3 Things to Know About Your Financial Advisor
Choosing a financial advisor, whether it's your first time or you're looking to make a switch, can be one of the most important decisions you make for your financial future.
The professional you work with will ultimately be the steward of your finances, and it is critical to make sure they will always act in your best interest, maintain a portfolio that aligns with your risk tolerance and avoid recommending any products that aren't suitable for your unique situation.
Here are three questions that you can ask any prospective advisor to gauge whether they are the right fit:
-- Do you act as a fidiciuary on my behalf?
-- How many clients have you served that are like me?
-- What mix of investments will ensure the risk in my portfolio aligns with my financial goals?
[See: Stop Believing These 7 Investing Myths.]
Do You Act as a Fiduciary on My Behalf?
There continues to be a discussion about the potential resurrection of the Department of Labor's fiduciary rule, which would impose legal requirements on advisors to act in their clients' best interest at all times.
But until such a regulation is implemented, it is important to ask an advisor about their fees and commissions as well as what types of products and investments they would recommend. This will help you get a sense of whether you think they will continually act in your best interest.
An unethical advisor may recommend an unsuitable investment because they are seeking the high commission that investment provides them, or because they have a particular book of investments and products that they are allowed to sell you.
For example, an advisor who is not acting as a fiduciary might choose to recommend an illiquid real estate investment trust, or REIT, to an older retiree who has a low risk profile. This would be a poor choice, as a REIT is not considered a conservative investment and, given the illiquidity, the individual would not be able to access the money he or she invested if they needed it.
As another example, if an advisor is pushing you to buy an annuity, it is critical to understand why he or she is trying to sell it to you.
Annuities typically bring in high commissions for advisors and are sometimes recommended to individuals who would benefit more from other investments or products.
Annuities are illiquid assets and have high fees, so they should generally only be used by investors who need to receive a guaranteed amount of money each year (for example, a widow or widower who lacks other income sources).
Also, it is important to note that any money withdrawn from an annuity is taxed as ordinary income. Thus, if you have an advisor who is advising you to take non-qualified money (money that has already been taxed) and locking it up in an annuity -- that money will become subject to income tax, instead of capital gains.
In most situations, capital gains taxes are more favorable than income taxes.
[See: 8 Things to Remember When Reviewing Your 401(k).]
Clearly it is critical to avoid these types of situations and make sure your financial advisor will only recommend what is best for your specific portfolio, regardless of what commission they will or won't receive.
How Many Clients Have You Served That Are Like Me?
A good advisor should be equipped to understand your life stage and plan for various likely scenarios as well as unique circumstances.
For example, if you are an entrepreneur who expects to sell your business, it will be beneficial to work with an advisor who has helped other entrepreneurs and executives with the extensive financial planning that surrounds a successful transaction.
Ask any prospective advisor to share details on the demographics and common life events of their client base.
What Mix of Investments Will Ensure the Risk in My Portfolio Aligns With My Financial Goals?
Advisors should offer you a broad range of investments, such as stocks, bonds and mutual funds, that create a diversified portfolio tailored to your risk tolerance, life circumstances and financial goals.
When considering your age, if you are younger and feel comfortable with taking on a strategic amount of risk, you can set a more aggressive asset allocation and incorporate gradual adjustments over the years to make it more conservative as you get older and approach retirement.
Your financial advisor should also design your portfolio to align with your current level of assets.
Index funds, for example, can be a beneficial vehicle for individuals who are still accumulating wealth and have less than $500,000 in assets. Having a smart allocation of index funds enables you to track the market based on your risk profile for low internal investment fees, and unlike a mutual fund, performance isn't subject to the good or bad years of a portfolio manager.
Yet regardless of whether you are mass affluent or ultra-high net worth, it is important to have a strategic mix of both passive and actively managed investments that can work together to achieve your long-term financial goals.
[See: 5 Economic Factors That Influence Stocks.]
Searching for and choosing the right financial advisor can be a time-consuming and stressful process, but the effort spent will be well worth it.
Working with a professional who is trustworthy and understands your individual circumstances is a key element in securing a lifetime of financial security.
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