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How to keep your financial advisor honest

(MoneyWatch) All financial advisors -- including me -- are not completely honest. Why? Because, like doctors, dentists, and lawyers, we are human. Dan Ariely's new book, "The (Honest) Truth about Dishonesty: How We Lie to Everyone -- Especially Ourselves," holds some fascinating and practical insights to use when dealing with others. I interviewed Ariely with an emphasis on dealing with financial advisors. The findings may be key to your financial future.

Honesty in the real world

Ariely's book is brilliantly written and covers data-driven experiments on the subject of human honesty. As it happens, the results of those experiments show that we typically cheat up to the level that allows us to retain our self-image as reasonably honest individuals. Ariely states that all of us continuously try to identify the line where we can benefit from dishonesty without damaging our own self-image.

He gave me the example of a surgeon who might choose to operate even though the data indicates that taking a wait-and-see approach statistically has better outcomes. Apparently, when we profit from seeing the world in a certain way, our view of reality gets distorted. It's not that we are dishonest, it's that we are human.

Through a series of experiments, Ariely and his colleagues determined some factors that increase dishonesty and increase honesty. A couple of the factors that increase our cheating are the ability to rationalize conflicts of interest and watching others behave dishonestly. It appears that even after we outgrow the schoolyard that the bad behavior of others can still lead us astray. Interestingly, the amount of profit from cheating and the probability of getting caught have little effect.

In selecting an advisor, Ariely told me that the key is to select one who has the fewest conflicts of interests. He said that the commission model has the most conflicts, followed by the assets under management approach. An annual fee or an hourly model has the fewest conflicts of interests. An advisor charging for advice, but who is not profiting from the product being used or from capturing assets, has even fewer conflicts.

Keeping your advisor honest

Ariely found that four drivers increase a person's honesty.

  • Pledge
  • Signatures
  • Moral reminders
  • Supervision

To use these drivers with your financial advisor, Ariely suggests asking the person to put in writing why a given portfolio is right for you and what the amount of your total fees will be. Ask your advisor to sign it, reminding him that this portfolio represents your family's financial future. Having him make this signed pledge on an annual basis serves as a moral reminder. And asking questions showing healthy skepticism reminds the advisor that you are supervising the process.

Ariely says that advisors play a critical role in society, yet often concentrate on the wrong thing. Though they are unlikely to add value by trying to beat the market, they can add immense value by helping the client think about money. How consumers spend money has the largest impact on reaching financial goals. For example, understanding the impact buying a new car will have on reaching financial independence is more valuable than picking stocks or funds advisors think will outperform.

I highly recommend Ariely's new book for a fun and fascinating read that will change the way you view honesty. If you, like me, are looking for the profit angle, this book will also give you key insights on keeping your doctor, dentist, lawyer, accountant, and even financial advisor more honest. Trust me -- I'm a financial advisor.

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