For well over a decade, my unrelenting focus has been understanding financial risk and developing practical strategies for managing the risk created by job loss, illness or disability, bear markets and funding thirty years of retirement. Since 1997, I have watched the job of managing those risks become increasingly complex.
One reason understanding and managing
financial risk is more difficult is the world, in general, changes at such an
incredible pace. Fellow speaker, Vince Poscente, calls it the more-faster-now
culture. The other more sinister reason the job is more difficult is it seems
so difficult to know who to trust. Over the last ten years or so, in the
financial services industry in particular, so many have proven themselves so
untrustworthy.
I am not just talking about the Enrons and
Bernie Madoffs of the world. I am talking about the countless number of
brokerage firms, insurance companies, mutual fund complexes, brokers and
investment managers who continue to sell you products - like mutual funds or
annuities - and lies - like market timing or stock picking - when all the
evidence clearly says those products are only good for the people selling them.
So let me give you some guidelines to help you sort out the snakes from the
good guys.
Transparency
The first criteria is transparency.
Transparency means everything is up front and out in the open. It is the
financial services equivalent of an open kitchen in a restaurant. Ask yourself
these questions:
- Do you know exactly how the advisor is
getting paid, how much and by whom?
- Can you see where the conflict of
interests might be so you can evaluate whether they are coloring the advice you
are receiving?
Requiring transparency will eliminate the
vast majority of advisors working for banks, insurance companies, brokerage
firms and almost anyone selling commissioned financial products. Why is
transparency important? It is quite simple. If someone else is paying the bill,
their interests will likely come before yours.
Truthfulness
The second thing on your checklist is do
they promise the impossible? Ask yourself these questions:
- Do they promise unrealistic returns?
- Do they claim they can predict which way
the market will go or pick the stocks that will do better than average?
- Do they tell you that an investment is
no risk, or change the subject when you ask about risk?
All of these should set off alarm bells in
your head. The first is most pervasive among unregulated entities promoting
active trading strategies. The second will disqualify a lot of advisors -
including an advisor that promotes an actively managed mutual fund. The third
seems to be most common in the variable annuity and life settlement markets but
it also occurs elsewhere. In February, 2008, the Auction Rate Securities market
failed. $200 billion worth of ARSs that had been sold as a cash equivalent
became illiquid.
Remember, there is no such thing as a
risk-free investment. Risk takes many forms. Just because something doesn't
have market risk or credit risk does not mean it doesn't have other forms of
risk.
Expertise
The third criteria is expertise. And you
have to be careful here. We often infer expertise from things that are
meaningless. Being a celebrity doesn't make you an expert. Having a newspaper
column, TV show, radio show or having written a book doesn't make you an
expert. Having hundreds of millions or even billions of dollars of assets under
management doesn't make you an expert. Ask yourself these questions:
- Is the advisor recommending the same
thing a hundred other advisors would or could?
- Is there any original thinking going
into how to solve your specific financial challenges?
- Can the advisor back up their
recommendations, with empirical data, from unbiased researchers, supporting
their recommendations?
My favorite definition of expertise comes
from Mark Sanborn. Expertise is the ability to synthesize existing ideas and
think creatively - to add new knowledge and contribute new ideas to your domain
of expertise. If your advisor spends most of his time reading about sales
skills or practice management rather than the latest academic research, that
should be a red flag.
Behavioral Finance
And finally, knowing, as we do, that
investors rarely act in a completely rational manner as traditional economic
theory would suggest, and knowing that when it comes to investing, our emotions
are our worst enemy, if your advisor doesn't have some sort of emphasis on the
behavioral component of investing, I would be concerned. Ask yourself these
questions:
- Does the advisor address the behavioral
component of investing in their presentation or materials?
- What safeguards or mechanisms are in
place to keep me from sabotaging my portfolio in a fit of fear or greed?
- What safeguards or mechanisms are in
place to keep the advisor from sabotaging my portfolio in a fit of fear or
greed?
The Quantitative Analysis of Investor
Behavior, done each year by Dalbar, tells us that over the twenty year period
ending in 2005, the stock market averaged roughly 12%. Over that same period,
the average stock mutual fund averaged roughly 9%. The average stock mutual
fund investor? Only 4%!
The difference between 4% and 9% is the
result of buying and selling at the exact wrong time and what causes that is
fear and greed. That's the low hanging fruit! If an advisor doesn't emphasize
the behavioral aspects of investing, they are pretty limited in what they can
do for you. Those are my four, although there could certainly be more. I am curious
what you think - about these and about what you would add to the list.