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:

1. 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).
2. 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.
3. has a clean regulatory record.
4. 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.
5. 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.
6. 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.
7. 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.)
8. 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:

1. is always happy to explain why they are doing what they are doing.
2. generally uses inexpensive investment vehicles (primarily index funds and other passive-type funds).
3. 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.
4. proactively contacts you about changes to income, gift, and estate taxes, etc. and is responsive when you reach out to them.
5. 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.
6. 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.
7. 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.)
8. 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:

1. 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.
2. 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.”
3. 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.

We are all prone to a variety of mental mistakes including (but not limited to) anchoring on irrelevant information, searching for confirming evidence rather than disconfirming data, extrapolating from small and recent data sets, etc. Some time ago I created a checklist of things to think about when making a decision – particularly an investment decision, but most of the factors generalize. Here is my checklist:

• Clearly define the question/problem (not the symptom).
• Create a Pro/Con List (Ben Franklin).
• Determine the distribution of outcomes.
  • Best Case?
  • Worst Case?
  • Expected Case? (the sum of the possible outcomes times their probability)
  • Standard Deviation? (the spread or range of the outcomes)
  • Skewness? (the range of outcomes is skewed to the positive or negative)
  • Excess Kurtosis? (outliers occur frequently)
• Check for biases.
  • Do I have feelings of euphoria, excitement, fear, or worry? (decide when dispassionate)
  • Am I anchoring on irrelevant data?
  • Am I narrow framing? (decisions should be made in the broadest appropriate context)
  • Is “everyone” doing it? (be wary of “going along with the crowd”)
  • Has the paradigm shifted? (past data may no longer be relevant)
  • Am I overconfident? (almost certainly unless suffering from clinical depression)
  • Have I considered sunk costs? (these are not relevant to the decision)
  • Have I searched for disconfirming evidence?
  • Have I overcome status quo bias?
• Is a decision required? Or is the lack of a decision a decision?
• Is there a correlation with another risk exposure?
• Have I identified all the alternatives?
• Have I conducted a pre-mortem?
• Is there empirical data? If so,
  • Is there data mining?
  • Have I tested out of sample?
• Are there theoretical underpinnings independent of the data?
• What if the decision is wrong?
  • Can poor outcomes be mitigated?
  • Can the bet be hedged?
• Does this decision maximize happiness?
• Does this decision minimize regret?

I should also note that a good decision is not the same thing as a good outcome, though they should be correlated. For example, investing all of your retirement funds in lottery tickets or one single stock is a bad decision even if you happen to win the lottery or the stock skyrockets. Conversely, investing in the market (prudently, with an appropriate asset allocation, etc.) is a good decision even if the market subsequently crashes.

Many of our clients make regular charitable contributions.  The tax laws can be fairly complicated in this area, but there are ways to give more efficiently that are worth knowing if you have charitable inclinations.  While these strategies apply to most of our clients, please contact us or an appropriate tax professional before taking action as there may be differences in your individual situation that may limit your deduction, or the appropriateness of a particular strategy. I have also had to omit some details to keep this to a reasonable length and comprehension level. The tax code, as I’m sure you know, is what is known here in the south as a “hot mess.”

Charitable Gifts. First, here are two ways to make charitable gifts with generally better tax outcomes than a traditional cash gift:

1. Qualified Charitable Distributions (aka QDCs). If you are over 70½ years old and have an IRA you may redirect some or all of your Required Minimum Distribution (RMD) to a charity (up to $100,000). Note that this must be a public charity (not a private foundation) and it also cannot be a Donor Advised Fund (more on these below). This option is best for taxpayers who have large impacts from a higher AGI (Adjusted Gross Income). For example, taxability of Social Security, itemized deduction phaseouts, personal exemption phaseouts, etc. are all based on AGI. This is a particularly good option for taxpayers who do not itemize or who would not itemize in the absence of charitable contributions. If your IRA has basis (i.e. after-tax contributions) QDCs are considered to use the taxable portion first (this is a good thing).

2. Donation of Appreciated Securities (DAS). Frequently the best gift to make to a charity is a donation of appreciated securities that you own in a taxable account (not a retirement account).  Suppose 100 shares of stock were acquired many years ago for $5,000 and the value has subsequently grown to $50,000.  The position may be transferred to a charity and (with some limitations) a deduction taken for the current value.  The charity can sell the securities, and as a non-profit will pay no taxes on the appreciation.  The $45,000 gain is never taxed in this case.  This is a particularly good strategy if you have a position you would otherwise sell (for diversification perhaps), that has a very low cost basis.  It is also nice for positions where you are unsure of your exact cost basis since it never needs to be determined. The example I gave was securities but any property that is long-term capital gain property can work but the rules are very specific so please contact us or another qualified professional in that case. If the taxpayer plans to leave these assets intact to heirs the advantage of gifting these securities is removed as under the current tax code all of the appreciation will be eliminated on inheritance anyway (this is known as a “step-up in basis”).

Assuming the taxpayer has the choice of either (i.e. they are over 70½ and have securities with long-term capital gains) here is my simplified flowchart of the optimal choice:

1. Does the taxpayer itemize?
   1. No, not even with the prospective DAS → QCD
   2. Yes, or only with the prospective DAS → go to next question
2. Is the taxpayer’s LTCG rate greater than 0% (including through a future step-up)?
   1. No → QCD
   2. Yes → go to next question
3. Is the taxpayer subject to SS or other phaseouts?
   1. No → DAS
   2. Yes → uncertain (you have to run the numbers)

Charitable Bequests. Under current law, at death most holdings will be “stepped-up” in value so heirs will have a cost basis equal to the current value.  Thus, leaving a bequest of securities as mentioned above doesn’t have an income tax advantage.  (In fact, if the estate is not large enough to be taxable, and most estates are not, it would be better to leave the property to an heir and have them make the charitable contribution so that they can have an income tax deduction rather than wasting it by leaving the property to the charity directly.)  For bequests, the best gift is generally assets in a retirement account that has only pre-tax contributions.  This would include most IRAs, 401(k) plans, etc.  To do this, simply name the charity on the beneficiary designation for the account.

Alternatively, to maintain flexibility it is possible to name the charity as a contingent beneficiary and have the primary beneficiaries disclaim the amount they would like to go to charity at that time.  Disclaimers are frequently not executed properly, so discussing the plan beforehand and involving competent advisors would be prudent.

The reason these retirement accounts are optimal for charitable bequests is that they generally have no cost basis at all, and as IRD (Income in Respect of a Decedent) property they do not receive a step-up in basis as discussed above.  Thus a $50,000 traditional IRA left to someone in the 25% marginal tax bracket would only provide them $37,500 after taxes if they withdrew the funds immediately.  Conversely, the entire $50,000 would be available to a charity as a tax-exempt entity.  This is an even better strategy than the gift of appreciated securities above because 1) rather than simply a “low” basis, these retirement accounts typically have a cost basis of zero, and 2) the taxes saved are ordinary income taxes rather than the lower capital gains taxes.

Donor Advised Funds (DAF). Sometimes referred to as a “poor man’s foundation” a Donor Advised Fund is a charity and a gift to the DAF is a completed charitable gift that qualifies for a current tax deduction. (Family foundations are generally not recommended unless they will be funded with initial gifts of at least $1,000,000 and there is a reason a simple DAF wouldn’t work to meet the family’s charitable goals.)  The DAF account can be invested and the donor, who is no longer technically the owner of the funds, may advise the fund where and when to make contributions, and in what manner (within limits) it should be invested in the meantime.  It would be extremely rare for a DAF to disregard the donor’s wishes in regard to gifts to a public charity.  DAFs can be opened with as little as $5,000-$10,000 and successor advisors (typically the donor’s spouse or children) may be named as well.

Here are a few specific cases where DAFs can be very useful:

1. Timing
   1. A taxpayer sells a business or has some other transaction that temporarily raises their income level this year, which puts him/her in a high tax bracket so they want to make a gift to get maximum tax savings, but there isn’t time to figure out what organization would be the best recipient before year end.
   2. A taxpayer sells a business or has some other transaction that temporarily raises their income level this year, which raises AGI. They want to make significant charitable contributions thus need the high AGI to be able to get the deduction (given the AGI limitations a five-year carry-forward limitation).

2. Simplicity/Lack of sophistication of the recipient charities
   1. A taxpayer wants to give $5,000 each to three very small country churches and wants to use appreciated securities (because their advisor has coached them in previous years that that is the optimal way to do it) but these churches don’t have brokerage accounts, have never accepted stock donations, and are frankly confused by the whole thing.  Solution, send $15k of appreciated securities to the DAF, sell the securities and have the DAF send checks to each of the churches.  (This is a true story, I was despairing of getting the churches on board when I realized we could just use a DAF.)
   2. A taxpayer wants to give a large amount to a charity but fears a lump sum would overwhelm them (and be used poorly) and thus uses a DAF to make donations over time while getting the deduction today.

3. Post-mortem/Legacy planning
   1. A family has charitable intent and a taxable estate (over $5,450,000 for an individual – double that for a married couple – in 2016) and prefer leaving funds to charity particularly from an IRA that would be subject to income taxes as well as estate taxes.  By naming the DAF as the contingent beneficiary of the IRA, the heirs can use disclaimers to contribute the exact amount the client’s estate is over the estate tax threshold, and the decision doesn’t have to be made until that time.  This adds significant flexibility as future estate tax rates, thresholds, and even the family’s finances change over time.
   2. A family wants giving to continue for many years, and would like younger generations to be able to direct some of those gifts. A DAF with successor advisors can continue the legacy.

4. Privacy or Memorials
   1. A DAF can be named the “Emerson Jones Memorial Fund” or whatever the taxpayer desires.
   2. A DAF can also be used to preserve the donor’s anonymity. By routing a large gift through a generically named DAF to the eventual recipient charity, no one need know from whom the gift actually originated.

Of necessity, the above discussion has been very superficial.  As I noted at the beginning, before implementing these strategies it would be prudent to consult with an appropriate professional for advice and guidance.

While many of the financial planning issues that small business owners face are the same as everyone else’s, there are some differences – primarily in the area of risk management.

• Many small business owners have a large portion of their net worth tied up in their business and thus are not properly diversified.
• The owner generally works in the business also which means his or her wage income is extremely correlated with their investment in the business.
• Frequently the spouse and other family members work in the business as well, further exacerbating the risk to the family as a whole.
• A number of psychological biases cause the owner to dramatically underestimate the risk he or she is taking:
  • Illusion of control is the tendency for people to overestimate the amount of control they have over situations – even when those situations are completely random and they have no control whatsoever. For example, many people have a marked preference for picking their own lottery numbers (and stocks for that matter).
  • Illusory superiority, also known as the Lake Wobegon effect, is the tendency for people to overestimate their abilities relative to others. For example, well over 80% of people believe they are above average drivers, will finish in the top half of their class in school, or that they are better looking than average.
  • Optimism bias causes people to believe there is a smaller chance that something bad will happen to them compared to other people. For example, in one study 81% of new business owners thought their business had at least a 70% chance of success, but only 39% thought a business like theirs would be likely to succeed.

While a comprehensive list of financial planning issues is impossible, following is a good sample:

• Business continuity – there should be a buy/sell agreement in place, a well-thought-out plan to transfer the business to the next generation or next owner, etc.
• Key person risk – in the case where there is one individual upon which the business is unduly dependent, frequently the owner, the risk of that individual leaving (voluntarily or perhaps due to premature death, illness, etc.) should be been planned for with insurance products, non-solicitation or non-compete agreements, etc.
• Retirement – a retirement plan should be established (and funded) for the owner and the employees (if appropriate).
• Disability – disability insurance should be in place for the owner and available to employees (if appropriate).
• Liability – this risk can be mitigated by prudent choice of entity type (C-Corp, S-Corp, LLC, etc.) and appropriate property & casualty insurance. In addition owners should be cautious in personally guaranteeing business loans and may want to structure their lives so as to shield a spouse in the event of catastrophe (having the personal residence only in the spouse’s name for example).
• Estate taxes – successful small business owners may find their net worth has become large enough to create a significant potential estate tax liability. Not only are the common estate tax mitigation strategies available, but business owners also have opportunities specifically for them such as special tax treatment available under IRC § 6166, 303, and 2032a. In addition, having an existing business makes the utilization of strategies such as discounts on valuations of gifts easier not only to do, but to defend to the IRS.
• Income taxes – in addition to typical income tax planning, business owners also have some discretion over the form in which they recognize income (wages vs. salary while working and capital gains vs. interest upon disposition) and can frequently take advantage of fringe benefits including health insurance, business travel and entertainment, employer-provided cell phone or car, etc. In addition, since the business owner frequently has more erratic income than an employee, there may be opportunities to shift income and expenses between tax years to the taxpayer’s benefit.
• Liquidity – many businesses have erratic cash flow and all of them have the possibility of facing tough times, thus it is of vital importance to have adequate sources of liquidity (credit lines, etc.) set up before they are needed.
• Leverage – both financial leverage (debt vs. equity) and operational leverage (variable vs. fixed costs) increase the risks (and potential returns) and must be evaluated carefully. Frequently an increase in one type of leverage would make a decrease in another prudent.
• Complexity – frequently business owners have very complicated financial and legal situations with a variety of contracts, agreements, guarantees, business entities, etc. in place, many of which may simply be legacy items that could be eliminated. Simplification may be appropriate to not only enable better management now, but also to aid heirs in the future.
• Other risks – small business owners also frequently neglect to adequately secure their intellectual property, use employment contracts, conduct background checks, drug tests, credit checks, etc.

The best known (and most parsimonious) rule of ethics is what is known as the “golden rule” which most of us learned as “Do unto others as you would have them do unto you.” This maxim is found throughout history and in almost all religions. For example,

In ancient Greek philosophy:

• Do not to your neighbor what you would take ill from him. – Pittacus
• Avoid doing what you would blame others for doing. – Thales
• What you do not want to happen to you, do not do it yourself either. – Sextus the Pythagorean
• Do not do to others what would anger you if done to you by others. – Isocrates
• What thou avoidest suffering thyself seek not to impose on others. – Epictetus
• It is impossible to live a pleasant life without living wisely and well and justly (agreeing ‘neither to harm nor be harmed’), and it is impossible to live wisely and well and justly without living a pleasant life. – Epicurus
• One should never do wrong in return, nor mistreat any man, no matter how one has been mistreated by him. – Plato’s Socrates

In the Bible, the Apocrypha, and Torah (those three overlap in what is considered canonical):

• Thou shalt not avenge, nor bear any grudge against the children of thy people, but thou shalt love thy neighbour as thyself: I am the LORD. – Leviticus 19:18
• But the stranger that dwelleth with you shall be unto you as one born among you, and thou shalt love him as thyself; for ye were strangers in the land of Egypt: I am the LORD your God. – Leviticus 19:34
• Therefore all things whatsoever ye would that men should do to you, do ye even so to them: for this is the law and the prophets. – Matthew 7:12
• And as ye would that men should do to you, do ye also to them likewise. – Luke 6:31
• Do to no one what you yourself dislike. – Tobit 4:15
• Recognize that your neighbor feels as you do, and keep in mind your own dislikes. – Sirach 31:15
• That which is hateful to you, do not do to your fellow. That is the whole Torah; the rest is the explanation; go and learn. – Talmud, Shabbat 31a

In the eastern religions of Confucianism and Hinduism:

• Do not impose on others what you yourself do not desire. – Confucius, Analects XV.24
• One should never do that to another which one regards as injurious to one’s own self. This, in brief, is the rule of dharma. Other behavior is due to selfish desires. – Brihaspati, Mahabharata (Anusasana Parva, Section CXIII, Verse 8)

Some of these formulations are superior to others. Those worded in the positive (“Do unto others as you would have them do unto you.”) are unworkable. There is no natural limit to the amount of self-sacrifice involved. (E.g. I would like it if everyone gave me all their money, so I must give away all my money to others.) The negative formulations are superior (“Do not do unto others what you would not have them do unto you.”) but still have a problem in that people’s desires can be, and generally are, different.

As George Bernard Shaw said in Maxims for Revolutionists in 1903, “Do not do unto others as you would that they should do unto you. Their tastes may not be the same.” In other words if we should treat others as we want to be treated, then a masochist following the golden rule becomes a sadist.

Perhaps a better ethical formulation can be found in Immanuel Kant’s categorical imperative, which can be stated, “Act only according to that maxim whereby you can, at the same time, will that it should become a universal law.” This is a deontological (as opposed to utilitarian) view of the world, which holds that ends cannot justify means. Indeed as Emerson believed, the ends pre-exist in the means.

Thus, the fundamental code of ethics here at Financial Architects is Kant’s. In addition, the myriad designations and memberships held by principals at Financial Architects subject us to numerous other codes of ethics and standards of professional conduct including:

• CFA Institute
• CFP Board
• Financial Planning Association (FPA)
• Investment Management Consultants Association (IMCA)
• National Association of Personal Financial Advisors (NAPFA)
• The American College