U.S. Markets open in 4 hrs 15 mins

If You Don't Know These 2 Things About Your Financial Advisor, You're Making a Big Mistake

Maurie Backman, The Motley Fool

Working with a financial advisor could spell the difference between meeting your money-related goals and falling glaringly short. Yet new data reveals that Americans are disturbingly in the dark about how these professionals operate. A frightening 48% incorrectly believe that all financial advisors are legally obligated to act in their clients' best interests, according to Personal Capital's 2019 Financial Trust Report, while 20% have no idea how their advisors are compensated. If you're going to work with a financial professional, you must be able to answer these two key questions.

1. Is my financial advisor a fiduciary?

Whether your financial advisor is obliged to act in your best interests at all times depends on whether he or she is a fiduciary. Advisors who are fiduciaries must solely recommend investments that put their clients' needs first, which means a fiduciary cannot sell an inferior investment to make a greater profit. If your advisor isn't a fiduciary, however, then he or she is merely held to the suitability standard, which, as the name implies, states that a given investment must be suitable for your portfolio.

Man in suit shaking hands with man sitting next to woman on couch, with documents with graphics and laptop on table between them

IMAGE SOURCE: GETTY IMAGES.

Now you might be thinking that suitable sounds just fine, but in some cases, it's a distinction that could end up costing you money. Imagine your advisor has two seemingly equivalent investments to offer you, only one will cost you $1,000 in fees and the other, a mere $300. Under the suitability standard, your advisor is in no way barred from pushing the choice with the $1,000 price tag, even though it'll cost you more. That's why finding an advisor who's a fiduciary is crucial.

In the aforementioned report, 97% of customers who work with a financial advisor have faith in the professionals they've chosen; yet 18% don't know whether their advisor is a fiduciary. Therefore, if you're looking for a financial advisor, ask that question. And if you learn that your existing advisor isn't a fiduciary, you might consider taking your business elsewhere.

2. How is my financial advisor compensated?

Financial advisors have to get paid, but it's important that you understand how they make their money. There are two common compensation models in the advisor world. The first is a percentage of assets under management, and the second revolves around commissions for investments sold.

Now you might think that the latter option is preferable, since it means your advisor will be more proactive in sourcing investments. But actually, it's the former option you should be aiming for. The reason? The last thing you want is a financial professional who promotes investments for the purpose of landing individual commissions and padding his or her bank account. On the other hand, if you work with someone who takes, say, a 1% fee annually (which is fairly reasonable in the investment world, though if you have a large amount of assets under management, you should aim to negotiate downward), it'll be in his or her best interest to boost your portfolio as effectively as possible. The more your assets grow, the higher your advisor's cut amounts to.

Surprisingly, Personal Capital found that only 44% of customers who work with advisors know what fees they pay on their investment accounts. If you don't know how you're being charged, ask. And if your advisor can't explain his or her fee structure clearly, consider it a sign to move on.

Working with an advisor can set you on a solid financial path, provided you choose the right one. If you're not sure what to look for in an advisor, keep the above points in mind, but also, don't hesitate to solicit recommendations from friends, neighbors, and colleagues. After all, if you're going to put your money in someone else's hands, it helps to go in with the knowledge that people you know find that person trustworthy.

More From The Motley Fool

The Motley Fool has a disclosure policy.