Learn Five Rules For Getting The Best Financial Advice For Your Investment Dollar
- Discover how a financial adviser’s pay structure influences the advice you receive.
- The four different compensation plans and how each impacts your portfolio.
- Five valuable tips that will keep more money in your pocket when dealing with salespeople.
Quick – tell me the difference between a broker and a financial adviser.
If you’re not really sure, then you’re not alone.
Multiple studies show investors are confused – and for good reason. The formerly clear lines of demarcation have been blurred in recent years.
Both offer services that are becoming more similar than different, so why should you care?
The reason is compensation structure – how you pay for the financial advice you receive, and the conflicts of interest it causes.
How your financial adviser is compensated effects the financial advice you’ll receive.
For example, back in the heady days when investment banks still called themselves investment banks, Merrill Lynch settled a $100 million dollar multi-state settlement for alleged wrongdoing and conflicts of interest regarding biased financial advice.
I mention this case not to pick on Merrill, but because it was a high profile, landmark settlement demonstrating a fundamental conflict of interest with brokerage advice.
Every year the financial periodicals report on similar problems with brokers accused of recommending stocks to the public when their firm has an investment banking relationship with the company, and recommending stocks that the analyst owns or the brokerage firm holds a large position in.
The list of wrong-doings also includes churning accounts, recommending inappropriate investment products, and much more.
“History shows that where ethics and economics come in conflict, victory is always with economics. Vested interests have never been known to have willingly divested themselves unless there was sufficient force to compel them.”– B.R. Ambedkar
The motivating cause for each ethical violation is rooted in compensation incentives. Brokerage firms wear too many hats and serve (get compensated by) multiple masters.
How can you possibly be an investment banker to a company and sell that same company’s stock to your retail clients while representing your organization as an unbiased fiduciary giving impartial financial advice? Sorry, but it doesn’t work that way.
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It’s the equivalent of your personal physician writing prescriptions for drugs while being employed by a drug wholesaler and getting paid a commission for his recommendations. Would you trust your health to a doctor with those financial incentives hiding behind his recommendations?
I doubt it, yet people do the same with their financial security every day.
I encourage you to confront every source of financial advice in your life with this question: “Is this person an adviser or a salesperson?” Nobody can be both at the same time.
If they’re an adviser, then they’re paid a fully disclosed, up-front fee for their time and advice. If they’re a salesperson, they’ll be compensated for their advice in other ways. It’s just that simple.
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The Business Reality Of Financial Advice
The sad reality is most investment brokers, financial planners, financial advisers, and financial consultants are euphemisms for the word “salesperson”. They’re paid to either sell investment products or investment management services.
Their business model is driven by gathering client assets under their umbrella and then selling investment products. The more assets under management, the more product that gets sold. They aren’t paid for the ability to make money with money even though that’s the very skill you want from them. Time spent developing investment expertise is a distraction from what puts money in their pocket: selling.
In other words, your best interest isn’t the same as your adviser’s best interest, and there isn’t a compensation structure in existence that can motivate them to care more about your money than their own.
They make money from their business, and you make money from your investments. That’s a critical, fundamental difference.
“The popularity of conspiracy theories is explained by people’s desire to believe that there is some group of folks who know what they’re doing.”– Damon Knight
This isn’t some grand conspiracy theory against the financial adviser community; it’s a natural result of division of labor in business. Brokers are in the sales department and their job is to sell. Management does the managing and research does the research.
Each department’s function is specialized for business efficiency. A broker is no more responsible for investment skills than a secretary is responsible for sales calls. Each cog in the wheel has its function, and the broker’s function is to sell.
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This wouldn’t be a problem if brokers and financial advisers represented themselves as marketing professionals with a product or service to sell, but they don’t. They represent themselves as fiduciaries and investment experts, which is where the problems begin.
Anytime financial advice comes from someone with a product or service to sell, treat that advice as if it’s coming from someone peddling used cars, computers, sofas, or any other product or service.
You wouldn’t view a used car salesman as a fiduciary representing your interests, so why is your financial adviser any different? They’re both salespeople who must get in your back pocket to fill their own back pocket.
I know that sounds harsh. There are many financial advisers furious with that statement, but it’s true nonetheless. Their advice is impacted by how they get paid. It’s not a grand conspiracy theory. It’s the inherent nature of the business.
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How Compensation Biases Your Financial Advice
The choices for compensation in the financial advice business are varied with no perfect solution. Every compensation package creates incentives that affect the quality of financial advice you receive.
Below are the four most common compensation structures and how they bias financial advice:
1. Commissioned Sales
Transaction commissions motivate the sales person to create transaction activity and to concentrate activity on high commission products.
It’s all too common to hear about brokers being sued for churning accounts and selling high commission investments to their clients regardless of suitability to capitalize on graduated commission incentives.
Commissioned sales have the greatest conflict of interest of any compensation structure. The incentives created for the broker have no congruence to the client’s interests and can sometimes be diametrically opposed.
“Fortunately for serious minds, a bias recognized is a bias sterilized.”– Benjamin Haydon
2. Percent of Assets Managed
An alternative pay structure for financial advice is “percent of assets” management fees. This is a superior alternative to commissions, though it’s not without its own flaws.
When I ran a successful hedge fund under this compensation structure, our motivation was to maximize consistency of returns rather than profits. The reason was simple: consistent returns maximizes client retention, which maximizes the investment adviser’s profits.
Volatility scares clients away, even if it might put more profit in their pockets.
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3. Profit Incentive Fees
Under this arrangement, the adviser is paid a percentage of profits from your account. This sounds great on the surface because the adviser is only paid when you make money, implying congruent interests. Unfortunately, that’s a half-truth.
The adviser shares only in your profits, not the losses. This motivates the adviser to take greater risks in hopes of creating larger returns so he can get paid more.
Why? Because the capital he’s risking is yours – not his. However, the money he’s earning is both yours and his. From the adviser’s standpoint, it’s a risk-free return because the loss is yours to bear, but the gain is shared.
You may or may not end up with more profit, but you’ll likely get more risk with this incentive structure.
4. Fee-Only Advice
Fee-only financial advisers are paid by the hour for financial advice. They shouldn’t receive any other reward such as transaction commissions, residual trailer fees, or back end revenue.
Paying by the hour is probably the closest you’ll come to getting financial advice that isn’t biased by compensation. However, you should be aware that your financial advice will still be biased by the limitations of the adviser’s experience, education, skill, and intelligence.
Examples of fee-only financial advice include fee-only financial planners and my educational coaching services. The sole motivation of a true fee-only adviser is to give you as much valuable financial advice as possible for the dollars you spend so you’ll continue to purchase more services.
But beware of people who hang their hat as “fee-only” because few are truly fee-only financial advisers (watch for back-end kickbacks!). The reason is because “fee-only” isn’t the most profitable business model, so few actually operate in its true form.
In fact, that was one of the challenges I faced in becoming a financial coach. I could make more money if I sold financial products or managed money directly, but I believe the client is best served by separating the financial advice function from the investment product sales function.