Most people still cling to the quaint idea that Wall Street’s job is to make you money. In fact, nothing could be further from the truth.
Most investments.. and most investment advice, is designed to make the person selling it rich. Not you.
I was reminded of this by two different questions I received from Mastermind Members, within the last few weeks.
One was asking my opinion on some newsletter advice that, to those who understand basic finance and investing, can only be a blatant, bald-faced ploy to take money for bad advice from people who don’t know better.
The other was asking what you look for, or how you choose a trustworthy, competent financial advisor. Sadly, that is easier said than done.
The financial services industry is chock-a-block with perverse incentives
At least from the perspective of the investor.
And if you show me the incentives, I can predict the outcome about 99% of the time. For example…
The worse an investment is, the more they pay people to sell it.
It only makes sense… Because without that additional incentive, all things being equal, the advisor would sell the better investment for their client.
The more people who sell it, the more people who buy it… not because they want it but because they have been sold it.
The basically random odds of short-term investing mean, in any pool of investors or investments, some of them will be successful.
Of course, those are all the successes in the ads and testimonials. No one publishes the investors who lost money or the funds that went out of business because they were so bad.
Social proof says, in the absence of certainty we look around, see what everyone else is doing and do the same thing. And when we look around, what do we see?
Mostly we see random odds and skewed representations of results on a bunch of investments that were bad and sold not because they were right but because they paid the advisor the most.
It all becomes this vicious, self-perpetuating circle.
Sadly, by definition, the opposite is also true.
The more an advisor does what is in the client’s best interest, the less money they make.
That is what I mean by perverse incentives.
The Economic Policy Institute estimates investors acting on bad advice from advisors costs them $1.9 billion a month, or roughly $23 billion a year.
And this doesn’t include the impact of advice given elsewhere, including financial gurus, newsletter writers, courses and the financial press.
As a heuristic, in my experience, the bigger their house and fancier their cars, the less likely an advisor is to be acting solely in your interest.
In a perfect world, you’d want an advisor who’s wealth comes predominantly from successfully managing their own money, as opposed to managing or giving advice on yours.
But since, we can’t always find that, or see it, here are…
Seven glaring red flags that tell you don’t walk away from the advisor or advice, run!
- Claiming he/she can successfully pick the winners… or teach you to pick winners
- Claiming he/she can successfully and consistently time the market
- Accepting a commission from the products they sell
- Recommending a portfolio with an expected return of less than 10%
- Assuring you that an investment cannot lose money
- Recommending you move money out of your 401(k) or stop contributing to invest with them
- Suggesting that you borrow from your home equity to invest
Doing what is in your client’s best interest is hard. It is. Because investing is hard.
People want to get rich quick. They are bedeviled by fear and greed, which cause them to want to sell when things go down and buy when they are going up. Their brains don’t process probability or risk well. They have hundreds of emotional biases they are, for the most part, completely unaware of. And, quite frankly, they are, for the most part, gullible.
The path of least resistance is to give people what they want. And, perversely, the industry pays you well for doing exactly that. It’s set up that way.
One of the things that was most disheartening, when I first started working in the investment industry was, when you’d go out for drinks after work and people were talking amongst themselves, it was as if you were going out for drinks with the mob and they were just casually talking about the guy they just whacked.
The things that they just took for granted, and talked about so casually, felt like they should be illegal. Or, at the very least, troubling. It isn’t. And wasn’t.
Wall Street legend, Charley Ellis, who has been working on Wall Street since the early ’60s, described the system recently, on a podcast, by saying…
“The secret to successful active investing is to have a never-ending pool of ‘willing losers’.”
What are willing losers? Well, as they say in poker, ‘If you’ve been in the game 30 minutes and don’t know who the patsy is, you’re the patsy.’
To help you protect yourself from bad financial advice, I’d like to go into a few of the red flags in a little more detail…
An advisor claiming he/she can successfully time the market, pick the winners… or teach you to
We know and have known, for over a hundred years, no one can consistently time the market… meaning knowing when to get out and when to get back in.
Nor can we consistently pick individual winners, beyond what one would expect from random chance.
We’ve known it since the 1900 Ph.D. dissertation of the French mathematician Louis Bachelier.
While largely ignored at the time, it is now the basis for much of the theory related to the predictability of free market prices.
Bachelier’s conclusion, even way back then, was:
“The mathematical expectation of the speculator is zero.”
But what fun is that? People don’t want to believe that.
As an advisor, not only does that not maximize my income, but it jeopardizes it.
If I am counseling the correct, long-term approach to investing, my client’s are just sitting ducks to be picked off by some salesman with the next great, more exciting pitch.
If I am a newsletter writer, what do I have to write to you about each day or week, if not my latest pick or market call?
If I teach a course on proper investing, how do I keep you from getting bored or losing your patience?
In financial services, the way to make a lot of money without having to work very hard is to give them what they want.
Advisors who get paid commissions for the products they sell
Any advisor who takes a commission off the products they sell you has a clear conflict of interest.
You have no way of knowing whether the product he recommends is really in your best interest or if he is recommending the product because it pays him well.
There is just no reason, except a big fat commission, for example, that someone should ever sell you actively managed mutual funds, especially proprietary ones to their company.
Variable annuities or any insurance product that combines investing and insurance is another example. Never ever mix the two. The rule of thumb is to buy term and invest the rest.
Or, in the “give them what they want” bucket, a conflicted advisor who either overtly encourages you to make frequent changes in your portfolio and/or turns a blind eye and does not advise against it.
That is just skimming the surface, but hopefully gives you the idea. To minimize conflict of interest, you want to look for fee-only advisors.
Recommending a portfolio with an expected return of less than 10%
The next is a little more subtle. But I believe that any advisor who recommends or constructs a portfolio for you, with an expected annual return of less than 10%, is a red flag.
The reason? It is going to take at least that for you to retire. At least.
And, if they don’t know that, that’s a problem.
It means they aren’t keeping up. They are still doing things the way we thought in the 1950s when we had jobs for life, affordable health care, and lifetime pensions.
That is not who you want advising you.
More likely, they do know it. But their firm is limited in the investments it can recommend and sell so they don’t tell you that.
The formula for required rate of return is your expected annual withdrawal rate plus the rate of inflation divided by 1 minus your marginal tax rate.
If I assume best, best case numbers, like 5% withdrawal rate, 3.5% rate of inflation over your retirement, and a 33% marginal tax rate, your required rate of return is 12.5%.
If any of those numbers are too low, you’ll need more.
If your advisor isn’t starting with the end in mind, and figuring out how to get you to the finish line, and helping you stick with that plan, they are not an advisor, they are a salesman.
Two totally different things!
Assuring you that an investment cannot lose money… Or just omitting any discussion of risk
An employee of mine, a few years back, showed me a postcard she received from a financial advisor near her neighborhood.
He advertised a historical annual return of almost 15 percent with “no known history of loss.”
The implication is that he can deliver high returns with no risk. Sounds like the perfect investment, right?
Ref!! Throw a flag!
There is no such thing as a risk-free return above what is guaranteed by the U.S. government, meaning US Treasury bills, which at the moment, is about 2%.
So 15%, without risk, is like saying you can jump up into the air, flap your arms and fly. It is not possible.
But sadly, people fall for it. Because we want it to be true.
Recommending you borrow money, even from yourself, to invest
If someone recommends you move money out of your 401(k), or borrow money to invest, even borrowing from yourself, like from your home equity or 401(k), you know, straight away, that person has is not legitimate.
No one can look you in the eye and tell you that is a good idea… ever!! Ever!
I wish there was no need for guides like this. But there is.
And, of course, this list is by no means exhaustive.
Hopefully, it gives you some mental shortcuts you can use when evaluating the information you hear or read, the advice being given and the people giving it.
I would say the number one rule is, if you have ANY doubt, walk away.
Trustworthy and competent sources of advice do exist
You just have to filter for them… carefully!
As always, I hope that helps.
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