Three qualities to look for in an investment adviser

Your financial/investment adviser should have the following three qualities:

They must be unfailingly honest.
They must be competent in handling your situation.
They should be able to communicate well with you.

These three qualities – honesty, competency and communication – are important in that order.

Honesty

Dishonesty can take many forms. Some dishonest people will try to steal your money outright. Others will say one thing and do another. Yet others will take or recommend actions to benefit themselves at your cost. Blatant fraud makes headlines. However, persons who do a disservice to their clients through unreasonable fees, commissions and kickbacks are far more common. As in any business, there are some very honest and some dishonest people in finance. Do not settle for anything less than complete honesty.

How to detect fraud? Several books have been written on the subject. Two that caught my eye are:

Here are some common warning signs of fraud:

If you are not rich, and someone approaches you with an attractive opportunity to invest with them, some form of dishonesty is usually involved.
The allure of unusually high returns or unusually steady returns.
Pressure to make a quick decision.
Taking custody of your assets.
Lack of transparency into operations or transactions.

The person you suspect of being dishonest may look rich, successful and charitable. Another person whom you trust and respect may vouch for them. Many people, including those in your social circle, may be invested with them. There may be pressure on you to join. When in doubt, just say no politely.

Seek out a true fiduciary. When searching for an investment adviser, people are often told to ask the question, “Are you a fiduciary?”. A fiduciary is someone with a legal obligation to act in someone else’s best interest. While you are indeed looking for a true fiduciary, the question is guilty of providing a false sense of security. This is because:

The law requires anyone managing other people’s money for compensation to register as a Registered Investment Adviser (RIA) or its representative.
The law requires all RIAs to act as fiduciaries.

In other words, anyone registered to manage other people’s money will answer “yes” to being a fiduciary. Judging honesty is not so trivial that it can be answered by asking, “Are you honest?”. To weed out crooked people, you need someone knowledgeable and skeptical, someone who is a demanding judge of character. This could be you. It could be a friend or a relative. The important thing is to not skip this step.

Competency

Your adviser should have both knowledge and experience. Knowledge can be partially measured through educational qualifications and certifications. If your situation is unique, then your adviser must be skilled in recommending a plan suitable for you. Sometimes, this requires a specialist. Investment professionals are required by law to consider suitability before recommending investments.

Experience is essential in investing. An inexperienced adviser is more likely to make assumptions that fail in a financial crisis. A professional who has navigated a number of major financial crises thinks about risk differently. You can judge experience by looking at an investment professional’s track record.

Communication

Your adviser should have a communication style that works for you. Note that this is the last of the three qualities to look for. An adviser who is honest and competent will serve you well, even if you dislike talking to them. Let me illustrate with an example.

My friend Chan (not his real name) is sixty years old. When he was forty, Chan was diagnosed with cancer. During the conversation in which his cancer diagnosis was revealed, his oncologist giggled. Chan turned to his sister, who was also a doctor, and asked, “Why is he giggling?!” His sister explained, “He is extremely uncomfortable delivering the news.” As far as bedside manner is concerned, this ranks among the worst. However, the story is memorable for another reason also. Chan asked several medical professionals for advice on where to seek treatment. He was advised to stick to Dr. Giggle, who consistently produced the best treatment outcomes in his area. Chan took this advice and stuck to his oncologist. He made a complete recovery. The cancer has not returned in two decades. Imagine if Chan had switched to a doctor who was less competent at treatment but had the best bedside manner. The same is true for an investment adviser who is competent but communicates poorly vs. one who is well-spoken but lacks investment skill.

On another note, communication impacts investment outcome. Clients often withdraw funds after a period of poor performance. Every investment style has good and bad periods. Returns are not steady, but are often mean reverting, meaning that long periods of under(over)performance are followed by periods of over(under)performance. A client who withdraws after a period of underperformance misses out on the future outperformance. Good communication between adviser and client can prevent such an outcome.

It is important to understand that the above is the behavior of a typical client, not someone who is foolish or greedy or impatient. In other words, you or I could act in this way. Poor returns create psychological pressure. Legitimate reasons present themselves for selling out of investments that have underperformed. To meet cash needs, it seems logical to sell the investment with the least gain (due to recent underperformance) thereby minimizing the tax burden. Unfortunately, this induces the client to sell near a low, in the process hurting their long-term returns.

If your adviser does not have the first quality (honesty), let them go. Sooner the better. If they don’t have the second quality (competency), also let them go. They may be doing very well momentarily, but you are running the risk of ruin. If they don’t have the third quality (communication), that alone does not pose imminent danger, but the relationship may be uncomfortable. Finally, the guidelines above should apply to any adviser, but there is an urgency to applying them in a financial context.

Thanks for reading. If you like my writing, please share my blog and consider following me on Twitter.