Choosing a Financial Advisor (white paper excerpt)

In our soon-to-be-published white paper, “Redefining How to Choose a Financial Advisor” we follow a train of thought from a common method for finding an advisor, starting with a conversation I had a year or two ago, and then taking a step back and looking at the process in a new way.  One step in that process is defining your own “mental map” for what you want that relationship to be like.   In the paper, we examine a few of these schema with the hope that the reader can either use one of ours of construct their own after going through the exercise.  We delve deeply into the topic in that paper, but I wanted to advance a piece of it now, because I continue to see articles in the financial press that do the topic a huge disservice.  This is not a simple checklist to follow, or a process for choosing an advisor.  It is an alternative way to look at the question.  It seems like the investment industry is so impressed with our collective sophistication that we market it aggressively to our collective clients, leaving them convinced that even relatively simple questions, like finding somebody you can trust to help you out, become intractable.  Because human beings are “inference machines” here is a simple scenario to compare to picking an investment person. 

Did you hear some clunking from under the car hood?  Maybe a mystery light just went on deep in the dashboard?  Time to call the mechanic.  What, you don’t have a mechanic?  Well, better find one.  Lets look at how you might do it, and see if we can find any parallels to the question at hand.

How would you choose an auto mechanic?

First, let’s look at why you would bring your car to a mechanic in the first place.  It is because you cannot fix it as well yourself.    There are a few basic probable reasons.  First, you may not know anything about fixing cars.  Second, you may not have the time to fix it yourself, or have other activities that are more rewarding that you could do with your time.  Third, you may not have all of the necessary tools, or the specialized tools to do the job quickly.  Last, you might have a car that is so intricate that you would only trust the work of a pro.  There may be other reasons, but this covers what I think are the most common situations. 

Choosing an auto mechanic can be awfully stressful for people that don’t know a lot about cars.  It is just so hard to know if they are inflating the bill, or making recommendations to replace things that don’t need replacing.  If that happens to you, the odds are pretty good that you are not going to go back, but you only find out after the fact, and by then it is too late.  Sound familiar?  This sounds a lot like the quandary of picking a financial advisor to me. 

Consumer reports has a brief discussion on choosing an auto repair shop. They observe a few salient points worth repeating. 

Their recommendations:

• According to a survey [they] conducted, people who used independent mechanics were generally more satisfied than those who had their car serviced at a dealership. (www.consumerreports.org/cro/2012/12/how-to-find-a-great-car-mechanic).  Independent repair shops presumable rely on steady repeat business from a small group of loyal consumers, and because of this, and the lack of “Name Recognition” that comes from not being part of a big brand, they may tend to deal fairly with their clients, and avoid some of the less savory practices that might exist in their industry. This may also be true of independent investment advisory firms.  The less they can bank on some big reputation, and the less they can get automatic clients, the more inclined they could be to deal fairly.  I don’t mean to imply that larger firms are more prone to chicanery, but a culture of abuse at a large organization can certainly cause systemic abuse.  It is probable to me that a small firm would be crippled by systemic abuse, and therefore the odds would seem better that it would be avoided.  Larger firms are also more likely to have “goals” for their advisors, and bonuses that go along with the achievement of those goals.  I think goals for revenue production and incentives along these lines are a problematic issue.  A small independent firm does not generally have as much reliance on such an incentive structure, in my experience. 

• “Seek recommendations, particularly from people who have the same kind of car.”   You wouldn’t go to the most expensive mechanic in town that specializes in pricey foreign imports to repair your 1980 Pinto.  You wouldn’t spend the money.  By the same token, you probably would not go to the local boneyard mechanic to fix your new Benz either.  Choosing the professional that matches your need is important.   When choosing an advisor, talk to people who are in similar circumstances to yourself.  But don’t limit yourself to that, really examine what the experience is like, and make sure that it matches what you need.  Also, in this case, you might look a little further down your own road, and try to find somebody who has skills that will suit what you hope your future needs will be. 

• Search the internet.  There are sources of information on car repair places, with local reviews.  This is more challenging when it comes to financial advisors, but it can help to move you along if you do a little homework. When you look at their website, do they seem credible?  Do they have valuable content there?  If you go to FINRA.org are they listed?  If they are not, where are they regulated?  Are they listed on the SEC website?  If not check the state securities administrator to see if they are regulated by the state.  I personally prefer to see an advisor who is regulated by the SEC and FINRA, and you can look at their records to see if an advisor has ever been found to be guilty of any financial malfeasance.  I advise that you stick with the more powerful regulators, and the more regulators, the better the odds are that somebody misbehaving will get caught.  A Financial advisor doing business in any state is going to be overseen by the state securities administrator (if they engage in financial advice or securities) the state insurance commission (if they are engaged in offering insurance), The Financial Industry Regulatory Authority (FINRA) (if they are registered brokers, traders or principals with that body), and possibly the Securities and Exchange commission (if they are with a large enough firm, or choose this because they operate in a number of states). 

• “Check for Certification” [or credentials] Auto mechanics are generally ASE certified.  In the financial world there is a veritable alphabet soup of different certifications, and a number of certifying bodies.  Make sure that these are appropriate to your needs.  There is a lot of discussion about this in plenty of other articles, so I will not spend more time on this than is required to say that credentials are useful as guides, but understanding what they really mean is important if you are going to use them.    Also keep in mind that if you go to an independent repair shop that has been around for twenty years or so, the people running it probably know their stuff. Consider that the certification for an Auto Repair person is graded in 1, 2, and 3 year experience levels and that the course work is about 81 hours. (Source: http://www.tatidelval.com/courses/).  If you add in three years of work, at forty hours per week, with two weeks of vacation, that would be about 6081 hours.  This probably does not compare to the amount of time fixing cars for twenty years.  Using the same work and vacation logic, you are looking at about 40,000 hours.  Applying the same logic to the CFP, there are 6 modules each expected to take between ninety and and one hundred and twenty hours.   There is a requirement to have been in the industry for three years prior to certification being awarded.  So, that is an average of six hundred and thirty hours plus about six thousand hours of work, for a total 6681 vs 40,000.  Credentials are then more relevant for a newer entrant, to establish their basic bona fides.

• “Give the shop a tryout.”  With an auto repair shop, you can go in for small repairs, and see how they treat you.  In the financial advice world, this is the equivalent of opening up a small relationship with someone to test the waters.  There are a couple of reasons that this is a challenging way to evaluate a financial advisor.  First, advisors will generally allocate their time by the responsibilities that they are charged with, so you may not get as much of their time as you would have otherwise, and this could skew your perception of their responsiveness. You also might not get a good example of the advisors skills, if you are holding back from them.  It is tough to really help somebody on a trial basis.  On the other hand, you will get a chance to figure out if you like them, and that you can rely on them, and evaluate whether you can trust them.  This is probably not a bad approach, just remember that it does have limitations.

• Ask about warranties.  For all practical purposes, this is out of the question, Advisors are not able to offer warrantees, but the analog for financial advisors would be to look for an advisor that acts as a fiduciary.  There is a lot of information on this topic available, but in short a legal fiduciary is: “A person or company that has the power and obligation to act for another under circumstances which require total trust, good faith, and honesty. Fiduciaries can include trustees, business advisers, attorneys, guardians, administrators of estates, real estate agents, bankers, stock brokers, title companies, or anyone who undertakes to assist someone who places complete confidence and trust in that person or company.” (Source: Nolo.com)  A fiduciary has a legal obligation to work in the best interest of their client.   If this is important to you, an advisor that acts in a fiduciary capacity would probably make sense as a criteria.

So, it looks like we can take the model of choosing an auto mechanic and apply it to choosing a financial advisor.  This is a practical comparison, because in many ways a financial advisor is like a mechanic.  A financial advisor takes something in need or maintenance (in this case your financial life) and fixes it up so that it runs smoothly.    A mechanic has specific tools for this purpose that the average person does not.  They have worked on other cars, and seen a variety of problems.  A financial advisor translates the experience of other clients and other situations to help you.  Both  have specific technical expertise that can make a complex system, like a modern automotive (or a modern financial life), work smoothly.

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