In retrospect, Debbie Klug knows she shouldn't have trusted him with her family's nest egg. "If you're not comfortable with somebody," she said, "just don't go there." It was a lesson hard learned.
Her previous experience working with a financial advisor had been a positive one. The advisor was part of a fee-based practice and he went to great lengths to get to know his clients. Klug parted ways with that advisor for a few years, though, and when she sought him out later, he had joined a company that didn't take clients with less than $3 million in liquid assets. He pointed her in the direction of another advisor.
The new advisor immediately made Klug uneasy. "I didn't like the way he made predictions. I just don't think the market is something that can be predicted and he was predicting things 10 or 15 years down the road." Trusting her original advisor's recommendation though, she handed over the keys to her accounts.
What followed could be used as a worst-practices guide for financial advisors.
Josh Brown, a financial advisor and author of Backstage Wall Street, said that a good advisor focuses on this question: "What's the client's real need?" Klug's new advisor asked very few questions and so had no way of knowing her needs. In fact, Klug got the impression that her advisor "really didn't care." This was another bright red flag.
Without an open communication channel, the problems only compounded. Klug never ended up with a clear understanding of how the advisor was being compensated. "I never paid him directly," she told us. "So I don't know how he got [paid]." According to David Lo of JD Power and Associates, this isn't unusual, as less than half of advisory clients say they "completely" understand the fees they're paying. Nor was Klug's extreme dissatisfaction surprising -- Lo also noted that client satisfaction is closely tied to advisors' communication efforts.
The advisor's investment recommendations were no better. The investment approach that Klug learned from her father was to first have "ready money," then a fallback stash of "safe money," and finally, investments. For this advisor, the strategy was "to invest it all." The bonds that Klug had kept aside as safe money were sold and reinvested in mutual funds. And while that alone was enough for her to lose sleep, the advisor either didn't know or didn't care about the tax implications of what he was doing, and Klug was "hit like a ton of bricks at the end of the year by taxes."
The advisor also made downright odd recommendations, including suggesting that the family take out a home equity loan to pay for their son's college tuition -- when he was just starting his junior year in high school. It was a recommendation that they didn't follow.
To top it all off, at the end of the day, Klug said, "I didn't feel like I was making any more money with him than with Vanguard" -- referring to the pioneer of low-cost index funds.
She ended up doing the only thing that made sense: She dropped that advisor like a bad habit and moved her money back to Vanguard.
There is a right way to do this
Talking to customers like Klug, it doesn't take long to come to the conclusion that for many clients, the financial advice industry just isn't working. For some, it's spending money on a service that doesn't seem to add much value. For others, it's an outright disaster as poor communication, misaligned incentives, and high fees cripple financial standing and dash hopes of retirement.
But is it as easy to pick out advisory relationships that are healthy and successful? To find out, we talked to a wide range of industry experts from Josh Brown and David Lo to University of California professor Terrance Odean, as well as Carl Richards, author of The Behavior Gap, among others. In our conversations, three elements of a successful, valuable advisory relationship came up over and over again:
- Creating a financial plan.
- Combating behavioral biases.
- Employing clear and illuminating communication.
These aren't the only elements of a really great advisory relationship, but if you can identify these three key components in an advisor, then there's a good chance that you're getting real value from the relationship.
Creating a financial plan
As the director of the Financial Services practice at quality-ratings giant JD Power, David Lo knows a thing or two about measuring the value of a financial advisor.
Regarding client satisfaction, Lo told us that "what we see is that satisfaction is correlated highly with best practices." Which begs the question, "What are best practices?" At the top of the list, Lo puts "[having] a written financial plan."
New York Times columnist and financial advisor Carl Richards further underscored how important a plan is:
The big story is that nobody is writing about is that nobody can make investment decisions in a vacuum -- it all depends on the situation, goals in life, etc. Good investment decisions can only be made in the perspective of something larger. ... We all want to take a plane, train, or automobile, but we have no idea where we're going.
As important as this is, it's also easy to ignore. I learned this through personal experience when I sought out a financial advisor -- Will Duncan, a member of the fee-only Garrett Planning Network -- because I realized that my wife and I had a portfolio full of investments and a vague idea of where we wanted to end up, but no plan for getting there.
As Duncan explained:
Until people have gone through the process they haven't really solidified their goals. Sometimes we go through life and get so busy with the day-to-day stuff. If you don't keep your eyes on the prize, it's tough to get there.
According to research from industry watchdog FINRA, overlooking planning isn't unusual. Among non-retired households, 58% haven't tried to figure out what they need to save for retirement.
An investor doesn't need a financial advisor to build and follow a plan. But will they do it on their own? Edward Jones managing partner Jim Weddle quipped, "I make a New Year's resolution every year to lose weight, but I never do. Why not? Because I never pay for a trainer or coach." A good advisor takes exactly that role, or, as Weddle put it, "We bring discipline to our clients' savings and investments."
Judging an advisor on this component is much more than checking a box though ("Yup! He gave me a printout that says 'financial plan.'"). Today, cheap software can spit out a sharp-looking yet generic "financial plan" in no time at all, which allows some brokers and advisors to fake their way through this crucial step. By contrast, a worthwhile financial plan grows out of probing questions, a sharing of in-depth financial information, and a relationship with the advisor.
Combating behavioral meltdowns
The facts are plain: We're not wired well to make consistently good, sober financial decisions. That's why it can be a big help to have a third party keep our undesirable emotional impulses in check.
Richards, who wrote The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money, put it to us this way: "Unless we see Warren Buffett in the mirror, we need somebody to help us avoid making those genetic behavioral mistakes. ... An investment advisor is a behavior modifier ... that helps us follow some of the best advice that Buffett's ever given: Help us be fearful when everyone else is greedy."
Few know more about the subject of behavior-induced investing mishaps than Professor Terrance Odean. He's a leading voice in the growing field of behavioral finance whose work has covered topics such as overconfidence, excessive trading, regret, and investors' tendency to hold losing investments and sell wining ones -- also known as "the disposition effect."
When asked about the value of financial advisors, Odean replied, "Good financial advisors basically encourage investors to follow good investment practices. Left to their own devices, investors don't do that." He added that sometimes a good advisor is someone who simply "[injects] common sense where it's needed."
Finding a broker or advisor that actually delivers on this is easier said than done, though. A recent paper (PDF file, Adobe Acrobat required) from the National Bureau of Economic Research that audited and evaluated financial advice came to an ugly conclusion:
The advice by and large fails to debias and if anything may exaggerate existing biases. ... The evidence further suggests that advisor self-interest plays a role in generating the low-quality advice even when incentives of both the advisor and the client are aligned ...
In short, in some cases, not only did the advisor not combat the behavioral biases, he made them worse.
The results do, however, suggest two ways for customers to increase the chances that their advisor does steer them away from biases. First, certain fee structures in the industry actively incentivize brokers and advisors to encourage behavioral biases like overtrading. The NBER team notes that their results are "in line with an interpretation where the advisor's goal is to maximize fees by placing more weight on actively managed funds that create more income for the advisor." And further, "evidence suggests that most of the interaction is driven by the need to generate fees rather than to respond to the clients rebalancing needs."
For customers looking to avoid this outcome, fee-only financial advisors have a compensation structure that is much more aligned with clients' interests.
In addition, customers should look for advisors that are willing to tell it how it is from day one. Unfortunately, the NBER paper notes evidence that many advisors pussyfoot around delivering the hard, but necessary, truth to clients because they're too concerned with winning or keeping their business. When it comes to battling behavioral biases, an advisor like that is useless.
Clear and illuminating communication
David Lo at JD Power has seen the huge difference that communication makes in terms of customer satisfaction. "A huge part is the relationship with the advisor," he said. That means not only "courtesy, friendliness, and responsiveness," but, maybe more importantly, "did your investment advisor talk about investment performance, etc." According to Lo, a "yes" answer to the latter "significantly raises" satisfaction scores.
David Shucavage of Carolina Estate Planners suggests that clients ask themselves: "Does this person really listen to you and ask questions of real depth? Do they understand what it will take for the money to bring you peace of mind?"
Just like in any other profession, though, there is doing what is necessary and then there is going above and beyond. Motley Fool co-founder David Gardner suggested that one way an advisor can do that is to don the professor cap:
This isn't something I'd require, but it's something that I'd seek: education and engagement. That the advisor is helping the investor learn and grow. I realize some people may not want this, but the best financial advisors should enlighten.
In a similar vein, Edward Jones' Jim Weddle referred to the company's advisors as "coaches" and "financial trainers" -- a label that underscores that this relationship can be more than "Here you go, do this for me."
Putting the pieces together
These qualitative aspects of a good advisory relationship help set the stage for achieving the client's financial goals. But they're no guarantee of success. As Neal McNeil of Ibis Capital told us, "If the client needs a certain rate of return and [the advisor isn't] accomplishing that for them, then the plan doesn't work."
Investment returns are a tricky subject in the world of brokers and financial advisors, and many industry participants are loath to tackle the topic. In the next section though, we take on this sticky subject in an effort to figure out how advisory clients can strike a balance between achieving returns while avoiding fast-talking brokers just looking for their next big payday.