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You can ask family, friends, or co-workers for names of financial advisors they like and trust.
Interviewing potential financial advisors is definitely worth your time and effort.
If you aren’t sure what to ask, here are ten important questions to get you started.
Ask These 10 Questions to Help Choose a Financial Advisor
1. What is Your Investment Philosophy?
This is an open-ended question as investment philosophy can mean a variety of things.
Advisors can either take a passive or an active approach.
An advisor who believes in a passive approach designs your portfolio based on your long-term goals. Then, they will not change the portfolio much unless fundamental assumptions change.
For example, they might reduce emerging markets stocks if they think emerging markets will not perform well for the next twenty years. But they will not reduce emerging markets just because it might not do well next year.
An advisor who has an active approach, on the other hand, will change your portfolio as market conditions change. Most advisors fit somewhere between a fully active and an entirely passive approach.
If the financial advisor has an active approach, ask them these follow up questions:
- How do you decide when to make the change? This will further clarify their investment philosophy.
- When was the last time you made such a change? How did it perform?
Similarly, advisors may also use either passive or active funds to implement your portfolio. Passive funds are index mutual funds and exchange-traded funds (ETFs) that simply mirror the index.
Active funds, on the other hand, are more customized and try to do better than the index. If your financial advisor uses any active funds, ask them these follow up questions:
- How do you find and evaluate active funds? The more thorough the evaluation, the better.
2. What is Your Asset Allocation?
Research shows that asset allocation is the most significant determinant of your portfolio’s performance. You can ask to see a sample portfolio to get a sense of the asset allocation.
While the best asset allocation for you is dependent on your investment goal, here are some clarifying questions to ask:
What is the Stock/ Bond Split?
Generally, the longer your time horizon and the higher your risk tolerance, the more stocks you should have. The lower your time horizon and lower your risk tolerance, the more bonds you should have.
If you’re investing for a retirement that is 25-30 years away, you should be invested primarily in stocks. If you need the money sooner, you’ll also want to invest in bonds to make sure that the money is there when you need it.
How Diversified is the Asset Allocation?
Research shows that diversification not only reduces risk but also improves return. Assets that best diversify each other, move in opposite directions.
For example, when stocks go down, high-quality bonds typically go up. So, they are great diversifiers.
The stocks and bonds you hold should be further diversified.
For example, within US stocks, instead of just holding large-cap stocks, it is better if you also include value and small-cap stocks of diverse industries and sectors.
Value stocks are stocks of companies that are currently undervalued and small-cap stocks are stocks of companies with a smaller financial market value.
Research shows that including both small-cap and value stocks can improve your returns.
Similarly, a diversified portfolio would also include international stocks, including international small caps and international value from diverse industries and sectors.
3. Do You Offer Financial Planning Services?
Access to financial planning can be the most crucial requirement for some individuals. Some advisors will help answer specific questions about planning for life events like buying a home, marriage, or retirement.
If your financial situation is more complicated, you might need a financial advisor who provides a more integrated and comprehensive planning service rather than just answering some questions.
The financial advisor will work with your trust and estate lawyer, accountant, and if you have any equity compensation, with your company’s attorney to provide you comprehensive wealth management.
4. How Are You Paid and What am I Getting?
Your advisor may be commission-based or fee-based. Generally, it is advisable to use a fee-based advisor because a commission-based advisor may try to make higher commissions by selling you expensive products.
Within fee-based advisors, there are several ways in which they can charge you. Some may charge a flat fee. Some may charge an hourly fee.
A common way to charge fees is to charge a percentage fee on the assets managed. In this case, your total fee consists of advisor fees and fund fees.
The advisor fees will be higher for traditional and full-service financial advisors and lower for robo-advisors.
The average fee for a financial advisor is 1.02% and that for a robo-advisor is between .25%-.50%. This means that if you invest $10,000, you will pay $102 a year on average for a typical financial advisor.
If you invest with a robo-advisor, it will cost you $25-$50 a year.
Similarly, fund fees will be low if you primarily use passive funds like ETFs and more if you use active funds. The average fee for an active fund is around .67% and that for a passive fund is .15%.
If all you need is to invest some money and you are comfortable dealing with your advisor mostly online, a robo-advisor may be sufficient for you.
But if you need more planning help, a higher service advisor may be more suitable.
Needless to say, if you can get the same service at a lower price, the provider with the lower fee is a better choice.
Fees can be really detrimental to your portfolio’s performance. This is because when you pay a fee today, you’re also giving up all the compounding and future returns of those dollars.
Consider this example: In 20 years, 1% annual fees reduce a portfolio’s value by nearly $30,000, compared to a portfolio with a 0.25% fee.
5. Can You Bring Down the Fees?
Explore options to bring down your total fees. If your advisor primarily uses active funds, one way to bring down costs might be to use more ETFs.
Some markets such as the US Large Cap are very efficient and there's little for an active fund manager to do to add value. Hence, an ETF might be a more cost-effective choice in replacing an expensive active fund.
6. Can You Show Me Your Returns?
While past performance is not a guide for the future, seeing past performance will help you gauge your advisor’s effectiveness to some degree.
Your advisor should be able to provide you past returns of their sample portfolio.
If they are relatively new, they might provide you a backtested performance that shows how their performance would result if they existed at the time.
Make sure these sample returns are net of fees – that is, they take both the fund fees and the advisor fee into account.
7. How Do Your Returns Compare to the Benchmark?
A benchmark is a yardstick for your account so that you know how well you did.
For example, if you have a fund that generated 20% in return last year, you might think it’s great. But if you compare it to its benchmark, the S&P 500 Index that made almost 30%, now, you might not think it was so great.
Each fund you invest in will have its own benchmark. If your advisor invests only in index funds, the benchmark will be the index itself, and the performance of the fund will match or be very close to the index.
But if you invest in active funds, they will have different benchmarks, and the performance of the fund relative to its benchmark shows how effective it is.
Similarly, your total portfolio also has a benchmark. Ask your advisor what that benchmark is and how well their portfolio did compare to it.
When you compare performance, look at long-term performance – over the last 3 years, 5 years, and even 10 years if available. If you find the portfolio or funds are lagging their benchmarks, ask the advisor why.
8. If I Leave Your Firm, Can I Take My Investments with Me?
This will be important if you need to change your advisor in the future.
If you are invested in ETFs or public mutual funds, you should be able to take your investments with you to a new advisor.
Your new advisor will then evaluate the funds and sell the ones not needed in a tax-efficient manner.
But, if you have any private mutual funds or other vehicles that can’t be held outside, you will have to sell them with your current advisor and transfer out the cash.
This will trigger capital gains tax. If you have held those investments for a long time, your capital gains could be substantial.
9. What Security Controls Do You Have?
Increasingly, account security is becoming top of mind for financial advisors and clients because of the heightened security risks out there from scammers and thieves.
Pay special attention to what controls your advisor has to prevent unauthorized parties from transferring money out of your account.
10. Do You Provide Tax-Loss Harvesting, Dividend Reinvestment, and Rebalancing?
Although housekeeping items like these can seem insignificant, they can make a big difference in your portfolio’s performance.
It's one of the main reasons to even hire an advisor – so you don’t have to spend a lot of time managing the day-to-day operations of your portfolio.
As you receive dividends from your investments, it is imperative to invest them right away to compound your returns over time.
Similarly, over time your asset allocation will go off course as some positions appreciate and some lose value. Your advisor should have a disciplined rebalancing strategy so that your portfolio doesn’t go off course too much.
Tax-loss harvesting is a process by which your advisor will incur capital losses in your portfolio to lower your taxes.
If you decide you’re ready to invest and want to work with a financial advisor, asking them the ten questions above will provide you with a lot of information.
Make sure you understand their background, experience, and goals.
Then ask for and check references of anyone you’re seriously considering working with, before investing any of your money with them.
Lastly, never be afraid to switch financial professionals if you’re unhappy with the relationship or the results.
Article written by:
Guest Contributor, Roshani Pandey, an investment industry veteran, who's spent 16 years advising individuals and institutions on their finances at firms such as Goldman Sachs and BlackRock. She created True Root Financial to help individuals make smart, life-changing decisions about money so that they can live their best life. Follow her on Facebook, LinkedIn, and Instagram.