Investments pay higher returns because they involve risk. Some risk is necessary. Some risk is not. Risk from a self-serving advisor can be avoided. Headline grabbing stories about Bernie Madoff and other scams publicize one type of advisor risk. More commonplace is simply an advisor who profits at your expense from arrangements like commissions that may conflict with your best interest. For an investor who understands the different types of advisors and is willing to inquire, this kind of risk can be minimized.
It is often difficult for clients to distinguish between the different types of people and organizations that call themselves financial advisors. There are important differences, however. Some advisors are fiduciaries, some are not. Simply put, a fiduciary puts their client's interest before their own. Registered Investment Advisors must meet this responsibility by law. Members of the National Association of Personal Financial Advisors (NAPFA) take a fiduciary oath as a condition of membership. Certified Financial PlannerTM professionals have also adopted a fiduciary standard.
Often the way in which advisors are paid is a
good indicator of whether an advisor is a fiduciary. Some consumers are not
aware that they pay any fee at all for financial services. That is because the
fee structure is often obscured. You can be fairly sure that any advisor who
seems to charging no fee, or a only a token amount, is not fully disclosing
their compensation and is not acting on your behalf as a fiduciary.
If you have a choice between an advisor that is committed to putting your interests first and one who is not, it would make sense to select the fiduciary, if all other characteristics are similar. Likewise, if you currently use the services of a an advisor, you should know whether that individual is committed to a fiduciary standard. If they are not, you should make sure that they fully disclose to you all of their sources of income, so that you may judge whether any conflict of interest exists in the advice they provide to you.
A stock broker who receives a commission for products that they recommend to you is not a fiduciary. Stock brokers must meet the lower "suitability" standard of responsibility to you. This standard says that they must assure that their recommendation is suitable for you, but it still may be influenced by a commission or other arrangement that is in their interest. Stock brokers may also offer advisory accounts in which they are acting as a Registered Investment Advisor. When they do, they should also rise to the fiduciary standard.
Recent regulations issued by the Department of Labor also require commissioned brokers to adopt a best-interest standard for retirement accounts. The regulation has been vigorouly opposed by the brokerage and annuity industries. Only part of the regulation has taken effect. The remainder has been delayed for further study. At present, brokers should be changing their behavior to act in a client's best interest for retirement accounts, but there is no effective enforcement mechanism. The regulation does not apply at all to non-retirement accounts.
There can also be mixed arrangements where a broker's representative maintains an advisory account relationship with you, but also sells you financial products, such as an annuity, and receives a commission. Technically, the former relationship must be a fiduciary one, the latter is not. Alternatively, the DOL requires best interest for retirement accounts, but not for reqular accounts. We question how a person can act as a fiduciary one moment and not the next. Placing a client's interest first should be a permanent mindset, not something that is turned on and off depending on the situation.
Jason Zweig, writing for the Wall Street Journal describes the issue this way,
"A key factor still is ... cost. Let's say you tell your broker that you want to simplify your stock portfolio into an index fund. He then tells you that his firm manages an S&P-500 Index fund that is "suitable" for you. He is under no obligation to tell you that the annual expenses that his firm charges on the fund are 10 times higher than an essentially identical fund from Vanguard. An adviser acting under fiduciary duty would have to disclose the conflict of interest and tell you that cheaper alternatives are available."
Zweig also quotes Mary Shapiro, the former director of the Securities and Exchange Commission,
"I think investors would rationally say that they prefer fiduciary duty as the standard of care. And they are entitled to have their interests come first, always.""
Another class of investment relationships, hedge funds, have no responsibility to you, other than by contract. Hedge funds are largely unregulated. Hedge funds can only sell to "accredited" investors, who, in theory, are sophisticated enough to watch out for themselves. The problem is that the qualification standard for individuals is $1 million net worth or $200,000 annual income. While this may seem to be a substantial amount of money, it is a lot less today than when the definition was enacted. Many people who meet the standard today are not sophisticated investors and are prime targets. The fallout of the Madoff scheme clearly shows this.
What are some things that you can do to improve the odds that your advisor is looking out for you first?
Choose an advisor that commits to a fiduciary standard at all
times. Let them personally assure you of this.
Avoid advisors that receive commissions for products that they recommend. Let them confirm this as well.
Make sure that the advisor's transactions on your behalf are fully transparent and disclosed to you.
Make sure that your investment assets are held in your name at a reputable, SIPC insured custodian and that the custodian's records match with the advisor's statements.
Do not give your advisor authority to remove funds from your account.
Ask for a copy of the advisor's "ADV II" disclosure form. The form discloses the advisor's business methods and discloses potential sources of conflicts of interest. All registered investment advisors and financial planners must provide one to you. If they do not, they are not a registered investment advisor or financial planner.
Check the SEC website for any disciplinary history.