Understanding Performance Mistakes

Suppose a hypothetical investor meets with a financial advisor hereinafter referred to as Advisor A. Advisor A describes his investment process as based on sound Asset Allocation principles with a slant towards being conservative. Further he provides evidence that he will take large cash positions in bear markets when necessary based on their portfolio management experience. In addition Advisor A says that for the last 5 years, their performance was 5%.

Our investor is unimpressed with a 5% return. Our investor is searching for a financial advisor with a 10% return. The first mistake that this investor makes is that they have no frame of reference. That 5% may have actually outperformed the market by a significant margin, but they will never know because they were fixated on 10%.

Nevertheless, our hypothetical investor seeks out another financial advisor, Advisor B. In a meeting with Advisor B, our investor hears about a 10.41% return. Our investor gets excited because this is more in line with their investment performance objective. Advisor B tells our investor that they have a proprietary strategy using options, stocks and hedging positions in order to produce their returns. The proprietary strategy is a secret to the firm and they cannot share it for fear that the competition may try and duplicate it. Advisor B shows their track record for the last 5 years and it is 10.41%. Unfortunately, our hypothetical investor jumps all over this and opens several accounts with Advisor B. This would be a mistake without further investigation.

What is wrong with this picture?

• Advisor B's strategy is a secret. - Bernie Madoff's strategy was a secret too.
• Advisor B made large bets on the energy sector. - The energy sector is in a bear market now and our investor is completely unaware how this firm achieved the 10.41% return. The odds of Advisor B making 10.41% for the next 5 years would be next to impossible if they are primarily an energy sector manager and the energy sector is in a bear market.
• Our investor made as his goal 10%. - There is no guarantee of future performance from any financial advisor. Picking a number by the investor is fraught with peril.
• Our investor completely discounted Advisor A because the 5% return was not the 10% that they wanted to make. - Our investor made a decision not to invest with Advisor A based on an unrealistic expectation.

What our hypothetical investor should have asked:

• Will you prepare a Comprehensive Financial Plan for me?
• What types of investments do you recommend that I invest in?
• What kind of strategy or strategies do you use? Please explain your strategy(s).
• What are the fees associated with your recommendations?
• What will be the tax implications of your recommendation?
• What conflicts of interest do you have?
• How are you compensated? Fees, Commissions or a Combination?
• Can you be hired on an hourly or retainer basis?
• How do you make investment decisions after accounts are invested initially?
• How will additional investments be handled?
• Have you ever gone to cash? If so, why?
• Where will my accounts be held? What custodian or firm?
• What protections do you have in place for the safety of my funds?
• What licenses do you hold? What designations do you hold?
• Have you ever had a license or designation subject to any type of disciplinary action?
• What can you provide me as verification of a background check and the background check for all principal members of your firm? (Those with access to my accounts.)
• Where are your written disclosures? Please provide in writing for my review.

This is a short list of good questions to ask any Financial Advisor. Of course, there are other questions to ask in addition to these. It depends on your personal situation.

I trust that you can see now why seeking a 10% return is the absolute wrong way to go about choosing a financial advisor. A Comprehensive Financial Plan is what you should demand as your starting point. You need to look at the entire balance sheet which is Assets and Liabilities. You need to understand the plan and the process that goes into designing the financial plan for your needs. Believe me, you will be much better off with a Financial Plan.

Please feel free to comment.