In my senior year of college at Miami, I had to choose which Capstone I was going to take. Since I was in the business school, I looked at a couple options including the Marketing capstone, the Finance capstone, and the Business Law capstone. After looking them over and talking to my mentor Mrs. Michelle that I mentioned in the article last week, I decided to take the Business Law (BLS) Capstone. In the BLS Capstone, we explored the legal aspects of business decision-making from an ethical perspective. We focused on the business manager as an ethical decision-maker and on the corporation as a social moral agent. It would be conducted seminar style using cross-functional cases from the core business disciplines. I wanted to do this Capstone because ethics is something that is important for everyone no matter what your occupation is and having low ethical standards has led to the downfall of many people and companies.
Because of basketball season I missed about half of the classes but fortunately, the teacher and I had a good relationship and she always worked with me to make sure I stayed caught up as best as I could with the class. She also recognized that because I had missed so much, I would need to do a little more. We came up with the idea of doing a supplemental 12-page paper and she said, “She wanted me to choose a topic that I wanted to learn more about or will help me in my future”. This was all around the time I had been learning about personal finance and had also done a case study on the 2008 market crash and how bad advisors played a big role in it. So, I decided financial managers would be my topic and wrote my paper called “Financial Managers and Their Duty to Society”. I did not know how much it would help me by doing that research, but I learned a lot of information that I want to share with you today and this is why I’m writing this article, “Why I Will Not be Hiring a Financial Advisor.”
If you would like to read the whole paper I wrote, here is the link.
Financial Managers and Their Duty to Society
When looking for a financial advisor, the first thing you should do is see if they are a fiduciary. If not, you should turn and run the other way. According to the Securities and Exchange Commission which regulates registered investment advisor as fiduciaries, “The fiduciary duty says that fiduciaries must act with undivided loyalty and utmost good faith. They must provide full and fair disclosure of all material facts, defined as those which a reasonable investor would consider being important. They also are not allowed to mislead clients and they can't use the client's assets for the advisor's own benefit or the benefit of other clients. One of the biggest issues that a fiduciary must abide by is that they have to avoid conflicts of interest like when the advisor profits more if a client uses one investment instead of another and they must disclose any potential conflicts of interest.
Research by digital wealth manager, Personal Capital, an online financial advisor service found that nearly half of Americans falsely believe all advisors are legally required to always act in their clients' best interests. The non-fiduciary advisors might operate using the suitability standard. According to (Forbes) The suitability standard requires that a broker make recommendations that are suitable based on a client’s personal situation, but the standard does not require the advice to be in the client’s best interest. That means that if a time comes where this a conflict of interest, they don’t have to do what is best for you. They can recommend something that is “suitable” for you but really isn’t the best available option out there and most times will put more money in their pocket.
That can lead to a lot of personal interpretation on the advisor’s side and if not required by law most people will always act in their own best self-interest (Global Financial Private Capital). In a way, when a broker checks the suitability of a potential buyer, they are measuring how much financial product can be sold, not the needs of the investor. You can be losing out on many gains that you could be making and also paying more in fees and taxes than you really should be (Global Financial Private Capital). Brokers that abide by the suitability standard also offer products that are usually carried by the company that they represent and are paid a commission calculated as a percentage of the amount of money invested into the product. These brokers are more like a salesman instead of someone who can help you reach your financial goals.
One of the ways that advisors who operate under the suitability standard can make money is through a practice called churning. Churning is a term applied to the practice of a broker conducting excessive trading in a client's account mainly to generate commissions. Churning is an unethical and illegal practice that violates SEC rules (15c1-7) and securities laws. While there is no quantitative measure for churning, frequent buying and selling of securities which does little to meet the client's investment objectives may be evidence of churning (Investopedia). This usually benefits advisors who are commission based and not fee-based, which is why advisors who are fiduciary's do not usually do this. When a broker engages in churning, it usually has a negative effect on your own personal investments.
Fee vs. Commission Based Compensation
Along with choosing whether you want to work with a fiduciary or someone who operates under the suitability standard, another thing to consider is whether they are a fee or commission based. While some advisors can use a combination of both fee and commission based, it is usually one or the other. Fee-only advisors are either a flat or hourly rate, on a per-service basis. They do not earn commissions or trading fees, so their compensation is independent of the investments they recommend (US News). Commission-based advisors are paid from the sale of investments. They may also receive a fee from their financial institution for selling a particular product, collect a percentage of the assets a client invests or be paid per transaction (US News). If you are a fiduciary, you can’t be paid by commission but if you are not, you can be paid either way.
This leads us to the issue of high fees and how that can eat into your portfolio returns as an investor. There are two ways of investing, invest using low-cost index funds which are pretty low maintenance and have low fees or hire a manager who is usually engaging in an active strategy where they are trying to beat the benchmark. It is hard to beat the benchmark and most managers underperform so for most investors, going with a passive strategy and investing in low-cost index funds is the best bet for them.
To show an example of this, in 2007 Warren Buffett said that the S&P 500 stock index would outperform hedge funds. The length of this bet was 10 years, and in the end, Warren Buffett won. The S&P 500 returned 7.1% while the hedge fund only returned 2.2%. Part of this is because the fees that an active manager or hedge fund has to take out for actively managing the investment can take a big chunk out of your overall return. Especially if the active manager that you hire is underperforming, you can be getting a very low return for your money compared to what you could be getting by investing in a low-cost index fund. Actively managed fund fees on average cost around 1.1% per year (Forbes), while the average fees for a low-cost index fund are around 0.2% per year.
The reason that investment fees for actively managed funds are such a big deal is that they hurt you twice. An investor pays an ever-increasing amount in fees as account balances grow because the fees are based on a percentage of assets. And fees also strike a blow to the portfolio's returns. That's because every dollar taken out to cover management costs is one less dollar left to invest in the portfolio to compound and grow (Nerd Wallet). By using a numerical example, we can get a better understanding of what paying high fees really looks like.
In a fictitious scenario we are going to look at different investment scenarios for a 25-year-old who has $25,000 in a retirement account, adds $10,000 to the account every year, earns a 7% average annual return and plans to retire in 40 years.
As you can see the difference in fees and ending portfolio after 40 years is very substantial. After 40 years if you were invested in the actively managed portfolio with a 1.02% annual expense ratio your portfolio would be worth 1.77 million. That is still a large amount but if you compare it to what your portfolio would be worth after 40 years investing in a low-cost ETF fund with an annual expense ratio of 0.09% you would have 2.30 million. That is a $533,000 difference! Using the 4% safe withdrawal rate that they recommend you use while retired that is the difference between living off $70,800 and $92,000. You might have to work a few more years to get to that same level and you could have been in a better position if you had chosen to go with a portfolio with a lower fee structure.
The Need for Financial Advisors
After reading this, I don’t want you to think that all financial advisors are bad, there are actually a lot of good ones out there! I have met with my parents’ financial advisors several times to ask questions on how they operate and what their strategy is, and they have done a great job with my parents! Because this is their full-time profession, they are able to stay up to date on the latest tax laws, research, and market trends that can help you with your decisions and they may catch something you may have missed or given you a different perspective that you didn't have. If I were going to choose an advisor, I would choose a fee-only based advisor who is a fiduciary. Some resources that you can go to that meet those qualifications are The National Association of Personal Financial Advisors and the XY Planning Network.
I do want to share a few reasons why you might need a financial advisor. Managing your own investments does take work and knowledge because you want to feel confident about the decisions you are making. There are many resources out there to help you become a DIY investor but if you don’t want to do it all on your own or need to know where to start, a financial advisor can be good. Although, you still want to ask the right questions and know what they are doing because it’s your money on the line! Another reason for a financial advisor is for emotional help; most people’s initial thought when the market goes down is to sell. You have to have a steady temperament to wait it out and not sell like everyone else and an advisor can be that voice of reason to help you not to panic and potentially save you thousands of dollars.
All that being said, I WILL use a fee-only advisor at times especially when it comes to double checking on the financial plan that I set up (which I did at the end of 2018) which includes estate planning, taxes, and transfer of wealth. At the end of the day, you have to look at your own circumstances and make the best decision for you. There are a lot of examples out there of people who have figured out how to do it on their own and share how they did it! I think if you take the time to educate yourself and reach out to people you can realize that you can do it on your own too!