequate? (Most advisors aren’t estate planning attorneys.)
- review the client’s mortgage(s) to see if refinancing is advisable? (Most advisors don’t sell mortgages.)
- Does the advisor do things that help the client, even when the client doesn’t notice? Virtually all advisors execute on things where the client would notice if they were doing it wrong, but what about if the client would have no idea? Does the financial advisor:
- employ a prudent asset location strategy? Getting the asset location right gets the advisor no credit (except with very rare clients who are very knowledgeable) but is clearly advantageous to the client. It’s also more difficult than ignoring it.
- tax-loss harvest throughout the year or just at year end (or, worse, not at all)? Since investments grow (on average), harvesting economically meaningful losses when they occur is important – they may not exist at year end.
- rebalance the portfolio in a systematic, well-thought-out manner? Many portfolios, particularly smaller ones, are too-often neglected. (While the larger portfolios are overtraded!)
- Does the advisor do things that sound (or look) good but are actually counterproductive? Does the financial advisor:
- recommended small-cap growth funds? Of course that sounds like a great idea – who wouldn’t want to buy small growing companies? Except voluminous academic research concludes this is a terrible investment category.
- tell the client that they can safely retire when they really can’t? That will make the client happy – until they run out of money later!
- make frequent changes to the portfolio? Overtrading leads to worse performance, but most clients (erroneously) take it as a sign the advisor is “doing something” for them.
- This last category really sets quality advisors apart. Does the advisor recommend things (strongly even) that actually cost them (the advisor) money? Many prudent actions can reduce the size of the portfolio, and thus the amount of fees or commissions an advisor will earn for managing that portfolio. Nonetheless, when appropriate, does the financial advisor:
- recommend delaying Social Security benefits? (Thus increasing portfolio withdrawals in the short run.) This is virtually always a prudent recommendation.
- recommend paying off (or down) the mortgage?
- recommend directing additional savings to the employer’s retirement plan rather than to the taxable portfolio managed by the advisor?
- The reason to diversify internationally is not because expected returns are higher on foreign* investments, but because they will be different. Diversification is about risk reduction, not return enhancement.
- Hedging currency risk is optional in equities but essential in fixed income.
- The belief that foreign holdings are unnecessary because domestic companies have large foreign sales, operations, subsidiaries, etc. is a canard. You could also only invest in every other stock in the S&P 500 – but why?
- In (academic) theory portfolios should be market cap weighted (currently 54% US, 34% foreign developed, and 12% emerging markets).
- Reasons for US investors to hold less than market cap weights in foreign stocks:
- Diminishing marginal benefit from diversification – the biggest “bang for the (diversification) buck” is from the initial exposures
- Maximizing happiness (i.e. minimizing tracking error) – US investors are typically “benchmarking” off of the S&P 500 (or off of people who are doing so)
- Hedging – competitors for (retirement) resources are generally overweight domestic equities
- Reasons for US investors to hold more than market cap weights in foreign stocks:
- Other exposures (real estate, human capital, pensions, SS, etc.) are generally domestic
- In our experience, knowledgeable and prudent portfolio managers typically allocate 20-30% of the equity portion of a portfolio to foreign equities.
- Our foreign allocation is 25% of investment grade fixed income and 25% of equities (20% of “risky”) but with a more concentrated dosage than typical in the equity positions.
*The investment industry for some inexplicable reason uses the term “international” to mean “foreign” and are then are forced to use “global” to mean “international.” I will use “foreign” when I mean “foreign.”
The title of this piece is “guaranteed” to make financial regulators hyperventilate and plaintiff’s attorneys salivate, but I think you will find it hyperbole-free. Of course, as Benjamin Franklin famously observed, “in this world nothing can be said to be certain, except death and taxes” but I think these rules come very, very close.
Before we get to the rules, two initial items need to be clarified. First, we need to define “financial success.” As I have noted before (here) financial success can be defined as simply having more than you need. With these rules I’m thinking more along the lines of lifetime consumption smoothing (which Milton Friedman, among other economists, showed maximizes happiness). Second, these rules get you “guaranteed” and they may seem extreme. Many people will be successful doing less than suggested here, but the further you are from following these rules, the less certain your financial success.
So on to the rules…
The first rule is to start young. These rules will help at any age, but for “guaranteed” financial success starting young is imperative.
The second rule is to maximize all tax-advantaged retirement plans such as your 401(k), 403(b), SEP, SIMPLE, IRA, Roth IRA, etc. There are two pieces to this, 1) make the maximum permitted contributions while working, and 2) take only the required minimum distributions upon retirement. (If you don’t have access to a plan through your employer, or your income is high, you may need to save in a taxable account as well. The idea is to have about a 25% savings rate – just for retirement, other saving, such as for children’s higher education, would be in addition to that. Note that in reaching 25%, principal payments on a mortgage count as savings, as do Social Security contributions.)
The third rule is to never borrow money for a depreciating asset. A depreciating asset is one that declines in value over time such as a car, consumer goods, etc. For this rule it is easier to explain the things that it is acceptable to borrow for. I think there are only three:
- A prudent education. Prudent in two ways – the field of study and the cost. For example, borrowing $60,000/year to go to an exclusive private university for a bachelor’s degree in theater arts is likely to be a terrible investment for most students. Borrowing $20,000 to go to the state university for an engineering degree is likely to be a very good investment for most students. Obviously not borrowing at all is optimal, but if it is the only way to get the degree it can be a good use of debt.
- A primary residence. Obviously homes can decline in value, but assuming you make a reasonable purchase (purchase price no more than 2x gross income) this can be a “good” debt.
- A low-risk investment. Many businesses appropriately borrow money to fund expansion or for seasonal working capital. Borrowing conservatively to purchase a rental property can be prudent as well.
The fourth rule is to hedge all the risks you reasonably can. This would include buying appropriate amounts of life, health, and disability insurance, as well as liability insurance. Also, avoid concentrated stock and business investments and further diversify your portfolio between stocks and bonds, domestic and foreign holdings, etc. Finally, realize that divorce is one of the biggest risks of all.
It may be possible to follow these four rules and still end up a financial failure, but I can’t think of a way.