What does the 8th wonder of the world have to do with selecting an investment professional?
Full disclosure - I started in financial services as a retail broker with a well-known national firm, but I didn’t last long as a broker. Why? As a true believer in the power of compound interest which is often described as the eighth wonder of the world, I quickly learned that it was virtually impossible to do what was in the best interest of my clients, make my sales quotas as a broker and still allow my clients to enjoy the greatest possible benefits of compounding.
Brokers are not advisors
Consumers should understand that the retail financial world falls into two camps; brokers who are licensed to sell and registered investment advisors (RIAs) who are licensed to give advice. Today’s brokerage firms give their representatives titles like “consultant” and “wealth manager”, but pull back the curtain and you realize that they are actually salespeople who are held to a minimal legal standard of selling investments that are simply “suitable and appropriate”. Sadly, I have seen and heard far too many stories of the damage done by brokers who sold investments, usually with high commissions, that might have been “suitable”, but were far from being in an unsuspecting client’s best interest. When dealing with a broker, essentially the law says buyer beware!
RIAs are held to a much higher standard. They are paid for their advice and thus legally have a fiduciary duty to do what is reasonably in the client’s best interest. This is why many investors are leaving traditional brokers and turning to RIAs for financial advice. RIAs commonly charge for advice based on a percentage of their clients’ “assets under management”. To capitalize on the trend, many brokers now obtain licenses that qualify them as RIAs so that they too can generate asset-based fees. However, investors must be cautioned that these “broker-advisors” are not required to exercise fiduciary responsibility when acting as a broker, meaning that even with a dual-licensed representative, the law essentially still says buyer beware!
What is a reasonable fee?
Because the services are presented as “just 1% of assets” many investors think that this is a small price to pay for professional management. However, a competent financial professional can quickly show you how even just a 1% fee can effectively be a bigger drain on your returns than taxes. Making matters worse, investors must sometimes even pay fees on cash or on a windfall like an inheritance or a bonus without receiving any additional service or value. Finally, before you agree to these fees, keep in mind that even a 1% fee on a $500,000 portfolio will cost an investor $5000 annually or roughly $1000 per hour for a competent professional!
Financial visionaries such as Berkshire Hathaway’s Warren Buffett and Vanguard’s John Bogle have written and spoken extensively on the harmful impact of exorbitant fees, but the industry has convinced millions of investors that this is a sensible way and a sensible price to pay for advice.
Pardon me ma’am, but can you spare $390,000?
A better alternative – fixed and hourly fees
Your advisor is of course entitled to make a living. Smart consumers are increasingly turning to competent “fee-only” advisors that charge only flat or hourly fees for their services, similar to other professionals like doctors, lawyers and accountants. In addition to the lower costs typical of this consultative approach, fee-only advisors have less incentive to recommend unreasonably risky strategies because they receive no personal benefit from the growth of your portfolio. Fee-only advisors also have no incentive to advise you to convert other valuable assets like real estate and collectibles to cash and securities simply so that they can generate fees.
Finally, a fee-only advisor only gets a raise when you authorize it, not simply because the markets went up or your investments paid interest (note that the advisor in the example above gets an average 8% raise every year). This leaves more of your money working for you and your family. Thanks to the eighth wonder of the world, that’s a powerful argument for working with a true fee-only advisor.