Published September 24, 2018
It is critical for any investor to fully understand the difference between a broker and an investment advisor; investors need to understand whether the advice is objective or, perhaps, driven by financial incentive. To better understand this concept, we can analogize the comparison of the “grocer versus the nutritionist.” The grocer (the broker) can only sell what he has in his store. However, the nutritionist (the fee-only advisor) can provide advice on what is the best move for a person’s financial health and is not compelled by any obligation to sell his firm’s products.
As the senior managing director of a financial advisory firm, I know there’s no such thing as free financial advice. Smart investors ask questions, especially about how their advisor makes money. The Council of Economic Advisers under President Obama estimated Americans lose a whopping $17 billion a year as a result of overpaying on investment products that they buy based on conflicted advice.
Make sure to ask these four questions before choosing a financial advisor.
1. What Kind Of Advice Are You Paying For?
Fee-only financial advisors typically provide a full-service offering to clients. They offer comprehensive, big-picture strategies for the management of one’s wealth through all aspects of life, including budget planning, life insurance, and even interfacing with clients’ tax advisors and estate planning professionals.
On the other hand, I’ve noticed that brokers have begun using the term “financial advisors” in recent years too. They’re actually stockbrokers. They’re paid a commission when they buy and sell stocks. Unlike fee-only advisors, they tend not to consider the other elements of a client’s total financial picture, such as coordinating with tax and legal professionals to ensure that all members of the client’s financial team are on the same page.
2. Who Is The Regulator?
Both types of financial professionals are required to adhere to regulations, but they do so differently.
The Securities and Exchange Commission (SEC) is the government agency that regulates the securities industry in the United States, as well as both brokers and advisors. The SEC governs the Financial Industry Regulatory Authority (FINRA) and also oversees the Securities Investor Protection Corporation (SIPC).
In addition to oversight from the SEC, fee-only financial advisors are also held to a fiduciary duty.
Those advisors who sell insurance are also subject to state insurance commission regulations in their respective states.
3. What’s At Stake?
The North American Securities Administrators Association (NASAA) has detailed exactly what an investor is entitled to in its Investor Bill of Rights. This is an invaluable tool for the investor, especially one who is new to investing or is starting a relationship with a financial professional.
Even a quick skim of the Bill of Rights makes clear that its purpose is to give investors a blueprint for what types of questions to ask. The document establishes the policies around information as “rights,” and its name reminds investors not to feel hesitant or self-conscious about asking questions. Some crucial questions to ask in order to understand the goals of your financial professional include:
• What are the potential commissions, sales charges, transaction fees and penalties?
• How are problems addressed?
• What is the work history and background of the person handling your account?
A defensive reaction from any financial professional to any of these questions is a red flag.
In today’s volatile market, I advise my colleagues that a client who asks questions is giving us an opportunity to strengthen our relationships, better understand their needs, exhibit our knowledge and most importantly, demonstrate our value, so I recommend looking for a professional who responds positively to questions.
4. How Are They Making Money?
We’ve already established that brokers are transactional. I must note, too, that in my experience brokers are often beholden to the investment banking arm of the brokerage. That means that commissions, bonuses and even the broker’s job may depend on their ability to sell shares of companies their banks take public.
Surprisingly, many brokerage firms also make money hand over fist when it comes to the portion of the clients’ portfolio that is kept in cash. While investors generally seem to keep very little of their portfolio in cash and can choose other options, such as money-market funds, very few probably know that, according to a 2018 article (paywall) by Wall Street Journal columnist Jason Zweig, it’s not uncommon for a brokerage firm to make multitudes more on an investor’s cash than the investor will see from it.
To put it plainly, the broker typically makes his living by buying and selling, whereas fee-only advisors are often incentivized to grow the investor’s portfolio because their fee will grow correspondingly, as illustrated by Business Insider.
There are competent and ethical practitioners in both categories, but investors must understand all the reasons their advisor is making recommendations. Are your advisor’s financial goals aligned with your own? Besides, when was the last time you walked into a grocery store and asked for advice on how to get healthier?