Assessing Value of the Advice and the Advisor

It’s been a tough 12 months to be managing someone else’s money.

But for financial advisors and their clients, the dramatic year that just passed in the markets also may be the most important test of whether the relationship can last.

“When the market is going up, everybody looks good,” said Michael Andreola, tax partner at BDO Seidman in New York. Now, he said, investors have had a chance to measure the talents of their financial planner, broker or other advisor against the toughest stock market in more than a decade.

Yet investment return--in good or bad markets--is just one aspect of sound financial advice, experts say.

Has your financial advisor earned his or her fees during the last year? These questions can help you objectively answer that:

1. Were you prepared?

Good financial advisors go over the potential risks and rewards of various investments before customers put their money on the line. That means whatever losses you suffered in the last year should have been in a range you expected.

“Examine the surprise factor,” said Chuck Jaffe, author of “The Right Way to Hire Financial Help” (MIT Press, 2001). “You should not be surprised by something happening in your portfolio.”

There are nuances to investing that your advisor should understand and, more important, explain to you. For example, mutual funds and individual portfolios invested largely in one segment of the market, such as technology or financial services, tend to be more volatile than funds that spread their investments more evenly among a variety of industry groups.

Advisors who thoroughly explain investment risks to clients minimize the potential for those clients to become overly emotional about market swings, Jaffe said. And controlling fear is a key element in being able to stay the course with a portfolio.

2. Was your portfolio diversified before the market sank?

Savvy financial advisors make sure their clients are well-diversified--both in terms of asset classes and individual investments.

What that means is that most people should have some money in stocks, some in bonds and some in short-term cash accounts--the three basic asset classes. But that’s just step one.

Step two is making sure that the stock portion of the portfolio, for example, includes a variety of mutual funds and/or individual stocks.

An advisor who isn’t paying attention can fill a client’s portfolio with mutual funds that are heavily invested in the same narrow area--tech stocks, for example--even though the funds might appear on the surface to be broadly diversified. That can leave the portfolio vulnerable if that particular segment of the market takes a hit.

Proper diversification is a tough sell when one segment of the market is red-hot. But good advisors keep clients focused on the long-term merits of diversification.

3. Have your investments matched your ability to tolerate risk?

Investors often tell financial advisors that they want to earn a target rate of return on their money each year--say, 10% or 12%, said James Shambo, a certified public accountant and personal finance specialist with Lifetime Planning Concepts in Colorado Springs, Colo.

But clients frequently don’t understand the risks they might have to tolerate to generate their desired return, he said. They also might not realize that, to reach their financial goals, they might not need a particularly high return and its attendant risk.

An advisor’s job is to work with the client to determine what the client’s goals will cost and how best to achieve those goals, Shambo said.

“If you get people to be realistic upfront, you are much more likely to strike a reasonable balance,” Shambo said. “We figure that your investments have to provide a total picture that lets you both sleep well and eat well.”

4. Has your advisor created a long-term plan?

Besides helping you pick investments, an advisor ought to suggest a savings and investment regimen aimed at achieving your long-term goals.

It’s a good sign if an advisor got you started on a regular savings pattern--and can tell you how much progress you’ve made, experts say.

It’s a bad sign if the planner simply wants to help you invest money that you’ve already accumulated, without a plan for investing future savings, dealing with estate issues, etc.

5. Have you followed the plan your advisor laid out?

In the context of your portfolio’s performance during the last year, also ask yourself this question: Did your advisor give poor advice--or did you fail to follow good advice you were given?

You can have a personal trainer, but it will do little good if you continue to consume large quantities of doughnuts. Investing is much the same: You have to follow through on a plan.

6. Do you own products or a portfolio?

There’s no reason to own more than two mutual funds in a single market niche, Jaffe said. If your portfolio has numerous “copycat” funds, an advisor should have an adequate answer as to why similar funds are necessary to meet your long-term goals.

When experts see copycat funds in the same portfolio, their suspicion is that an advisor is simply selling clients products to earn commissions.

Practically speaking, owning too many funds in the same category can mean the sum of the funds’ performance is no better than what an “index” fund would produce. Index funds try to mimic a particular market index, essentially guaranteeing an average return.

With fund overlap, “you’re paying a lot of money [in fund management fees] to get essentially index fund performance,” Jaffe said.

Another sign of a product sale for its own sake: An advisor buys tax-deferred annuities for an individual retirement account. The bottom line is that the client is getting one benefit--tax deferral--for the price of two.

Which leads to the next question:

7. Have you understood and are you OK with how your advisor is compensated?

A good advisor should be willing and able to explain clearly how he or she is paid--whether through commissions on products you buy, a set annual fee or both.

Though conflicts of interest naturally can arise with commission sales, that doesn’t necessarily mean they exist with your advisor.

What’s more, fee-only advisors aren’t without potential conflicts of interest of their own. Because they typically make their money by charging an annual fee that’s a percentage of the assets they manage, they can benefit from counseling you to keep your money invested, rather than using it for other purposes, such as paying off debt.

Advisors are required to provide a copy of their “ADV” form to any client who asks. Make sure you get both Parts I and II. This form explains fees, commissions and reveals whether your advisor has had run-ins with securities regulators.

8. Has your advisor evaluated the level of fees charged by mutual funds you own?

In a strong market, mutual fund fees are easy to ignore. In a struggling market, they can mean the difference between a profit and a loss, said Lynn O’Shaughnessy, author of “Retirement Bible” (Hungry Minds, 2001).

“Your portfolio can hemorrhage . . . thousands of dollars by buying a high-cost mutual fund--or even an average-priced mutual fund,” O’Shaughnessy said.

An advisor should be able to show what your funds cost and the level of performance you’re getting for that cost--especially in the case of funds the advisor has recommended.

The Securities and Exchange Commission Web site, at https://www.sec.gov, has a calculator that can help investors compare the total cost of disparate types of fund fees--including front-end and back-end loads, 12(b)1 marketing fees and annual management fees--over time.

9. Is your advisor tax-savvy?

At year-end, a competent advisor should be examining clients’ portfolios to ensure that taxes aren’t being incurred unnecessarily. For instance, an advisor should determine whether there are money-losing investments that can be sold to offset capital gains the client will be reporting for that tax year.

Taxes can’t always be minimized, but an advisor should know enough to ask, experts say.

“Paying taxes in a year that your portfolio is down is not good business,” said BDO’s Andreola.

An advisor also ought to help you look for more tax-efficient mutual funds--those that generate fewer taxable capital gains each year--and help you decide whether you’d benefit from owning tax-free municipal bonds.

10. How has your portfolio performed overall?

The total performance figure is often the first thing investors consider when evaluating their advisor, but it should be viewed in the context of an advisor’s broader role.

At a minimum, however, your advisor should have explained early on what benchmarks would be fair to use in assessing your portfolio’s performance. The blue-chip Standard & Poor’s 500 index is a commonly used yardstick for stocks.

In the short term, a portfolio’s lagging performance relative to the appropriate benchmark isn’t enough reason to fire a financial advisor, Jaffe said.

“You hired for expertise; you don’t fire them because they tripped on a down market,” he said.

But if the issue becomes one of years of under-performance, an investor should question whether his or her portfolio is in the right hands, experts say.

“I wouldn’t go more than two years with an advisor that under-performs,” Andreola said.

If your answers to these questions leave you with the strong sense that something is wrong with the relationship, you can try to talk over your concerns with the advisor, of course.

If you’re convinced it’s time to find someone else to manage your money, there are several professional organizations that give referrals.

The Financial Planning Assn. ([800] 282-PLAN) offers lists of certified financial planners in your area. If you’re looking for a fee-only planner, call the National Assn. of Personal Financial Advisors ([888] FEE-ONLY). If you want a certified public accountant with a personal financial specialist designation, call the American Institute of Certified Public Accountants ([888] 777-7077).

Information on choosing a financial planner is also available at The Times’ Web site at https://www.latimes.com/finplan. The site offers stories, phone numbers, addresses and links to related sites.

Kathy M. Kristof can be reached at kathy.kristof@latimes.com.