Essential Insights to Know Before Choosing a Financial Advisor
“We are what we repeatedly do. Excellence, then, is not an act, but a habit.”
This quote of unknown origin perfectly describes financial success. It’s true that all it takes is to make a few small decisions right, and to be consistent!
In the world of investing where the power of compounding makes all the difference, those small decisions that don’t seem that important in the present can change the whole course of your life. But the wild thing is, many may never even know that it did, or didn’t, or to what degree.
After all, we don’t know what we don’t know. And we don’t know what might have been. So we can never quite know how much we know about anything, even if we think we’re experts on the subject!
That is why a financial advisor is such an important part of your wealth-building team.
But “financial advisor” is a broad word. How do you go about finding this individual? Are there different types of financial advisors? What are the conflicts of interest to watch out for? How do you know if you’re getting a good one?
In the past, I’ve worked as both a registered investment advisor and as a representative of an independent broker dealer.
Here are some details you’ll want to know before you choose!
Suitability vs. Fiduciary Standard
There are two main standards you’ll want to be aware of, because some financial advisors may be bound to one standard and others to both.
The suitability standard of FINRA Rule 2111 states that the advisor must have a reasonable basis that the recommended investment is suitable for the customer, based on factors such as:
- Investment objectives
- Investment experience
- Age and time horizon
- Risk tolerance
- Liquidity needs
- Tax status
- Other investments
- Financial situation
The fiduciary standard that was established in The Investment Advisers Act of 1940, and expounded by the SEC, states that a financial advisor has the duty “to adopt the principal’s goals, objectives or ends.” This means that the advisor must, at all times, serve the best interest of the client.
There is a slight difference between these two standards.
By the suitability standard, an advisor could theoretically have a number of investments available which would all be more or less suitable for the client. However, if he or she has a conflict of interest in which the commission on the sale of one product over another might benefit themselves, they could theoretically choose the higher paying product to sell even if it is not necessarily the best choice for the client, but simply suitable for their situation.
Under the fiduciary standard, an advisor typically eliminates (as much as possible) any conflict of interest which could potentially cloud their judgment in the selection of investment products or strategies.
Some advisors are bound by the suitability standard (those registered with FINRA), some are bound by the fiduciary standard (those registered with the SEC), and some are bound by both.
Just because an advisor is not bound by the fiduciary standard does not mean they will offer poor advice or even consider their own interests when advising the client; just because the standard is lower doesn’t mean that their personal standards are lower. It’s just something to be aware of, that a conflict of interest is present.
Lastly, I would be remiss if I didn’t mention that some advisors are bound by other standards besides these two. For example, if an advisor holds the CFP or CFA certification, both of these societies bind their members to a fiduciary standard that requires them to put their clients’ interest ahead of their own and act in the clients’ best interest.
Regardless of what type of structure an advisor works under, having a certification like one of the above holds him or her to a higher standard.
Wirehouse Broker
A wirehouse broker is a full-service brokerage firm that provides an all-in-one service of research, investment advice, financial planning, proprietary investment products, technology and trade execution. While there are not many firms that qualify as wirehouse brokers, you will certainly recognize their names. The main four consist of Morgan Stanley, Merrill Lynch, UBS and Wells Fargo.
These firms operate under the suitability standard of FINRA.
The benefit of these firms is that they have a massive operation which has the capacity to research and provide a clear, consistent message to the client in line with that research. They have many proprietary products that are uniquely offered at their firm and nowhere else. And they usually have very good technology which the clients can use to easily access and take action on their investments.
The negative is that there is a risk of bias toward the company’s own proprietary products, as well as the fact that commissions are often earned based on what investments are purchased. This can be a conflict of interest which encourages more trading than might otherwise be ideal as well as recommending certain suitable products over others which might be in a client’s better interest.
Independent Broker Dealer
An independent broker dealer is able to offer a wider range of products, because they are not tied to any one particular wirehouse firm. They may still have their own proprietary products, such as managed accounts, which they sell, but they are also able to sell products offered and managed by other firms (called an “open architecture model”).
They, too, are bound to the suitability standard.
The benefit of an independent broker dealer is that they are free to tailor investment solutions more precisely to their clients’ needs without being limited to, or biased by, in-house products. There is less of a conflict of interest, because they are not as restricted to proprietary products and have some flexibility on certain fees they charge.
They also often have a strong research team and technology platform which allows the message across advisors to be relatively consistent, though perhaps less streamlined than that of a wirehouse brokerage.
The negatives are that they are still largely commission-based, meaning that they are paid more for selling one product than for another. Again, this doesn’t mean they will choose a product based on its commission, but it is a potential to cloud judgment because a suitable product that pays more can look very enticing up against a best product which pays less.
Registered Investment Advisor
A common type of investment advisor in the US is the registered investment advisor (RIA). This means they are registered by the SEC or a state regulator (depending on assets under management) and are bound by the fiduciary rule.
The benefit of an RIA is that he or she uses a fee-based structure for their advising services. They typically do not make commissions, but rather charge a flat percentage of assets under management. This eliminates the conflict of interest of selling one investment over another, and truly puts the advisor and the client on the same side of the table. The advisor wants to grow the assets in the most effective way possible, because the advisor makes more when the assets are worth more. But first and foremost, the advisor is bound to act in the best interest of the client, beyond simply finding something suitable.
While most RIAs charge a percentage of assets under management, some prefer to charge a flat fee for their services. The percentage of assets under management, however, does give them an incentive to grow the account, because it directly benefits themselves, and resultingly also benefits the client. Win-win!
The negatives could include, depending on the RIA and the size of their operation, access to fewer proprietary products that might be offered by a broker dealer. That said, they still often have access to a wide variety of products that could be as good as or better than the proprietary products. They may or may not have an extensive research team, but might rely on third-party research. If the advisor wears too many hats (research, money manager, marketer, advisor), it can become difficult to prioritize focus on one particular area of expertise. They may also not be able to offer the kind of technology that a broker dealer can. Again, this is going to come down to the individual RIA, because there is a range of different sizes and ways that these firms can operate.
Conclusion
The financial advisor that you choose will come down ultimately to the individual.
As with any professional field, there are excellent, mediocre and below average financial advisors anywhere. But before you get to know the individual, their qualifications and their track record, it’s good to know how they make their money, what conflicts of interest might exist, and what standards they are held to.
In the end, it’s about trust. And the character which builds trust is something that has to be discerned in the heart. After all, this individual is someone you will want to really, truly like and enjoy being around. You want to feel like you’re truly being listened to, and your goals and feelings are being considered. But you also want someone who will challenge you, kindly disagree with you when necessary and provide you with new ideas and strategies.
So take a look around, and find your wealth-building team member that can help you make those tough but important decisions.
For more reading on financial advisors, check out these articles:
Wealth Management: Leveraging the Powerful Knowledge of Others
