How NOT to Hire a Financial Advisor

When to Sell -- Updated for 2008

Need to Replace Your Car? Double Your Money in Five Years

Don't Depend on a Home Equity Loan for your Cash Reserve -- Updated for 2008

Preparing for Divorce

How Much Wealth Do You Need to Retire?

How NOT to Hire a Financial Advisor | Wealth Management

Deciding on a financial advisor or planner to manage your investments is never an easy task. Here are five mistakes to avoid.

1. Hiring an advisor who only works on a nondiscretionary basis.

Unless you enjoy keeping up with financial news and tracking your own investments, this is the single biggest mistake a person can make. Nondiscretionary means you, the client, have the responsibility to approve what your advisor is doing. Anyone who is a “stockbroker” – a term banished from the marketplace these days despite the fact that most advisors are in fact stockbrokers – works this way. They call you up to get you to buy something but they have no responsibility to call you when that stock or fund is rolling over. They might call you and suggest selling – something you must approve – but they don’t have to.

An advisor who works on a discretionary basis, on the other hand, is responsible for both buying and selling in your best interest. You set the objectives for the account but you don’t have to “approve” any specific buy or sell decision. Someone who works on a discretionary basis is a fiduciary. A fiduciary must put your best interests ahead of his or her own. An advisor working on a nondiscretionary basis might do that, but isn’t required to.

It’s important to ask the discretionary/nondiscretionary question. Some people mistakenly think that an account where you pay a fee rather than commissions is necessarily a discretionary account. Not true. While a discretionary account is always a fee-based account, not all fee-based accounts are discretionary. This is a murky subject because of the complexity of regulations, but shining a spotlight on it is critical to your well-being.

2. Substituting trust for judgment.

What most people do is (1) hire a friend or associate, i.e., someone you have known for a while, or (2) hire someone who is recommended by a friend. What you’re really doing is substituting trust for judgment. Just because you know someone who seems to be responsible and honest – and maybe buys you the occasional dinner and/or drinks – doesn’t mean he or she is a good advisor. It’s the same story for the recommendation by a friend, just once-removed.

Investment advisors know you probably can’t evaluate the actual service they provide so they are experts at sociability. When I worked for a Wall Street wire house we were lectured over and over again to know every personal detail about clients, including the name of the family dog. Did this make us expert? No. But it sure made us tougher to fire. An advisor told me a story about a prospect she had once whose portfolio was a shambles. Her advisor had done a terrible job for her. But the prospect wouldn’t make a change because the advisor ate lunch at the same club every day that she did and she would have been too embarrassed to see him, after firing him, every day at lunch. And, I guess, she didn't want to change clubs. But really, most people are like that. It's hard to fire a friend or someone you see socially all of the time, even though you may be losing money (or more likely, simply not making any). So avoid the conflict and don’t hire a friend.

3. Seeing past performance as a promise.

It’s easy to do. I’ve sat through presentations to pension plan fiduciaries – chief financial officers among them – and marveled at how they treated past performance numbers as if they were interest rates credited to a bank account. “Look here,” one would say, “this guy’s three year average annual return is 20 basis points better.” What a joke.

Don’t be persuaded by past performance numbers, especially if the presentation lacks a comparison to the appropriate index. A number by itself is just a number. Most performance comes from the condition of the overall market and the sector the security is in. The truth about the investment business is that there is something called “reversion to the mean,” which simply means all performance eventually finds its way back to average.

Of course, many financial advisors aren’t portfolio managers themselves. Rather, they are “managers of managers,” that is, they pick the mutual funds or investment managers for you. So the question isn’t the performance of the portfolio manager or mutual fund. The question is when did the advisor first start using that portfolio manager or mutual fund, when did they stop using them and what was the performance before, during and after. In the event you find an advisor who can answer those questions you’ve found a gem.

Since most advisors aren’t portfolio managers you might ask a question like this: “For your clients who have a moderate risk profile, what was their average return in each of the following years: 1999, 2000, 2001, 2002, and 2003?” That was a five-year period in which a good advisor earned her pay. If that kind of data is unavailable, ask them how they make changes to their client portfolios based on changes in the market and economy: automatic rebalancing? If so, what criteria is used? If not, what guidelines are used to initiate a change?

Remember, a number is just a number. The real question is the risk involved in getting that number. Many investors will say that they can tolerate a 20% drop in their portfolio’s value . . . until it happens. The real performance issue you want to get at from an advisor is “risk-adjusted return.” Most Americans don’t believe reward depends on risk, according to research I’ve seen, but in fact it does. A ten or 12 percent annual return from a well-diversified portfolio may be more satisfying for you than a 20 percent return from a high-risk portfolio. A 20% loss takes a 25% gain to get you back to even. A 10% loss takes just an 11% gain to get you back to even. And while you’re getting back to even, you’re not getting wealthier.

4. Not knowing exactly what the advisor is going to do for you.

In Part One I wrote that you should avoid a nondiscretionary account. You should definitely avoid commissions because the incentives are all wrong; for example: When a broker sells you an “A share” mutual fund with a 5.75% front-end load, he or she gets paid immediately. Does this motivate the advisor to closely monitor the performance of that fund? Probably not. In fact, he’d just as soon avoid the pain of calling you up and telling you the fund is doing so badly that you should switch to another fund. That means another commission. Losses to your initial principal pile up. There is another reason as well; a financial advisor being paid only on commissions must keep selling in order to generate revenue. The focus of the job moves from monitoring to selling. Not good for you.

Many people, certainly any number of advisors I’ve met, seem to think that the most important part of the job is picking that mutual fund or stock or investment manager. To me, that is maybe one-third of the job. The real job is monitoring. You want to pay an advisor for diligence, not some mystic intelligence about which fund to pick or which stock to buy. This is why I warn against doing business with a friend. A friend is actually less likely to be diligent precisely because he or she already has a social bond with you. It’s the psychology of the situation. And to my mind, psychology is the single greatest factor in determining investment success. But that’s another story.

Back to the question, “what is it you do, exactly?” Don’t confuse brains for a bull market. The difference between the trustees of a pension fund and participants in a 401(k) is that the pension fund fires under-performing portfolio managers while the overwhelming majority of 401(k) participants never make a change in the mutual funds they picked when they first enrolled. It may take up to three years to decide if a fund or manager is underperforming – what are the guidelines you use to decide when change is appropriate? You, like most 401(k) plan participants, probably don’t have any. That’s a reason to hire a financial advisor – as long as you ask her or him in advance, what guidelines do you use? Why? Can you show me some evidence of how effective those guidelines have been?

Here’s a checklist of things an advisor ought to be telling you he or she will do for you:

5. Going for the low price.

Investment advisors who may have read the preceding installments of this series have probably nodded in agreement and shaken their heads in denial – the problem is that few advisors have the time to spend on all the things I’ve said are important. Since time is money for a financial advisor, the trick is to charge a fee that fairly compensates the advisor for his or her time.

Of course hardly anyone would agree with that strategy. Certainly not the “industry observors” who are always complaining about high fees. And certainly not the client, who considers negotiating the best possible deal a high priority.

My contention is: Don’t sweat the fee. Just make sure you get what you’re paying for.
Of course, that takes time and intelligence. I realize it’s easier just to negotiate down the fee and hope for the best.

I hope this series has shed some light on the financial advisory business. To me, the order of a client’s priorities should be:

1. Determine exactly what the advisor is going to do for the fee being charged.
2. Interview at least one other advisor for comparison.
3. Establish a convenient way to evaluate that service.
4. Don’t let the business relationship become a personal relationship.

A perceptive reader will have noticed that throughout this series I have addressed the financial advisor as a solo practitioner. This is the way the industry has been traditionally structured. A firm is just a collection of “individual producers” with the same systems and products and regulatory compliance. Recently the industry has begun promoting “teams,” but these are usually more of a marketing device than a functional operating unit. The industry hires people who are psychologically fit to be good sales people. They have big egos (as they must, to deal with rejection), are very competitive and driven to succeed. A group comprised of just these kinds of people is not likely to function effectively as a team for very long. It takes very strong leadership to pull that off. This is why an independent firm that is functioning as a team with a strong leader is probably a better choice than a team of the same number of people based in a brokerage firm like Merrill Lynch, Smith Barney, UBS or any insurance company.

Finally, I have not mentioned the critical issue of account size. The type of service you receive and the fee you pay will be based on the size of your account. Service for a smaller account will be mutual funds or exchange-traded funds (index funds). Larger accounts will have access to individual securities or separate account managers. The question for smaller accounts, say under $80,000, is this: what will you be paying for? If it’s no more than picking mutual funds, consider doing it yourself. If you’re uncomfortable with that, keep reading this blog.

When to Sell | Investing -- UPDATED 2008

The thing about all the different advice you can read about investing is that all of it -- at one time or another -- will probably be right.  The question investor's face:  Is now that time?  As things have worked out since I first wrote this, you could have pocketed $90,000 by selling at the break down (at $24) and buying the stock back at $15 (if you felt you really needed to keep owning the stock).  

"Buy and hold" is good advice as long as:  (1) You didn't buy weak fundamentals at a ridiculously high price; (2) your time horizon isn't stupidly short; (3) there aren't incredibly better opportunities elsewhere.

It's a tough question, so let's look at a case study.

Say you bought 10,000 shares of Frontier Financial Corp. (FTBK) at $10 a share.  When the stock settled in at the $14 - $16 range, you were feeling pretty good.  Then the "access to debt as if it were liquidity" binge hit and the stock, along with the bank index ($BKX), took off.

An old Chief Investment Officer once assured me that people buy stocks because they go up.  But putting the sales spiel in context, the market moves in cycles and one cannot expect the market to be going up all the time.  It doesn't.  So for all practical purposes, there is a time when selling is the right thing to do.

It's early February, 2007, on the chart below, an investor's expectations about FTBK might be turning negative, as the stock began tracing out a price pattern called a Head and Shoulders.  This formation is a picture of buyers losing interest in a stock.  The black line is FTBK.  The purple line is an index of bank stocks. 

The "left shoulder," just above the red line, is a new high on good volume, in September 2006.  The "head" is a higher high on lower volume, accomplished in November.  The "right shoulder" is a lower high on lower volume.  The pattern is confirmed when the price drops below the "neckline," indicated by the red line on the chart.

So our investor has seen the market value of his stock drop from $300,000 to $240,000 at the "neckline," not an insignificant loss.  Should he expect more bad news?  Probably.  Note that FTBK's price has fallen while the Bank Index (the purple line on the chart)  has continued to rise.  That tells us that investors are more negative about FTBK than about banks in general.

Based on the history of price movements, we can set a target price for FTBK of $20 if the Head and Shoulders pattern holds true.  This is not a 100% probability.  If FTBK were to rally above the "neckline" price, the validity of the price pattern would be cancelled.  But for now, such a rally seems less likely to happen, as FTBK's price has fallen decisively below the "neckline."  What should our investor do? 

So consider, if you bought the stock at $10, should you seel it at $24?  The first thing to think bout is why you bought the stock in the first place -- what you expected to get from it.

• Does your father work for the bank and thus make owning the stock a family/emotional decision?  Well, you probably won't be selling.  (But you could consider reading my book, The Joy of Stock Market Investing, which identifies all the emotional reasons for bad stock investment decision-making -- and what you can do to prevent it.)

• Does that 40% gain to $14 satisfy your financial goals?  If the stock falls to $20, you'd still be smiling.
  

• Is your time horizon 20 years from any need to liquidate this stock to provide income?  Sure you can wait, but what about the opportunity cost of waiting?

• Are there better opportunities (lower risk, higher reward) for all or part of his FTBK investment?  Right now, cash from the sale at $24 would look good.

• And finally, do you have a financial advisor who can add value to this question? 
  

If, for example,you had set a stop loss at a price just below the neckline, you could have sold some or all of your shares at around $24 and turned your attention elsewhere.  As things have turned out, you could have bought the stock back and, say $15 and pocket the difference.  If you sold all 10,000 shares you would have collected $240,000 on the sale and spent $150,000 buying back the same 10,000 shares.  That's $90,000 profit for owning the same asset. 

Ultimately, of course, the right thing to do will will always depend on:

• The condition of the market -- it does move in long cycles.
  

• Your financial circumstances and expectations;

• Your emotional response to the rising/falling value of the stock;

• Your awareness of these two factors.

You can maintain "awareness" by having an investment plan before you plunk down your hard-earned money in the stock market.  (Charts courtesy of StockCharts.com)

Say you have $25,000 and you'd like to double your money in five years. You’d have to earn 15% each and every year to do it.

The problem is that there aren't many assets - if any at all - that can return 15% each and every year. What if you earned, for example, 30%, 20%, 0%, 5%, 10%. That averages 13% per year, which seems close, but leaves you $5,239 behind what 15% each and every year would have gotten you.

(Of course, as human beings, we remember the really good stuff best, so we keep the 30% return in mind and don’t really notice the fall-off unless we’re doing the numbers each and every year. Keeping track is one of those things an advisor does.)

So how can buying a car help? It’s easy -- "invest" in a less costly purchase, like a previously-owned model.

• You could buy a new BMW 530i for $40,095, or a 2002 of the same model for $21,450. The savings on a 48-month car loan at 8.5% would be $436.07.  Save that amount plus the fifth year of no car payments and you've doubled your money.
• Or consider a Lexus RX300. New: $35,705. 2002 model: $21,800. You would have to earn about 4% on your savings each year to double your money.  Definitely do-able.
• How about an Audi A6 3.0? New: $35,400. 2002 model: $15,100. Savings: $351.45 a month.   All you'd need is about 3% a year in interest on your savings and you'd double your money.

These much-lower rates of return leave plenty of margin to cover the cost of repairs during the five years, should you need them. Buying a used car from a reputable source is one way to reduce the chance of repairs. Kelly’s Auto Sales and Service  is one such source here in Seattle, and also the source of the above new and used car numbers. Kelly Flynn is the owner. You can call him at 206.999.6339.  (Savings were calculated based on a 7.25% interest rate for the new car loan and an 8.5% interest rate for the used car loan.)

Preparing for Divorce | Financial Planning

A divorce is like a death. Both are betrayals -- though for the deceased, it may not have been a betrayal of the living by choice. Which may only make divorce worse. Both divorce and death leave you alone. The emotional strain is bad enough. It doesn’t have to be compounded by financial worries. Here are some steps to take to prepare yourself in the case of an impending divorce:

1. If you’ve been putting off "joint" expenses - repairs to the house, the car, braces for the kids, etc. - put them off no longer. Use your joint or household account to pay for them. Get those expenses out of the way so they don’t become a point of contention later.

2. If your financial paperwork isn’t organized - get organized. That means making copies of the following:

• The last three years of your joint tax returns. A tax return can be used to find assets and capital gains/losses and to understand depreciation and business expenses if applicable. You can use the tax return to verify the accuracy of the financial affidavit.
• Your spouse’s employee benefits. If you don’t have Summary Plan Descriptions on file - who does? - call the Human Resources department at your spouses’s place of work and ask for them: retirement plans, health benefits, and any other type of benefit plan such as deferred compensation, stock options, bonus plan, etc.
• Loan documents and statements. Home mortgage, home equity loan, car loan, student loan, credit card and other debt. You have to understand all the liabilities.
• A credit report for your joint accounts (just before you cancel them; see below).
• Account statements. Bank accounts, mutual funds, annuities, brokerage accounts.
• Insurance policies.
• If you can’t find these documents, contact the source: the bank, your mortgage lender, the IRS, etc.  Put the copies in your safe deposit box. (You have one, right?)

3. If you haven’t established a credit history in your own name, do so right away. Cancel any joint credit cards or other credit arrangements you may have.

A divorce means starting a new life. Once you have all these financial details assembled, you’ll have the raw material for a financial plan on which you can build your new life. So don’t think about this financial chore as a grim fact of divorce; think about it as a first step to your future.

Don't Depend on a Home Equity Loan for your Cash Reserve - UPDATED 2008

Two years ago many a financial planning blog extolled the virtues of using a home equity loan instead of keeping cash in the bank -- so old fashioned! -- as an emergency fund.  It took a few years for me to be right, but here we are.  Falling home prices, higher long-term interest rates and a souring economy should make those who opted to put cash in the bank feel a lot more secure than those who opted for waiting to take out a home equity loan until they had their emergency.  Good luck with that in today's environment.

How many months of cash should you maintain in case of an emergency -- losing your job, or being unable to work because of illness, or having the roof of your home ripped off in a windstorm?

Like all things financial planning, it depends -- on available insurance coverage, on whether you live paycheck-to-paycheck, etc. Insurance may reduce the need for a large cash reserve in some cases, but it takes time to get cash from an insurance company, so some reserve must be maintained.

Should you use the equity in your home? Some planners recommend that you wait and use a home equity loan or line of credit if an emergency arises. This can be problematic for several reasons.

First, a cash reserve is cash, spendable any time. A home equity loan depends on variables -- interest rates, the residential real estate market -- that you have no control over and that may not be favorable when your emergency occurs.

Second, building a cash reserve gets you into the habit of saving -- and that's a habit worth nourishing. Once you have a reserve, you get to take advantage of the power of compound interest -- making money with your money, so the reserve fund grows on its own. Rather than making interest payments to someone else, why not pay yourself?  A home equity loan is debt.  It's something you have to get rid of.

How much should be in an emergency reserve fund? There seems to be no generally agreed upon number; it could be anything from 3 months to 12 months of income. A key variable here is how much you are spending on debt repayments and other fixed costs, insurance for cars, for example.

If you're carrying credit card debt, and you don't have an emergency fund now, start small, say $1,000 or so, and focus on retiring your debts. Once your debts are paid off, apply all or part of the money that had gone to debt repayment to build your cash reserve. If you have few dependents, you might stop at three months of income, or whatever feels right to you. The more dependents you have, the more chances you have for an emergency, so your reserve fund should be increased as well.

How Much Wealth Do You Need to Retire? | Financial Planning

While some advisors are quick to throw out a big number to answer that question – as motivation to get you buying – the answer really depends on a lot of factors.

    * The state of your health now and in the future – Do you have a chronic condition?  Does longevity run in your family?

    * What you own – your home, other real property, a business.

    * What you owe and how soon it will be paid off.

    * How you live – just how expensive is your life style?

    * What benefits you will receive from an employer-sponsored retirement plan.

    * How many years before you intend to retire? – Do you plan to work part-time before full retirement?

    * What liabilities might you face for other members of your family?  Children’s education?  Parent’s nursing care?

    * What assets do you currently have in your retirement plan and investment accounts?  How are these assets allocated?

    * The price/earnings ratio of the stock market at the time you retire.