The ABCs of Behavioral Biases Introduction
Written by Andrew Hunt
Written by Andrew Hunt
In selecting or retaining a financial advisor, how do you know if you’re making a wise choice?
It’s a challenging subject for us, anyway, and one that we take very seriously as we develop and expand on our firm’s own best practices. It is even more challenging for investors. First, the stakes are high. The quality of the selection, or lack thereof, can literally make or break your family’s fortune. Second, the choices can seem bewildering. With a glut of baffling jargon and conflicting complexities clamoring for your consideration, it can be difficult to determine what to look for and who to trust.
Let’s cut through the confusion, and arm you with the information you need to choose an advisor who is a good fit for you and your wealth. Three essential steps can be your guides:
Part I: Understanding the Advisory Environment
First, There Is Fiduciary
Before you interview a current or prospective advisor to determine his or her worth, it helps to arm yourself with information.
In the medical profession, physicians practice according to a familiar standard: “First do no harm.” It seems that there should be a similar level of commitment for anyone who wants to advise you about your financial well-being, right?
Unfortunately, wrong. Financial advice is subject to a double legal standard: “fiduciary” versus “suitable” advice. Worse, it’s up to you to spot the differences between them, and heed the quality of the advice accordingly.
Fiduciary vs. Suitable: Different Incentives Drive Different Advice
Why the different legal standards? Government regulators assume that a broker’s primary role is to place trades, so any advice he or she offers is considered secondary to this main, transactional business. As such:
Let’s provide an example of how suitable and fiduciary advice can differ from one another. Imagine you are comparing two mutual funds that are equally appropriate for your portfolio, except one entails higher fees that just happen to offer a bigger commission to the trader. Brokers offering suitable advice can freely recommend the fund that compensates them more handsomely at your expense … without disclosing the underlying incentive to you.
On the other hand, if all else is equal between two investment selections, a fiduciary advisor must recommend the lower-cost investment that represents your best interest. As a fee-only firm, we do not accept third-party commissions or any other sales incentives to begin with, but even were we to do so, we would still be obligated to disclose the conflicts to you, place your interests ahead of our own, and recommend the lower-cost solution.
In his Washington Post column, “Find a financial advisor who will put your interests first,” Barry Ritholtz describes suitable advice in blunt terms: “The suitability standard is far more complicated – and offers much less protection to investors. The simplest way to describe this standard is ‘Don’t sell AliBaba IPO to Grandma.’”
A Suitable Illustration in Inaction
You may wonder whether suitable conflicts of interest really matter. If you’re working with a financial pro and your investments seem to be doing okay, is there any harm done if he or she receives a few extra dollars along the way?
We believe that the investment damage done can be considerably more significant than most people realize. Take this illustration of a couple in their 70s, the Toffels, who were featured in a New York Times exposé, “Before the Advice, Check Out the Adviser.”
The Toffels were not sold an AliBaba IPO for their $650,000 life savings, but their broker did saddle them with a variable annuity that cost more than 4 percent annually. “That’s more than $26,000, annually – enough to buy a new Honda sedan every year,” observed the columnist. The annuity also included a 7 percent surrender charge, effectively trapping the Toffels into the overpriced holding. Consider this in the context of a typical, no-frills index fund costing less than 0.25 percent, with no surrender charge.
The article points out: “Like many consumers, [the Toffels] say they didn’t realize that their broker wasn’t required to follow the most stringent requirement for financial professionals, known as the fiduciary standard.”
The Cost of Conflicts of Interest
Not yet convinced? In February 2015, the White House weighed in on the subject with its report, “The Effects of Conflicted Investment Advice on Retirement Savings.” Drawing on evidence from more than 50 independent resources including dozens of peer-reviewed academic studies, the report estimated that retirement investors may be losing an aggregate of $8–$17 billion each year from conflicted advice.
“Conflicted payments are payments to the adviser that depend on actions taken by the advisee,” explains the report, and lists an abundance of such practices, including revenue-sharing, 12b-1 sales fees, front-end and back-end sales loads, commissions on products sold, and additional incentives for pushing one product over another. And of course such common cost leaks are by no means limited to retirement savings.
Granted, the White House estimates may themselves be influenced by the political backdrop. But combine this with The New York Times piece (and many other examples we could cite), and the illustrations draw a clear conclusion: Suitable “advice” costs plenty of families plenty of wealth that would otherwise be theirs to keep.
That is why it behooves you to turn to a fiduciary investment advisor whose legal duty is to always advise you strictly according to your highest financial interests, ahead of any such conflicts of interest. When it comes to your life’s savings, we believe you deserve better than advice that is merely suitable.
Part II: Addressing the Decisive Details
Fiduciary vs. Suitable: How Do You Know?
One way to determine whether your advisor will be acting as your fiduciary is to ask these two essential questions with respect to your own relationship and your own assets:
Complementary Qualities for Your Advisor Relationship
Beyond accepting a fiduciary duty, there are other important ways that advisors can position themselves to sit on the same side of the table as you and your personal financial interests. Following are some of the details worth delving into.
Business Structure: The Registered Investment Advisor Firm
By law, independent Registered Investment Advisor firms must provide strictly fiduciary advice to their clients. In contrast, brokerages, banks, insurance agencies and other transactional businesses more typically offer suitable advice.
Regulatory Agent: Seek State or SEC Oversight
When a firm and its team of advisors are providing only suitable advice, they may not go out of their way to tell you so. A short-hand approach to sorting out the players is to determine which financial regulator oversees the firm by checking their fine print.
Compensation Arrangements: To Whom Is Your Advisor Beholden?
Speaking of potentially dueling interests, another way to determine how well your advisor’s interests are aligned with yours is by determining his or her sources of compensation.
If your advisor is receiving commissions from third-party sources, suffice it to say he or she is exposed to conflicting incentives to recommend particular products or transactions that may not be in your best interests. In addition, these conflicts and their resulting costs (which silently drag on your returns) often remain undisclosed to you.
A transparent, fee-only arrangement is preferred. First, you can clearly see what you’re spending in exchange for what you’re receiving. Second, if your advisor’s only compensation comes from you, it enhances his or her ability to offer the impartial, product-neutral advice you deserve.
A fee-based arrangement warrants further inspection. Fee-based advisors are receiving your fees, plus commissions from others. If the advisor is entirely fee-only, except he or she can write insurance policies for you as needed to protect your primary investments (with full disclosure of all commissions being received for this singular activity) then a fee-based relationship may still complement your best interests. If the commissions are coming from investment activities, the same conflicts arise as those described above for a fully commissioned advisor.
Investment Planning and Execution: How Stable Is the Strategy?
Bottom line, how is your advisor managing your money?
A comprehensive investment approach that you can consistently apply to your total wealth is core to your advisor’s fiduciary care of your interests, through the years and across various market conditions.
Custody Arrangements: Insist on Independence
Even if your advisor checks out so far, there’s one more way to protect your interests. After all, Bernie Madoff looked fine on paper before he was exposed as a smooth-talking criminal. In protecting yourself against scoundrels in disguise, it’s essential to ensure that your money is held in your name at a fully independent custodian that reports directly to you.
Ensuring your money is held at a separate custodian affords you the opportunity to review separate financial statements for any discrepancies. (Madoff maintained custody of his clients’ accounts at his New York brokerage house, enabling him to falsify their reports.) It also lets you log into your account anytime to keep an ongoing, “trust, but verify” eye on your assets.
Part III: Doing Your Due Diligence
Selecting the Right Advisor for You: How Do You Know?
Once you’re equipped with an understanding of the broad and detailed decisions involved in selecting an appropriate advisor relationship for you and your wealth, your final step is to actually conduct your due diligence.
A good place to start is by considering the insights of author, commentator and Wall Street Journal finance columnist Jason Zweig. Like us, he is a strong proponent of investing guided by rational evidence over reactionary emotions –which seems advisable no matter who may be helping you take care of the rest. We respect Zweig for telling it like it is, with his commendable mission to serve as a “Safe haven for intelligent investors.”
What does Zweig have to say about the challenge of selecting an advisor relationship that is right for you? In “Full Disclosure: Is Your Adviser Hiding Something,” he observed: “So how can you make sure you know everything you need to know about a financial adviser before you hire him? You can’t. While most advisers are undoubtedly honest, the few who aren’t can always find clever ways to hide another skeleton in an already bulging closet.”
And there’s the crux of the challenge. We know that we are fully committed in principle and practice to serving your highest financial interests, even ahead of our own … but how in the world do we prove it? And how do you, the investor, believe it? Following are some helpful tips on the due diligence that you can and should do when considering a new advisor relationship or reviewing an existing one.
Use your favorite search engine to periodically check up on what the virtual world has to say about your advisor or would-be advisor. Search on both the individual and firm names. Make sure you’ve got the right person or firm in your hits, especially if the name is a relatively common one, and remember that some resources will be more reputable than others.
Check the Reports (Form ADV)
Whether registered with their state or the Securities Exchange Commission (SEC), Registered Investment Advisor firms must file a Form ADV that is typically available on the SEC’s Investment Adviser Public Disclosure website. A firm’s ADV discloses a number of important details worth knowing. ADV “Part 2 Brochures” are meant to serve as the closer-to-plain-English version of the adviser’s full report, so you may want to start there. Most current and former brokers and advisors should also be listed in FINRA’s BrokerCheck system, where additional details and disclosures may be found.
Last but certainly not least, any reputable advisor should relish your candid inquiries, no matter how detailed, direct or seemingly delicate they may be. If the response underwhelms – if it’s incomplete, confusing, defensive or otherwise lacking – this may indicate an ill-fitting relationship, even if everything else checks out fine. Remember, it’s not only what an advisor knows, but how comfortable you will be working with the individual and his or her team over the long haul. If responses to your important questions feel stilted, defensive or incomplete – with either or both of you, if you are a couple – it’s unlikely you’ll end up living happily ever after in the relationship.
Finding Your Right-Fitting Advisor: Coming Full Circle
Finding Your Fiduciary Financial Advisor
We circle back to the question we posed at the outset: In selecting or retaining a financial advisor, how do you know if you’re making a wise choice?
We hope you’re convinced by now that the first order of business is to review an advisor’s background and ensure that his or her advice will be of the highest, FIDUCIARY standard, with the commitment confirmed in writing. Take advantage of resources such as the advisor’s Form ADV and other legally required disclosure statements that enable more apples-to-apples comparisons. Look for the additional characteristics described above, that best position an advisor to sit on your side of the table.
After that, look for someone you get along with on a personal level. If you and your advisor don’t “click,” even good advice will be hard to take, as described by author Seth Godin:
“Good advice … is priceless. Not what you want to hear, but what you need to hear. Not imaginary, but practical. Not based on fear, but on possibility. Not designed to make you feel better, designed to make you better. Seek it out and embrace the true friends that care enough to risk sharing it. I’m not sure what takes more guts – giving it or getting it.”
We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.