Is your investment advisor honest?

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Among the hardest things to do in managing your investments, I would say, is to find an honest advisor. The task is daunting. But commonsense provides a solution.

Honesty refers to a facet of moral character and denotes positive, virtuous attributes such as integrity, truthfulness, and straightforwardness along with the absence of lying, cheating, or theft. (Oxford English Dictionary)

Honest investment advisors do exist — in fact, there may be hundreds of thousands of advisors who have a high degree of integrity.

The problem is to distinguish the honest from the rest.

Do you need an investment advisor?

If you are in good health, of sound mind, blessed by commonsense, and of above average intelligence, and if you have time to dedicate to your own affairs, I would suggest that you consider managing your own portfolio.

By being your own advisor, you can:

1. Be assured that your advisor is on your side;
2. Save a lot of money;
3. Avoid being ripped off by an advisor with a conflict of interests.

The details of the certified financial analyst curricula can be found on the CFA website. There are innumerable sources of training in financial analysis available on the Internet, including distance learning courses, video training material, and books and course materials.

The self-taught analyst

If you are like me and prefer to be self-taught, the same books and materials used in these courses can be easily acquired. In many parts of the world, learning material is available in libraries at no cost.

Don't knock being self-taught. The Wright brothers were self-taught engineers who invented the first airplane.

If you are reading this article, you probably have what it takes to be your own investment advisor.

The time it takes to learn to be your own advisor depends upon your investment situation and goals.

• If you have limited assets and will probably invest only in mutual funds, there is no need to study the intricate details of collateralized mortgage obligations.
• If you are managing your retirement portfolio, you may prefer conservative, income investments and will not need to study the intricacies of day trading or derivatives.

In any event, most of what you need to know can be found somewhere on the Internet if you have the time and patience to look for it.

Three rules for hiring an honest advisor

If you are not able to be your own advisor for any reason, you’ll have to find someone to provide you with this service.

You should expect your advisor to be someone who will recommend securities to buy and sell from time to time, in order to maintain an asset portfolio that is consistent with your economic needs and prudent goals.

You should not hope to find an advisor who will be a second Warren Buffett and who will multiply your assets ten thousand times.

What you should not expect is advice that will consistently provide total returns on your portfolio that match or exceed average total returns in the market. You should not seek competitive financial performance. If your needs require that you preserve your assets to provide income on retirement or pay for your child’s education — it is more important to save more and preserve what you do save than to gamble in day trading, hoping to beat the wizards of Wall Street.

With this in mind, here are my three rules:

1. In any year, never spend more than 1% of the value of your portfolio on investment advice.
2. Only pay an investment advisor on a time basis, never on performance or as a percentage of your portfolio or in commissions on your trades.
3. Never give your investment advisor control over your assets. Here is how it should work: your advisor recommends an investment; you decide and give your order to your discount broker, who is completely independent from your advisor and who does not give an opinion on your trades.

Learning from Madoff clients

Every client of Bernie Madoff that lost their life savings on his Ponzi scheme violated rule three, above.

Madoff’s clients gave him absolute control over their assets, along with complete discretion to buy and sell.

This violates the most elementary conditions of financial control. See: The basics of 'internal control'.

High net worth individuals that turn their assets over to major Wall Street firms to manage, with full discretion to buy and sell, violate rule three of finding an honest advisor.  They are asking for trouble.

If the CEO of your investment bank earns $100 million a year in bonuses, it is exceedingly unlikely that you will do well in the long-run.  Extraordinary earnings of brokers are a clear signal that they are looking out for themselves, not their clients.

Mutual funds as advisors

Mutual funds are the exception to rule three because they are regulated as issuers and have independent auditors and custodians. It is easy to diversify investment across a number of funds.

Some of the nicest, most simpatico advisors, will suck your blood.

However, mutual funds do not go into cash when there are signs that a market crash is imminent, nor do they know anything about your personal goals.

Competition among mutual funds for yearly ‘total return’ performance means that they are heavily biased towards short-term relative performance (including non-realized capital gains), rather than long-term absolute results that reflect the interests of most ordinary investors.

If your advisor recommends a mutual fund, be absolutely sure that he or she is not earning a fee on this recommendation.

Some advisors may earn a fee surreptitiously on mutual fund recommendations, without your knowledge.  This is a sure sign of a dishonest advisor and a glaring conflict of interests — although many advisors would not agree.

Setting a limit on your advisor’s fee

The reason you should set a limit of 1% of the value of your portfolio as how much you budget for investment advice is that anything more than this will cut drastically into reasonable returns that might be expected on prudent long-term investments.

If you only have $10,000 in assets, you won’t be able to hire an advisor for only $100 a year (1% of your assets), but you will be able to invest in a mutual fund or exchange-traded fund and get professional management you can afford.

Old-fashioned factory time clock: You don't need to pay your advisor literally by the minute; but rather on the basis of a rough estimate of the time he will spend.

You should pay an advisor for the time he spends on your portfolio and his skill level. The time he spends will depend on your investment goals. If, for example, you have $1 million and want to keep it safe to pay a $1 million debt that comes due next year, you’ll probably invest in a bank CD or treasury bill. It’s not worth $10,000 (1% of your portfolio) to get such simple advice. If fact, such advice might be worth only a couple of hundred dollars, if that.

On the other hand, if you have $1 million to invest and prefer a diversified portfolio of 100 stocks and bonds, your advisor will have to do a lot more work. If you pay him $10,000 for this service, he or she should be able to do the job adequately. However, if you pay more, you’ll be sacrificing too large a share of your assets.

In the United States, over the period 1919-2003, the average yield of AAA bonds was only 5.9%. Over the period 1946-2003, the geometric average annual growth rate of before-tax profits of nonfarm nonfinancial corporations has been 5.3%. If you pay out 1% of your assets each year for investment advice, your paying perhaps 10 to 20% of a reasonable long-term expectation of return on your portfolio. To spend more that this would be unwise.

Not paying for performance

For decades, investment advisors have routinely contracted their services on a pay-for-performance basis.

For example, a hedge fund managers might charge 1% on the value of the portfolio, plus 25% of profits above 8% a year.

Many investors are taken in by this line, reasoning that ‘if Mr. ABC can earn me more than 8%, he deserves to be rewarded for this extra effort.’  This, in fact, is Mr. ABC’s sales pitch.

However, paying for performance has a number of problems:

Think of your advisor as a doctor saving your assets, not as a jockey racing for performance.

1. Investment markets tend to go up or down together, a phenomenon known as covariance. Often, an advisor ‘looks good’ merely because the market went up for everybody. He may have done no more work than in any other year, but would earn a fat bonus in an up year due to performance pay.
2. Pay for performance remuneration usually does not result in the advisor being charged when the market goes down.
3. Pay for performance gives an advisor a motive to take greater risks with your money than are appropriate for your investment goals. In certain times, it might be advisable to hold assets in cash, but a pay-for-performance advisor has no incentive to so protect your wealth.

If you pay your advisor on a ‘performance’ basis, you’ll probably be over-paying him in good years, when the market goes up for everybody, and encouraging him to risk your assets so that you lose more than you should in bad years.

The secret of finding an honest advisor

The secret of finding an honest advisor is really quite simple — don’t give an advisor a chance to be dishonest.

To keep an advisor honest, remove temptation.

If you follow the three rules above, the dishonest advisors will shun you like the plague.

They may argue with you and tell you that your conditions are unreasonable, but they won’t accept these three rules because they won’t be able to rip you off.

There is a corollary of rule two — that goes as follows:

Never take advice from a stockbroker who earns a commission on your trades — especially if the stockbroker appears to be rich and has a home in the Hamptons. Especially, avoid such advice if the broker’s firm engages in underwriting or proprietary trading — signs of an institutional conflict of interests.

I would suggest that you choose a discount broker that allows you to enter transactions on line, without having to talk with a broker, and that you have an advisor on a fixed fee basis, completely independent of any brokerage firm.

What to expect from an advisor

Just as your doctor cannot guarantee that you will live forever, your investment advisor cannot predict the future or select investments that will always work out well.

Don't expect your investment advisor to know the future.

The fact that advisors cannot see the future is a reason they should not be rewarded on the basis of ‘performance’.

However, even without being able to predict the future, an investment advisor can provide valuable services:

1. Information on how the market works, relative risk of different investments, and tax implications of various strategies.
2. Assistance in choosing an investment strategy appropriate to your financial needs.
3. Information on specific investments and advice as to suitability.
4. Recommendations and selection of investments suitable to your needs.
5. Advice on portfolio balancing, appropriate level of withdrawals, and evaluation of progress towards long-term goals.

How to find an advisor

There are hundreds of thousands of investment advisors registered with the US Securities and Exchange Commission. However, many work only on a commission or pay for performance basis and will not agree to the terms suggested in this article.

Remember: A con-man that is not simpatico dies of hunger.

This makes your search for a honest advisors much easier.  Advisors who work only with a conflict of interests will excuse themselves up front.

Before you interview a prospective advisor, you should have the following information ready:

1. The value of assets to be managed.
2. The maximum you are willing to spend annually on investment advice.
3. How often do you expect your advisor to review your situation. Monthly? Quarterly? Semi-annually? Annually?
4. The general purpose of your financial assets.  Saving for retirement? Current retirement income? Saving for a child’s education?
5. How much, if anything, do you expect to be able to add to your portfolio as savings from current income, annually.
6. The type of assets you expect to hold. Real estate? Stocks? Bonds? Mutual funds? Bank deposits?

Many types of professionals offer investment advisory services, including lawyers, accountants, and dozens of varieties of credentialed investment advisors.

With a Google search, you can find many internet sites that list or advertise investment advisors, as well as some search facilities specialized in this field.  Be cautious about revealing personal information over the Internet.

You will want an advisor close to home, so that you can visit his or her offices and make your judgment based on a face-to-face interview.

Check out your advisor thoroughly.  Remember, Bernie Madoff was registered with the SEC for years.  Credentials and a license are not proof of honesty and integrity.

Have any agreement with your advisor in writing and be able to sever your relationship easily, should you be dissatisfied.

It is important that you like your advisor for you are seeking a long-term relationship.  Only remember: Confidence men that are not simpatico, die of hunger.

Your comments

Please add your suggestions and experiences to help other readers.  If you know of an advisor that will provide services on the basis suggested in this article, you may so indicate here.