The immediate answer is you can’t, just like you can’t predict the future performance of the stock market. You invest in the market because you hope it goes up in value. However, you know the market is volatile and unpredictable so you diversify your investments to reduce your risk of large losses. The point is you don’t know short-term direction, but you hope the longer-term direction is up.
This type of optimism also occurs when you select money managers. You may interview four money managers, but there is a 75% probability you will select the manager with the best track record. Track records make the selection of money managers easy. However, they come with a major disclaimer “Past performance is not an indicator of future performance”. Like the market, the future performance of managers is unknown.
So what happens when you select a financial advisor who does not have a track record? What information do you rely on to determine which advisor will provide the best advice and services? Following are some tips that will help you increase your odds of selecting a good advisor and reduce your risk of selecting a bad advisor.
1. You start by listing the criteria you associate with good advisors. The criteria fall into four categories: Competence (education, experience, certifications), Ethics (clean compliance records, licensing, fiduciary status), Business Practices (compensation, expenses, disclosures, reporting), and Financial Services (planning, investment advice, insurance, tax, and legal).
2. Even though it is convenient and easy you must minimize the impact of subjectivity on your advisor selection decision. Otherwise, you run the risk of selecting the advisor with the best personality and sales skills.
3. Documentation is extremely important. High quality advisors are willing to document information because they have nothing to hide. Low quality advisors resist documentation because they have a lot to hide. You should trust what you see, not what you hear.
4. The financial services industry has two ethical standards. A lower standard applies to stockbrokers and other types of representatives who sell investment products for commissions. A higher standard applies to fiduciaries who provide financial advice for fees. You should limit your selection to professionals who acknowledge their fiduciary status in writing.
5. Method of compensation is also extremely important. Sales reps masquerade as advisors because it helps them sell investment products. But, they can’t hide their compensation method. If their only method of compensation is commissions, they are sales reps. You should limit your selection to professionals who are compensated with fees.
The above criteria reduce the playing field from 680,000 reps and advisors to about 68,000 advisors who provide advice and services for fees. This eliminates the 90% of the people who sell investment products. You focus your selection process on the 10% who are “real” advisors.
These criteria do not guarantee you will select advisors who produce superior rates of return. That guarantee simply does not exist for advisors, the stock market, or money managers who provide legitimate track records. You have to make the leap of faith that competent, ethical financial advisors will produce better results than their lower quality competitors!