By Matt Koppenheffer | September 19, 2012
There are a lot of ways that stockbrokers and financial advisors can take -- and have taken! -- advantage of investors. Some charge egregious fees that leave their customers little chance of meeting their investing goals, others trade up a storm in customer accounts to pad their own bottom line, and yet others sell their customers products that are wildly inappropriate for that customer's situation.
If you get me started, I could go on for a long time on some of the horror stories I've heard. We shared some of these stories earlier this year in our special report on financial advisors.
However, as we close in on The Motley Fool's Worldwide Invest Better Day on Sept. 25, I don't want to simply focus on what can go wrong with an advisory relationship. Instead, I want to look at ways you can avoid ending up with a bad advisor.
One thing many investors don't understand is the difference between a suitability standard and a fiduciary standard.
Under the suitability standard, brokers or financial advisors do not -- believe it or not -- have to recommend investments that are in your best interest. All they have to do is prove that they've recommended investments that are "suitable" for your situation. This suitability standard is a very low bar for advisors to meet, and you can probably imagine how easy it is to abuse it.
On the other hand, a fiduciary standard requires legally that an advisor do what's in your best interest. Yes, it may seem silly that all financial advisors are not required to act in your best interest, but that's simply the way the industry is right now. The bottom line, though: When looking for a financial advisor, prefer -- if not require -- a fiduciary. At the very least, make sure you understand the crucial difference between the suitability and fiduciary standard and what that difference means to the advisor you're working with.
When it comes to branding in the advisory industry, many people gravitate toward names like Bank of America's (NYSE - BAC) Merrill Lynch, Morgan Stanley's (NYSE - MS) Morgan Stanley Smith Barney, or JPMorgan (NYSE - JPM) simply because they have major, well-known brand cachet.
If you want to focus on brand when you're buying a TV, a pair of jeans, or a purse, be my guest. When looking for a financial advisor, though, that can be a big mistake. To be sure, there are plenty of good, quality advisors at places like Merrill Lynch. But that doesn't matter if the particular advisor(s) for Merrill in your area aren't the right fit for you.
Instead of focusing on brand, zero in on whether a particular advisor is right for your situation. Meet with the advisor face to face. Ask questions and make the advisor take the time to explain to you the way he or she works. This isn't a first date with a potential lifelong spouse, but it is an initial meeting with a person that you're thinking about trusting your life savings to, so it's essential that you're comfortable with how he or she operates.
Many a shady broker and financial advisor has gotten rich off clientele who don't understand the hefty fees they're being charged.
This one is easy: Make sure you understand how, and how much, you're paying your broker or advisor. If you can't figure it out on your own, ask the person to explain it to you. There's no reason this part of the relationship should be a mystery, so if your broker or advisor won't explain his or her pay to you, or doesn't do it in a way that makes it clear, it may be high time to look for a new advisor.
While you should always understand fully how your broker or advisor is paid, it's also important to understand that there are multiple advisor compensation models to choose from.
Many of the old-time broker/advisor relationships relied on a relatively opaque fee structure that had brokers getting an upfront sales fee when a client bought a mutual fund, and perhaps augmenting that with a smaller annual fee if the client continued to own that fund. Unfortunately, this compensation model gives your broker a lot of incentive to do a whole lot of what you don't want him or her to do: trade.
Fortunately, other compensation models are now widely used. In one, the broker/advisor charges you based on the amount of assets you have in your account. An example might be paying an advisor 1% of your assets, which means that if you have $100,000 in your account, the advisor would take $1,000 per year. Another advisory model that's growing in popularity is the pay-per-hour model. This works the same way as paying a lawyer or a personal trainer: The advisor has a per-hour rate, and what you pay is based on how long the advisor works with you and your account.
Each of these models has its own benefits and drawbacks. The per-hour model, for instance, cuts down on many conflicts of interest, but the client still typically has to handle the actual buying and selling in the account. Knowing what models are available, however, can help you pick out the right one.
Investing better can mean learning more so that you can do better in picking the right investments by yourself. But investing better can also mean learning more so that you can wisely choose somebody to help you manage your money.
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