Many investors believe that financial advice should be free. Although many professionals are happy to oblige with what they call free advice, those who follow their recommendations often pay an unseen price for that guidance -- and the dubious quality of that financial advice can lead to poor results.
The hidden way you pay for financial advice
The money management industry knows that if you have to pay money up front to get an appointment with a stockbroker or financial advisor, you're a lot less likely ever to set up that appointment in the first place. Yet they also know that the brokers and advisors who drive sales in the business need to get compensated, and money managers rely on those salespeople in order to gather assets under management.
To solve that problem, financial professionals have traditionally relied on commissions. Those charges can take a number of different forms, ranging from clear and concise fee schedules for certain services to less obvious means of funneling compensation to advisors. For instance, Morgan Stanley (NYSE:MS) and Bank of America's (NYSE:BAC) Merrill Lynch unit charge minimum stock commissions well above what you'd get at self-service discount brokers, with Merrill having raised its minimum fees for stock purchases from $50 to $75 last year. Morgan Stanley's Choice Select program has sliding tiers based on the volume of trades you perform, with fees ranging from 0.60% to 2.25%.
With commissions, at least, it's clear that you'll pay for financial advice at the time you make an investment. But other less obvious fees also lurk underneath the surface. For instance:
- With some advisor-sold mutual funds, front-end sales loads act like commissions, diverting a percentage of your initial investment to cover the cost of paying the salesperson who sold you fund shares. But other classes of funds can tack on an annual charge, some of which can go to compensate financial professionals on an ongoing basis. Over time, those recurring annual charges can exceed what you'd pay on an up-front commission.
- In addition to mutual fund marketing-related fees, funds often have revenue-sharing arrangements with the financial companies that sell fund shares. Under those agreements, the fund might agree to compensate the selling company for expenses like investment research and subscription services. Such soft-dollar incentives lead the professionals working for you to direct their business to those funds, even when they might not always be the best solution for your particular needs.
An arguably better way to pay for financial advice comes from asset-based fee-only arrangements. With these models, you pay a percentage of the total assets your advisor manages for you. As long as the arrangement is fee-only, rather than simply fee-based, you won't see commissions come out of your account.
The benefit of fee-only financial advice is that you know up front what you're going to pay. Yet again, there's not necessarily any correlation between the amount of your fee and the service you receive. One customer might have a tenth the assets of another yet need more guidance with their finances, and in such a case, the less affluent customer would get much greater value for the fee they pay than the more affluent customer.
The old-fashioned way to pay
Paying an hourly rate or fixed dollar amount for financial advice isn't all that common, but when you think about it, it makes the most sense. That way, what you pay is directly tied to the service you get. It also gives you an incentive to build your own expertise so that you don't have to rely as much on the professionals you work with.
For many investors, professional financial advice is something worth paying for. But don't cheat yourself by paying too much without even realizing it. When free advice seems too good to be true, rest assured that you're paying for it somehow.
Fool contributor Dan Caplinger owns warrants on Bank of America. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.