Tough Questions for Your Financial Advisor

(MoneyWatch)  I think it's pretty tough to find a good financial advisor. Larry Swedroe offers some helpful tips on how to find one in his column on 11 Principles for Selecting an Advisor. In addition to these, I suggest you ask any advisor a few questions.

1. Are we betting on certain companies, sectors, or countries to succeed?
The correct answer is "no." If they talk about over weighting energy and emerging market countries, they are speculating with your money. They don't know they don't know their award winning research merely increases risk and decreases return. On the other hand, if they talk about building a globally diversified portfolio owning securities that own thousands of companies around the world, and a high quality fixed income portfolio of investment grade corporate and U.S. government backed bonds, then your advisor passes this question.

2. If I insisted on buying some index funds, which ones should I buy?
I'm not 100% passive in my own portfolio so I can't rule out anyone that uses non passive funds. The correct answer would be a small number of index funds that have the lowest costs and the broadest diversification. Examples of these would be the Vanguard Total Stock fund (VTSMX), the Vanguard FTSE All World stock Fund (VFWIX), and the Vanguard Total Bond Index Fund (VBMFX).

Here are a few answers, however, that might concern you:

• They give you index funds with fees over 0.5%.
• They give you exotic index funds such as levered or inverse index funds.
• They give you narrowly based index funds such as health care or a single country.
• They give you a dozen or more index funds meant to make it look more complicated than it really is.

3. If I insisted on buying a variable annuity or an equity indexed annuity, which ones should I buy?
Yes, this is a trick question. There is no such thing as a good variable annuity or Equity indexed annuity. Some are worse than others but none are good. If they readily offer to sell you an annuity, just say buh-bye and head for the door. The correct answer is "if you want to buy one, you'll have to find another advisor."

4. What are my odds of reaching my goals and what are the risks?
It's important that your advisor be thinking about the ultimate goals of your portfolio and the probabilities of reaching those goals. I happen to be a fan of Monte Carlo simulation and its failure over the past year has far more to do with faulty assumptions than any flaw in the technique. Your advisor needs to be able to explain how certain conditions will change your financial independence date and the annual amounts you can spend in retirement.

5. How much am I paying in total costs this year?
Most investors only find out how much they are paying the advisor. While important to know, it's only part of the costs of investing. Make sure the following costs are included when the bill comes:

• His fees which can be commissions, percentage of assets, or hourly based.
• Expense ratios of mutual funds.
• Hidden transaction costs of mutual funds such as commissions and bid-ask spreads.

I suspect most portfolios will beat inflation by less than four percent annually, before costs. Thus, you have to decide how much of that you are willing to give up. I'm a firm believer that costs matter and suggest the following guide for total costs:

• Excellent - Under 0.5%
• Good - Over 0.5% to .8%
• Fair - Over .8% to 1.0%
• Bad - Over 1.0%

I know many will think I'm far too stingy in paying fees, yet at the end of the day, it's the fees that matter most. If your portfolio will beat inflation by four percent annually, before costs, how much do you really want to give up? You should know your total fees and I'd strongly suggest you get it in writing.

Conclusion
It's not easy or simple to find a good advisor, but these five questions will help. Combine them with Larry Swedroe's 11 principles and you've got a GPS of sorts that will help direct you towards the right person for you and your financial goals.