I usually recommend that investors avoid commission-paid financial advisors.  The conflict of interests created by commissions is too great to overlook.

Of course, that still leaves several options:

• Advisors who charge a fee equal to a percentage of your portfolio,
• Advisors who charge hourly fees,
• Advisors who charge a flat annual (or quarterly) fee,
• Advisors who charge flat fees for specific services,
• Advisors who use various combinations of the above.

So how should you choose between them?

Consider Conflicts of Interest

Asset-based fees: Advisors who charge as a percentage of assets have an interest in keeping as many assets under their care as possible, even when that’s not in your interests (such as when you would be better served by liquidating some assets and paying down debt).

Also, there’s a conflict of interests to the extent that the advisor’s tolerance for income volatility is different from your tolerance for portfolio volatility.

Hourly fees and fee-for-service: Hourly or fee-for-service advisors have an incentive to “over plan,” that is, to sell you services that you don’t really need.

Flat annual fees: Advisors who charge flat annual fees have an incentive to “under plan,” that is, to do the minimum amount of work possible to keep you around.

Personally, I find the conflicts of interests caused by asset-based fees to be the most concerning, though I’d argue that each of the conflicts mentioned above is far less significant than those involved with commission-paid advisors.

Which One Costs the Least?

An advisor might try to convince you that a fee equal to, say, 1% of your assets is a good value because he (or she) will be able to help you improve your returns by more than 1% per year. Such advisors may be correct about their ability to improve returns by helping you avoid mistakes, minimize taxes, and so on.

But that does not necessarily mean that the fee is justified.

If you’re able to find a low-cost advisor, one whose advice is every bit as good and whose fee would only total, say, 0.5% of your portfolio, wouldn’t that be preferable to using the advisor with the 1% fee?

The value of financial advice is not the degree to which it will improve your results. As with every other good/service produced, its value is the lesser of:

1. Its benefit to you, or
2. Its replacement cost–how much you would have to pay another provider for a similar service.

In other words, be sure to shop around!

Yesterday I linked to an article from William Bernstein in which he explains why he no longer thinks that most people are qualified to succeed on their own in the realm of investing. He believes that most people need to hire help.

I’m not sure (yet) whether I agree or disagree. But I do want to point out that if the two options you’re considering are:

1. Do it yourself, or
2. Have an advisor make the decisions for you

…then option #2 is probably at least as bad as option #1. You cannot go meet with a financial advisor and assume that everything will work itself out.

Why? Because as likely as not, you’ll get somebody who doesn’t know what he’s talking about. You absolutely must educate yourself about investment principles beforehand so that you can evaluate an advisor’s competence.

Selecting an Advisor

If I’m in a new city looking for a car mechanic, my goal is generally just to find somebody who I think I can trust. With financial advisors, however, trust is not sufficient.

Yes, trust is essential. But it’s not sufficient. You can find plenty of financial advisors who really do have your best interests at heart, who really do believe in what they’re saying, but who are still going to give you poor advice. I know this because:

1. I used to be one of them, and
2. It was very clear at the time that my limited knowledge about investing was significantly larger than that of most of my coworkers.

My advice is to educate yourself first. Take the time to read a few books. Then develop a list of specific criteria that you will use when evaluating a potential advisor. For example, Bill Schultheis (author of The CoffeeHouse Investor) suggests the following two requirements:

1. Fee only (as opposed to commission-based compensation)
   
2. 100% passive in entire portfolio.

To those I would add a few of my own suggestions:

1. Ask what the advisor sees as the primary purpose of his/her service. (If he/she says anything at all about helping you earn above-market returns, it’s time to keep looking.)
2. Make a list of the fees you’re aware of. Then ask “Is this everything?” Repeat until you’ve been explicitly told that your list includes all of their fees.
3. Ask a few test questions simply to try and determine the advisor’s level of competence. For example, you might want to ask about his views on market efficiency or asset location.

[Quick note: If you're looking for somebody who will help you with your entire financial picture rather than just your investment portfolio, there's a whole slew of additional considerations. For the moment, I'm speaking only to the question of finding somebody qualified to advise you on your investments.]

Great guy, or great advisor? You need to know the difference.

It’s not enough for an advisor to show the he cares about you and your goals, and it’s not enough for you to use an advisor rather than bothering to learn about investing. You must have a decent amount of background knowledge so that you can determine whether or not an advisor is demonstrating an acceptable level of professional competency.

My (slightly) tongue-in-cheek reply to Carl‘s most recent sketch:

Sorry for my poor freehand drawing skills in GIMP.

If you had a friend who had come out ahead each of the last 5 times he went to Vegas, would you feel comfortable giving him your life savings to use the next time he went? Of course not.

So why do we let financial advisors take our savings to Vegas, so to speak?

Admittedly, there probably are investment managers who have a genuine ability to earn above average returns without incurring above average risk. (Name your favorite: Buffett, Swenson, etc.) But they’re generally going to be very busy doing just that.

They’re not going to be available to take your phone calls. They’re not going to sit down with you to determine your appropriate asset allocation, how much money you’ll need in order to retire, or how much it will cost little Jenny to go to college in 14 years.

Any financial advisor who tells you that he can do both is either misinformed or misleading you. (In most cases, I’d bet on misinformed.)

Ben Graham on Financial Advisors

While reading Bogle’s Enough last week, I came across this delightful explanation by Benjamin Graham as to what a financial advisor’s job should be:

“A well-trained financial analyst can [justify his existence] by adhering to relatively simple principles of sound investment ; e.g., a proper balance between bonds and stocks; proper diversification; selection of a representative list; discouragement of speculative operations…And for this he does not need to be a wizard in picking winners from the stock list or in foretelling market movements.”

So what, according to Graham, should financial advisors be doing?

• Helping clients with asset allocation decisions,
• Selecting a “representative list” (that is, a group of stocks that will mimic the returns of the overall market–now made effortless via index funds), and
• Discouraging speculative operations.

And what should financial advisors not be doing?

• Trying to “pick winners from the stock list,” and
• Trying to “foretell market movements.”

Sounds like a good financial advisor to me.

I subscribe to a daily email list called Help a Reporter Out. Essentially, reporters write in with stories they’re working on, and experts/bloggers/whoever else can email them to provide information.

Today, a particularly noteworthy request arrived:

“In a time when some clients are blaming their financial advisors for their terrible portfolios, I’m looking for someone who is trying to repair that relationship and restore trust, perhaps even through counseling.”

Seriously? Counseling?! If you’re not only paying a financial planner, but paying a psychiatrist to help you deal with that planner, then let me make this clear: You’re paying too much for financial advice.

Just take your money, put it in a target retirement fund, and stop worrying about it.

[Note: My intent here is not to discredit either psychiatrists or financial planners, but rather to say that the use of one should not necessitate the use of the other.]