One of the ways a high-quality advisor adds value is by paying attention to asset location.  Low-quality advisors tend to ignore it. There are three reasons they may do so:

1. They don’t care.  The advisor may have the cynical view that clients only focus on pre-tax returns so don’t worry about it.  If the primary objective is sales rather than actually doing the best possible job, this makes sense.
2. It’s too hard.  It adds operational complexity.  Particularly for advisors with a high number of small accounts, it is easier to just “mirror” all the accounts exactly the same way.
3. They don’t know.  They either don’t know about the strategy at all, or don’t know how to implement it.

Taxes should not determine asset allocation (though it may influence it slightly at the margin), but once the proper allocation is determined, location is important.  Optimal asset location is simply locating the least tax-efficient assets inside of tax-advantaged (i.e. retirement) accounts and the most tax-efficient in taxable (i.e. non-retirement) accounts.  A combination of three factors are multiplied together determine tax efficiency:

1. Investment return. An investment with a rate of return of 0% (e.g. cash) is perfectly tax-efficient.  The higher the return the lower the efficiency.
2. Tax rate. An investment with a tax rate of 0% (e.g. munis) is perfectly tax-efficient.  The higher the rate (e.g. ordinary income vs. long-term capital gains) the lower the efficiency.
3. Turnover.  If an investment is never sold, under current tax law there is a full “step-up” in basis at death and thus is perfectly tax-efficient.  Keep in mind that yield (dividends and interest) are a form of turnover.  The higher the turnover the lower the efficiency (basically, there can be “good” turnover where losses are being harvested).  In the case of a mutual fund, use the higher of the expected fund turnover or the inverse of the investor’s expected holding period in years but not more than 100%.

In addition to the three factors above, there are two more things to keep in mind:

1. Volatility.  An investment with high volatility is more valuable in taxable account because of the possibility of being able to tax-loss harvest in an early year.  Of course, more volatile investments also tend to have higher expected returns which I noted above are better held in tax-advantaged accounts.  In general, I would say the expected return dominates the volatility, but it is something to keep in mind.
2. Foreign source income. Foreign investments (e.g. foreign stock funds) are better held in taxable accounts so as to be able to take a credit or a deduction (the credit is usually better) for foreign taxes paid.  The effect is partially offset by the fact that the yields on foreign stocks tend to be higher than those on domestic stocks which I noted above would indicate holding the higher-yielding investments in the deferred account.  In general, I would say it is just slightly better to have the foreign stocks located in the taxable account.

There are two types of tax-advantaged accounts, tax-deferred (e.g. traditional IRAs, 401(k) plans, etc.), and tax-free (e.g. Coverdell and 529 accounts if used for education, Roth IRAs, etc.).  Between those two, because (under the current tax code) the Roth does not have RMDs (Required Minimum Distributions), it is better to have higher returning assets located in the tax-free accounts.  Most people think that the reason is because it is tax-free, but this is not so.  There is no difference between a Roth and an IRA except the investor owns 100% of the Roth while (assuming a 25% tax rate) she owns only 75% of the IRA (the government is a 25% partner) but both are completely tax-free once you make that initial adjustment.

Again, the most tax-efficient assets are optimally held in the taxable account and the least tax-efficient in the tax-advantaged accounts.  But suppose relatively large amounts of inefficient holdings are end up in the taxable account anyway (either because the size of the tax-advantaged accounts is small or the holdings are large, or a combination).  For example, suppose the least tax-efficient holding in the taxable account is a total bond market bond fund (all ordinary income).  Particularly if interest rates are higher (say 6% rather than the current 2.3%), there are five things to consider doing to improve the tax efficiency:

1. Buy a municipal bond fund instead. This is particularly appropriate for high-tax-bracket investors.
2. Make non-deductible IRA contributions. While I would not make non-deductible contributions if the marginal holding is eligible for capital gain treatment and might receive a step-up on death, in a case where it is already ordinary income this probably makes sense.  The downside is the loss of liquidity if the investor is younger than 59½.
3. Use a variable annuity wrapper. This is exactly like the previous recommendation of the non-deductible IRA from a tax perspective, but has additional cost.  Despite the additional cost, if it is cheap enough (and I have in mind a plain-vanilla annuity with no riders at 25-30 basis points) and the time horizon long enough, this can make sense (not today, but in a higher interest rate environment).  I have discussed this option here.
4. Buy permanent life insurance. I am not a fan of permanent life insurance in general, but as I have noted before there are rare cases where it is recommended.  Ordinary-income holdings like bonds in the taxable account is one of the factors.
5. Pay down your mortgage instead. There are many other aspects to this decision also which I have covered here.

A full-service, fee-only, wealth management firm can only effectively handle 100 clients per financial advisor (approximately, with a sizable standard deviation and positive skewness).  A more transactional model can manage a greater number, but since many of the smaller accounts will be neglected (to some extent at least) it is unclear that the actual revenue generated will be greater than having a deeper relationship with fewer clients.  Because the number of clients that can be served is limited, it is important that the advisor ensure he or she is working with the right people.

It is far easier to get the right people from the beginning than to try to upgrade the client base later.  Firing clients who were with the advisor from the early days is at best awkward even if they are no longer a good fit.  On the other hand, it is better to “pull the Band-Aid” quickly than to let a poor fit continue.  Most advisors have at least a few clients who shouldn’t be clients.  To make sure we maintain the discipline to keep only the right relationships, we have a policy of (politely) firing one client every year.  Input on which client that should be comes from all of the associates of the firm.

A policy of proactively removing one client per year has a few positive effects:

• There is always someone who really isn’t a good fit.
• It keeps the advisor from accepting clients initially that are just going to be let go in the future.
• It reduces the stress on the firm’s associates during the year.

Let me explain that last point.  If a client is difficult or simply seems to require more work than their fees may justify, realizing that they may be the one to be let go can reduce the stress level of the associate who is dealing with them, even if they are never the client actually selected for removal.

When accepting a client initially or determining who should be asked to find another advisor, there are four things we look for (in order of importance from most to least):

1. Personality fit. If a client verbally abuses an associate or if we feel dread when seeing their name on the caller ID, that client does not qualify to work with us.  Life is too short.

2. Willingness to delegate. While our clients are intelligent (see the next point), if they do not wish to delegate portfolio management to us, obviously it won’t be a good fit.  For example, a retiree who watches financial news all day and wants to constantly discuss with us what the talking heads are saying will not be a good fit.  We are more than happy to explain what we are doing and why and obviously there has to be agreement on the appropriate risk level of the portfolio, but we are not “co-managers” of the portfolio with the client.

3. Cognitive abilities. While obviously people are paying us for our knowledge and wisdom (which are two different things), we want clients who are intelligent enough to recognize our value and who (at least at a high level) understand how we manage portfolios.  We have doctors, lawyers, CPAs, etc. and those are all very good clients for us.  We work less well with unsophisticated people.  In fact, we work well with professional people that other advisors typically struggle with; engineers, for example, are notoriously unpopular clients but we enjoy them.  Their thoroughness and analytical approach matches our approach.

4. Substantial assets. Our ideal clients have at least $1mm invested with us, but you will notice that this is the last thing on the list.  While a prospective client obviously has to have “enough” assets to be managed, once they are at that threshold, the other factors are far more important.

Many experienced Financial Advisors (aka Stock Brokers, Registered Reps, Financial Consultants, etc.) have learned, generally the hard way, what mistakes to avoid.  Unfortunately, newer advisors seem to make the same mistakes all over again (and many experienced folks never learn), harming their clients in the process.  Many high-quality, experienced advisors tend not to do a great deal of mentoring (though there are exceptions) because the turnover among new advisors is so high it isn’t a good investment of time.  Given that dynamic, I thought I would try to set down some advice to a new advisor to try to spare them, and their clients, some of that learning curve.

Conceptually, I am addressing a young niece or nephew who has recently been hired as a financial advisor and who, while intelligent, is a liberal arts graduate with no investment background beyond studying for, and passing, the Series 7 (stockbroker’s) exam. So without further ado, and in no particular order, here is my advice and the things I think you need to know for your new career:

• Stocks beat bonds (because they are riskier), but less consistently than you think.
• Value stocks outperform growth stocks (because people like growth stories and overvalue the companies, particularly in the small cap space), but again, less consistently than you would like.
• Simple beats complicated.
• It almost certainly isn’t different this time.
• Study market history. In particular, read contemporaneous accounts of different periods.  As Mark Twain is reputed to have said, “History doesn’t repeat itself, but it rhymes.”  As Santayana did say, “Those who cannot remember the past are condemned to repeat it.”  And finally, another quote from Mark Twain, “The man who does not read good books has no advantage over the man who can’t read them.”
• Arguably the most valuable function you serve is keeping people on track and not being sucked into the euphoria or panics that periodically seize the market.
• Psychological mistakes are more detrimental than cognitive mistakes. This applies to your clients and Study behavioral finance.
• If you get higher compensation to sell a particular product, it isn’t because it is a better product. There is a very strong inverse correlation between what is best for clients and what pays the advisor the most.
• You will tend to be swayed toward products where the costs (including your compensation) are less visible to the client. If you would be uncomfortable disclosing your compensation, avoid the product.
• You have undoubtedly heard and read disclosures that “Past performance is no guarantee of future results.” I would go further:  Alpha is ephemeral and past performance is not only not a guarantee of future results, it isn’t even a good indicator of them though it certainly makes investors feel better about what are inherently uncertain decisions.
• You can do a lot worse than simply putting 60% of a portfolio into a total stock market index fund and 40% into a total bond market index fund. You should have a high level of confidence that what you are suggesting is superior to that simple strategy before implementing it.
• Never buy an investment that requires someone else to lose for your client to win. Stocks and bonds have a tailwind (on average they make money), while derivatives are a zero sum game that requires someone else to lose money for you to make money.  That is unlikely to happen consistently.
• Performance may come and go, but costs are forever.
• One of the worst things that can happen to you or a client is an early investment that wins big. You will become overconfident of your abilities and proceed to lose much more in the future through imprudent decisions than you initially made on the winner.
• The purpose of fixed income in a portfolio is for ballast. It is not there to increase returns, it is there to reduce risk, hence you should keep the fixed income portion of a portfolio relatively short term, high quality, and currency hedged (if using international fixed income).
• In reality, there are only two asset classes: stocks and bonds. Or as I prefer to think of it, risky assets and safe assets.  Non-investment grade bonds are in the risky category.  Cash is just a bond with a really, really, really short duration.  The investment decision with the biggest impact is the decision of how to allocate the portfolio between those two buckets.
• In a bad market the value of risky assets will decline by approximately half. This is to be expected.  When it happens it does not mean that the world is coming to an end.
• Your projections, regardless of the quality of the software used to generate them, have high precision (the numbers have decimal points), but low accuracy (you have no idea what the numbers actually are).
• The projections of market prognosticators have neither precision nor accuracy.
• It isn’t what you don’t know that will hurt you. It’s what you don’t know you don’t know and what you do know that isn’t so.  Become a Certified Financial Planner as soon as possible.  Join the Financial Planning Association and attend the meetings.
• Don’t buy individual stocks and bonds. You won’t get adequate diversification, you will tend to end up concentrated in certain sectors and in U.S. large growth stocks, and you and your client will make emotional decisions based on how you feel about the company.
• A good company or sector or country isn’t necessarily a good investment and a poor one isn’t necessarily a bad one. In fact the reverse is generally true.
• Don’t confuse price and value. A low-price stock is not a better investment than a high-price stock just as cutting a cake into more slices doesn’t mean there is more cake.
• Don’t buy insurance or guarantees on investments. High fees and poor performance are the rule rather than the exception.  You can’t get something for nothing and you can’t get market returns without market risk.
• Don’t be afraid to reject clients who are irrational, not in your target market, are high maintenance, or that you simple dislike. This is hard to do early in your career, but worth it.
• When marketing, remember deep penetration of a small market beats shallow penetration of a large market.
• Anyone can design a financial plan or portfolio that does well if the assumptions are correct. The trick is to design one that works pretty well even if you are completely wrong.
• Your job is not to maximize portfolio size; it is to maximize client happiness. While these two things are certainly related, they aren’t the same thing.
• Successful people have long time horizons, unsuccessful people have short ones. (In finance terms, the successful folks have lower discount rates than the unsuccessful.)  Look for clients and associates who are in the long-term-thinking category.
• Get a mentor who has been in the business a long time but who is bad at sales and started very slowly. He or she is more likely to know what they are doing than the personable sales guy who was an overnight success.
• Sell wisdom rather than products, transactions, or information. Information is cheap, wisdom is dear.
• Good clients are wealthy people who delegate.
• Current market valuations frequently change expected returns. They much less frequently change the proper investment strategy.
• Financial success is having more than you need.
• One of the best fixed income investments is paying down debt.
• Don’t trust your peers or your firm. If you can’t or won’t do your own due diligence on a product, don’t sell it.  If you can’t explain a product to an engineer, don’t sell it.
• 4% is the sustainable withdrawal rate over a 30 year period for a portfolio that is predominately, but not exclusively, stocks.
• IRA and Roth type investments beat insurance products hands down.
• Base your business on fees rather than commissions as much as possible.
• Read books (not magazines and newspapers) on investing (not sales).
• Markets are probably efficient. To the extent they aren’t, you won’t be the one that beats them.
• Diversification is the only free lunch – but it works better when markets are going up than when they are going down.
• If everything in the portfolio is going up, you aren’t diversified.
• Focus on total return, not yield.
• Beware excess kurtosis and negative skewness – particularly in combination.
• As Warren Buffett said, “Be fearful when others are greedy, and be greedy when others are fearful.”
• Don’t change investment strategy when scared or euphoric. Wanting to change your strategy is an early warning sign you are about to do something stupid.
• Over-communicate with clients – particularly in times of market stress.
• Setting appropriate expectations is one of your most important functions.
• Just because “everyone” is doing it doesn’t make it right. This applies to investment fads.
• Taxes and inflation matter a great deal but because they aren’t reflected in performance reports they are inappropriately ignored.
• Taxes should not drive investment decisions though they may influence them at the margin.
• Make sure you are getting experience for the time you are putting in. Few people have 20 years of experience.  Many people have the same year of experience 20 times.
• Most mistakes are attributable to ignorance, myopia, and hubris. Principally hubris.
• Wanting or needing x% return doesn’t cause it to be available in the market.
• Returns are random and randomness is more random than you think. Control risk and accept the returns that show up when they show up.
• The difference between wise and foolish investors is that the first focuses on risk while the second focuses on return.
• No one has any idea what the market is going to do in the short run and only a vague idea in the long run. When J.P. Morgan was asked what the market was going to do that day, he replied, “It will fluctuate.” If your business model depends on your ability to forecast, you are doomed.
• Risk doesn’t equal return. You can’t earn excess returns without taking risk, but it is possible to take risks that have no reasonable expectation of excess return.
• Leverage works in both directions.
• Your clients cannot eat relative performance.
• Aside from tax management, the wisdom of a trade has nothing to do with the cost basis.
• Don’t mistake a bull market for investment skill.
• As Keynes is reputed to have said, “The market can remain irrational longer than you can remain solvent.”
• People don’t have money problems, money has people problems.
• Clients have no idea if you are competent. Thus they will extrapolate from things they can judge into areas where they can’t.  For this reason (among others) it is important to do all the other little things right like returning calls, being punctual, having a respectable office, having communications be without grammar and spelling errors, etc.
• The investor’s return is the company’s cost of capital. If you expect a high return, you should ask why a company has to pay that much for capital.

I am frequently asked by financial advisors what trade publications I read and what organizations are worthwhile.  Below is a list of my current subscriptions that I would consider most valuable:

• Financial Analysts Journal – free with membership in the CFA Institute
• Financial Planning – free for financial advisors
• Investment News – free for financial advisors
• Investments & Wealth Monitor – free with membership in IMCA
• Journal of Financial Planning – free with membership in the FPA
• Journal of Investment Consulting – free with membership in IMCA
• Wall Street Journal – subscription required
• Wealth Manager – free for financial advisors

If you are trying to narrow it down, I would recommend Financial Planning magazine for basic technical information and Investment News for industry information.  I would also join the Financial Planning Association (FPA) which comes with a subscription to the Journal of Financial Planning.  I also subscribe to a number of other publications (or pick them up on the newsstand), but I don’t find them all that valuable.

Joining the following organizations is highly recommended as well:

• Financial Planning Association (FPA) – for all financial professionals with private clients.
• CFA Institute – primarily for Chartered Financial Analysts (CFA).
• Investment Management Consultants Association (IMCA) – primarily for Certified Investment Management Analysts (CIMA), and Certified Private Wealth Advisors (CPWA).
• National Association of Personal Financial Advisors (NAPFA) – for all fee-only advisors.

I am frequently asked for a recommended reading list, so I looked through my library and created the list below.  It is by no means comprehensive, yet in some respects it is undoubtedly redundant.  Some books are out of print and attempting to read it all would be daunting; so think of it as a menu of options you may want to try.  To keep it to a somewhat reasonable length, I restricted myself to only one title per author and excluded textbooks.  Also, due to my predilections it is tilted toward the areas of behavioral finance, efficient markets, and historical perspective.

• Against the Gods – Peter L. Bernstein
• All About Asset Allocation – Richard A. Ferri
• Asset Allocation – Robert D. Arnott & Frank J. Fabozzi
• Asset Allocation – Roger C. Gibson
• Asset Management: A Systematic Approach to Factor Investing – Andrew Ang
• Behavioral Investing – James Montier
• Beyond Greed and Fear – Hersh Shefrin
• Book of Investing Wisdom, The – Peter Krass
• Common Sense of Money and Investments, The – Merryle S. Rukeyser
• Devil Take the Hindmost: A History of Financial Speculation – Edward Chancellor
• Efficient Asset Management – Richard O. Michaud
• Efficiently Inefficient – Lasse Heje Pedersen
• Extraordinary Popular Delusions and the Madness of Crowds – Charles MacKay
• Fooled by Randomness – Nassim N. Taleb
• Fortune’s Formula – William Poundstone
• Happiness – Richard Layard
• History of the Theory of Investments, A – Mark Rubinstein
• Intelligent Investor, The – Benjamin Graham
• Investment Management – Robert L. Hagin
• Investor’s Manifesto, The – William J. Bernstein
• Management of Investment Decisions, The – Donald Trone, et al.
• Manias, Panics, and Crashes: A History of Financial Crises – Charles Kindleberger
• Millionaire Next Door, The – Thomas J. Stanley & William D. Danko
• More Than You Know – Michael J. Mauboussin
• Myth of the Rational Market, The – Justin Fox
• New Wealth Management, The – Harold R. Evensky, et al.
• Only Guide to a Winning Investment Strategy You’ll Ever Need, The – Larry E. Swedroe
• Only Yesterday – Frederick L. Allen
• Plungers and the Peacocks, The – Dana L. Thomas
• Portable Financial Analyst, The – Mark P. Kritzman
• Portfolio Selection – Harry M. Markowitz
• Psychology of Investing, The – John R. Nofsinger
• Random Walk Down Wall Street, A – Burton G. Malkiel
• Reminiscences of a Stock Operator – Edwin Lefèvre
• Thinking, Fast and Slow – Daniel Kahneman
• Signal and the Noise, The – Nate Silver
• Stocks for the Long Run – Jeremy J. Siegel
• Where Are the Customers’ Yachts? – Fred Schwed
• Winning the Loser’s Game – Charles D. Ellis
• Wisdom of Crowds, The – James Surowiecki
• Your Money and Your Brain – Jason Zweig