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How to find a financial advisor you can trust

(MoneyWatch) I recently met with a wealthy widow, who had been quite a bit wealthier before meeting Bernard Madoff. After that experience, she was very concerned about finding a financial advisor she could trust to act in her best interests. I thought it would helpful to share with you my advice.

I began by pointing out that Madoff was able to execute his massive fraud because, like the Wizard of Oz, he operated behind an opaque curtain -- there was no transparency. Anyone bothering to perform proper due diligence, instead of relying on social connections and the desire to be a member of an exclusive club, would never have invested a penny. Yet many investors lost their fortunes.

In other words, it's OK to trust, if you also verify. Among the advantages of investing in publicly traded investment vehicles are that they are highly regulated. To my knowledge, there's never been a single dollar lost due to fraud. Among the reasons are that they avoid all the problems that investors in Madoff's funds should have spotted. For example, mutual funds are required to have audited financial statements. Mutual funds engage major public accounting firms to perform annual audits. The audits verify the financial statements of the money manager as well as check correspondence with the custodians, brokers and transfer agent of the funds to confirm reported trades and securities held.

Mutual funds don't perform the fund's accounting themselves, and they don't act as custodians of the assets under management, engaging banks or trust companies to perform that function. The bottom line is that all of these attributes should be requirements for working with any advisor or money manager.

Criteria for seeking financial advice

We now turn to the four criteria that should be absolute requirements in getting financial advice:

1. None of the advice should be based on the advisor's opinions. Instead, the advisor should be able to demonstrate that his or her advice is based on what might be referred to as the "science of investing" or "evidence-based investing" -- evidence from peer-reviewed academic journals.

Consider the following. You aren't feeling well. You make an appointment to visit a doctor your friend has recommended. The doctor's job is to diagnose the problem and recommend treatment. After a thorough exam, he turns around to his bookshelf and reaches for the latest copy of Prevention magazine. Before hearing his advice you're already thinking it's time to get a second opinion. Therefore, you make an appointment with another doctor. After her examination, she reaches for a copy of the New England Journal of Medicine.

At this point, you are feeling much better about the advice you're about to receive. The financial equivalent of the New England Journal of Medicine is a publication such as The Journal of Finance. The advisory firm should be able to cite evidence from peer-reviewed journals supporting their recommendations. And the advice should be easily understandable, transparent and make sense. One of the things I'm most proud of is that so many readers of my books have related that they had what might be called an "aha moment." Meaning that they finally understood how markets work, how prices are set and what the winning strategy is.

2. The firm also provide a fiduciary standard of care -- the highest legal duty that one party can have to another -- which requires the firm to provide advice that is based solely on what's in your best interests. This differs from the "suitability standard" present in many brokerage and insurance firms. That standard only requires that a product or service be suitable -- it doesn't have to be in your best interest. There's simply no reason why you should settle for anything less than a fiduciary standard. Not one. Unfortunately, most investors are unaware of the difference. They simply assume that an advisor is giving advice that's in their best interest. And that makes them vulnerable to being exploited.

Such exploitation is much less likely when you know there's bias. For example, imagine that you needed to buy a new car and had narrowed your choice to a Honda and a Nissan. Now, when you visit the Honda dealer you know he's biased -- he's going to try and sell you one of the automaker's cars. You certainly wouldn't expect him to extol the virtues of the competition. While the bias exists, at least you are aware of it. Forewarned is forearmed. If you want unbiased advice, you know you need to seek an independent viewpoint, such as from Consumer Reports.

Unfortunately, when it comes to investing, an advisor isn't likely to be wearing the equivalent of a shirt with the Honda emblem emblazed on it, which alerts you to the bias.

The bottom line is that there's no reason you should ever work with someone who isn't prepared to meet the fiduciary standard. Why would you work with someone unless you are convinced that the guiding principle of the firm is to offer advice that's solely in your best interests? That means that when it comes to investments the only thing the firm is selling is advice, not products on which they earn commissions. If an advisory firm is unwilling to put in writing that they provide a fiduciary standard of care, there's no reason to work with them.

3. Advisors should be "eating their own cooking," meaning investing in exactly the same investment vehicles they're recommending to you. The advisor should be willing to show you his own statement from the custodian holding his assets so that you can verify the veracity any claims. They should also be able to show you that the company's 401(k) or other retirement plans offer the same vehicles they are recommending to you. That doesn't mean that their asset allocations will be the same as they are recommending (because each person has a unique ability, willingness and need to take risk), but the vehicles offered should be identical. If they aren't, don't hire them.

4. The fourth criteria is that because financial plans can fail for reasons that have nothing to do with an investment plan, it's critical that the advisory firm integrates an investment plan into an overall estate, tax and risk management plan. For example, an investment plan can fail because of a premature death or a disability that prevents one from working. It can also fail because of the lack of sufficient insurance, be it life insurance, property and casualty insurance (such as for homes, cars, boats, and for protection against floods and earthquakes), or personal liability insurance. It can also fail because of lack of creditor protection (an issue particularly true for medical professionals). Remember that even if you don't have a large enough estate to have to worry estate taxes, there are many other non-investment issues that should be addressed, such as the need for wills and durable powers of attorney for health and financial matters.

A well-developed financial plan includes a detailed analysis of the need for life insurance -- as replacement for income, or as the most efficient way to pay estate taxes and transfer wealth to your heirs, or to a charity. It also includes the need for disability insurance and for longevity insurance to cover the risk of running out of money because you live longer than expected (a risk that can be hedged through the purchase of a payout annuity). It should also include the need for long-term care insurance. As we age, the risk of needing some form of long-term care increases.

Plans can also fail even when estate planning is done well. For example, far too often individuals have paid for high-powered attorneys to develop well thought out estate plans only to have the trusts created either go totally unfunded or are funded with the wrong type of assets. Some trusts are designed to generate stable cash flows. They should be funded with safe fixed income investments. Others are designed with a growth objective in mind. They should be funded primarily with equities.

Estate plans can also fail because the beneficiaries haven't been properly named. That can occur because documents are not updated to address life events such as divorce or death. This is another example of why a financial plan must be a living document, one that is reviewed on a regular basis.

It's also critical to understand that estate plans can fail despite the best efforts of top-notch professional advisors. Unfortunately, most estates lose their assets and family harmony following the transition of the estate. This occurs because heirs were unprepared, they didn't trust each other and communications broke down. While great attention is typically being paid by the family to preparing the assets for transition to the heirs, very little, if any, attention is being paid to preparing the heirs for the assets they will inherit. Thus, a good advisory firm can add great value by helping to prepare heirs for the wealth they will inherit.

Finally, you should also make sure that the firm's comprehensive wealth management services are provided by individuals that have the PFS (personal financial specialist), CFP (certified financial planner) or other comparable designations. Note that the PFS credential is granted to CPAs who have demonstrated their knowledge and expertise in personal financial planning. And once these designations are granted they must be maintained through required professional development to keep them current.

The choice of a financial advisor is one of the most important decisions you will ever make. That's why it is so important to perform a thorough due diligence.

Image courtesy of Flickr user thetaxhaven

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