Investors should be thoughtful in their search for a financial advisor to assure that the relationship will serve their interests well. This series discusses six aspects of the relationship which should be considered before making such as decision. It begins with the “Method of compensation”.
Often, investors spend too much time focused on the explicit cost of having an investment manager rather than the total cost. Financial advisors are paid on either a fee basis, a commission basis, or a combination of both. Paying a commission-based advisor on each transaction provides the broker with an incentive to trade more often, and to transact using products that pay the highest commissions.
The world of investment advice is fraught with conflicts of interest, whereby brokers and other commission-based investment professionals receive the highest compensation for putting their clients into bad investments. The reason is simple: wonderful investments, such as many Vanguard funds, thrive without having to offer commissions to salespeople – the products sell themselves. The best mutual funds offer the lowest management fees. This way, they can provide investors with great risk-adjusted returns.
Paying your advisor a quarterly fee based on portfolio size provides the advisor with an incentive to help your portfolio grow safely. Investors should seek fee-based advisors and demand clear – and preferably written – details that explain every potential conflict of interest involved in their business model. Registered investment advisors tend to be fee-based – meaning they charge for their services through explicit fees, such as annual management fees based on the size of the account. Brokers tend to be commission-based – meaning they charge for their services through commissions on transactions – often only explicitly revealing some of them.
Investors who think they are getting a free lunch when their commission-based investment professional takes them to eat to sell them commission-based products are probably enjoying one of the most expensive meals of their lives. Virtually every investment professional has compensation-based conflicts of interest, ranging from explicit upfront commissions to hidden fees like trailing commissions, high annual management fees being kicked back to the sales people, bonuses, and free trips – the list goes on and on.
The key point is that prospective investors should demand full disclosure of every potential way that a financial advisor might financially benefit from managing your money. It is only through the lens of full disclosure that an investor can evaluate the extent to which the advisor’s advice may be driven by his or her own self-interest rather than the investor’s best interests.
In my years in the investment industry, I have observed that the highest-paid investment professionals are those that work on a commission basis – and they often give self-serving advice. Yet many investors are drawn to commission-based professionals thinking they are getting advice at little to no charge. In truth, these salespeople are receiving huge amounts of hidden compensation. Investors who shy away from explicit charges, such as asset-level-based management fees (or hourly fees), are usually making a big mistake – one that they may never even realize was the cause for their disappointing performance.