Chapter 2:
The Least You Should Expect

What are the basic credentials, skills, and policies that you should expect from your financial advisor?

1. A clean disciplinary background. Ask the advisor which organization regulates his conduct: the Securities and Exchange Commission or the Financial Industry Regulatory Authority. Then, go to the appropriate website (www.sec.gov or www.finra.org), and see if the advisor has faced any disciplinary proceedings.

2.A full-time fiduciary obligation to always act in your best interests. A fiduciary is a person with a legal requirement to always act in your best interests.

3. Use of transparent investment vehicles that clearly identify the costs of ownership.

4. A reputation for honesty, integrity, accessibility, accountability, and confidentiality that is confirmed by several long-standing clients.

5. At least three years of work experience as a financial advisor in the specific area in which you seek advice, such as investment management or financial planning.

6. At least one professional designation, such as the Certified Financial Planner (CFP®) or the Certified Public Accountant/Personal Financial Specialist (CPA/PFS).

7. Broad knowledge of many areas and specialization in at least one area, such as financial planning or investment management.

8. Objectivity, as measured by a compensation formula that is aligned with your interests.

9. The ability to provide referrals to other competent professionals, such as CPAs and attorneys.

10. An investment philosophy with which you are comfortable. For instance, does the advisor attempt to beat the market or simply try to match the market’s returns? Asset allocation that reflects tolerance and goals.

11. A written client Agreement that spells out what services will be provided, the cost of the services, the method of compensation, and whether the financial advisor has “discretion” (permission) to act without first checking with you.

12. Reasonable advisory fees and full disclosure in dollars—as opposed to percentages—of all commissions and other expenses for all products. The fees should be compared to the annual expenses of low-cost invest- ment vehicles, such as no-load index funds.

13. A relationship with a well-known “custodian,” which is a financial institution safekeeping your account. For example, Charles Schwab and Raymond James are financial custodian firms. Custodians offer brokerage services as well.

15. Annual reviews, at a minimum, as well as a strategy for harvesting tax losses and realizing capital gains to mitigate your tax liability.

It’s a Relationship.

A relationship with a financial advisor is a personal relationship. Your comfort level with the advisor makes a difference. Your advisor should be a good listener who has a personality and demeanor that makes you comfortable. Remember that you are intending to work with this advisor for a long time.

The advisor should be responsive to your requests and need for service. You have a right to timely answers to your questions, and you have a right to ask your advisor for another explanation until you are confident you understand the situation. The advisor works for you.

An advisor can provide a wide range of services, depending on your needs and his skills; however, to ensure that your major concerns are being addressed, here are some basic services that should be part of the package:

Check the named beneficiaries on your accounts. It is not uncommon for people to have more than one brokerage account, bank account, 401(k) or IRA. People change jobs, and they open accounts and forget about them. Divorced people may have an ex-spouse who is still named as beneficiary on an account. Early in your advisory relationship, your advisor needs to collect all of your accounts and make sure that the beneficiaries are identified correctly.

Protect your assets. The financial advisor should be knowledgeable enough about estate taxation to protect your assets from the costly probate process, even though he may not specialize in the area of estate planning. You don’t need an attorney to have your accounts properly titled, such as establishing a payable-on-death account to protect savings held in banks or a transfer-on-death brokerage account. Your advisor should provide the necessary paperwork.
He should also be able to identify whether your insurance coverage is sufficient. The need for life, disability, long-term care—as well as additional property and casualty insurance or an umbrella policy—should be reviewed.

Identify your risk tolerance. Certainly, your goals and dreams for the future should be identified as well, but if your risk tolerance is not properly evaluated, your asset allocation—the mixture of stocks, bonds, and cash in your portfolio—may be too aggressive or too conservative. An asset allocation that is too aggressive may cause you to become more conservative and sell stocks after the market is already in a steep sell-off, only to see the market rally when you lighten up on stocks. Conversely, if your asset allocation is too conservative, you may be tempted to become more aggressive as you chase a market that has already experienced a strong rally, only to see the market wane shortly thereafter. In other words, improper asset allocation will tend to make you more emotional about your investments. Emotion is one of the investor’s worst enemies.

Develop your Investment Policy Statement (IPS). Your financial advisor should require that you complete an investment policy questionnaire that will help identify your risk tolerance. The IPS is a blueprint for how you and your advisor will direct your investments in the future. You should make sure that you understand and agree with everything in the IPS. Ultimately, the IPS serves as a basis for your asset allocation.

The IPS should address the following issues:

1. Liquidity. “Liquidity” is the amount of money you need available in cash or a cash-equivalent that you can have access to immediately for any need that might arise. It is a good idea to keep several months’ worth of typical spending in an extremely liquid account, such as a checking account or money market.

2. Taxes. Your tax obligations and your federal and state tax rates should be identified.

3. Investment restrictions. These can include investments you are refusing to make (tobacco stocks, for example), or that you are restricted from making by an employer or some other legal entity.

4. Primary goals. What are your primary goals—retirement, income
generation, savings, long-term capital gain, etc.?

5. Time frame for your investments.

6. Secondary goals and secondary time frame.

7. Risk tolerance. This leads to your investment approach based on your risk tolerance (conservative, moderate, or aggressive).

8. The level of volatility that you are comfortable experiencing. As an example:
How would you feel if your investments fell in value by 20 percent?

9. The projected volatility of your portfolio. What level of volatility should you expect?

10. Current and future income needs.

11. Estate planning considerations.

12. The use of leverage. Whether you will use leverage in the portfolio, such as a margin account, or any investment vehicles that employ leverage.

13. The frequency of rebalancing the portfolio. How often will you reallocate among certain asset classes, such as stocks, bonds and cash?

14. Performance evaluation. Which benchmarks will be used to evaluate the portfolio’s performance?

15. Evaluation frequency. How frequently will you evaluate performance?

The next chapter compares two very different standards of care among financial advisors.

“Risk comes from not knowing what you are doing.”

~Warren Buffet

Have a question? Contact Ed Mahaffy.

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