A typical financial advisor

Most advisors focus on either portfolio performance and asset management or financial products that solve your needs. While these services may be necessary, they’re only a small part of what a financial advisor does. Let’s discuss the advisors you want to avoid and then get into the traits and services of an advisor that you want.

Limitations of AUM (Assets Under Management) financial advisors

These advisors often charge a percentage of your portfolio or even a performance based fee. They’re often heard preaching that this type of fee aligns with your interests. If they make you more money, they make money. What they don’t tell you is that it's easier for them to focus on attracting clients and what they call “harvesting assets,” than it is to increase portfolio performance. Doesn’t sound like a great professional relationship.

Your tailored portfolio may not actually be that high performing

These advisors focus on creating marketing material and fancy graphs that show how their “tailored” portfolios outperform the market, while hiding the truth that they often lag behind market returns.

Here’s four simple ways they hide this truth:

  1. Not including their fees.
  2. Choosing a specific and short time period where their portfolio outperformed.
  3. Comparing their higher risk portfolio with a portfolio that contains less risky assets and companies.
  4. Closing and merging underperforming funds into new funds. This is called survivorship bias.

Closet indexers

Along with spending the majority of their time creating marketing material and finding new clients, many focus on creating cookie cutter portfolios that follow index funds, while looking like they don’t. These are called closet indexers. These advisors do this to differentiate themselves and charge their fat fees. Again, advisors often put these spins on the portfolios to hide the fact that the portfolios are really following their respective index.

Warren Buffett endorses index funds

Advisors do this because they know that the best performing funds are often those that follow their respective index. This has been proven and the evidence actually won a Nobel Prize in 2013. In fact, Warren Buffett, an extremely successful active investor, has been quoted that the majority of his family’s inheritance will be in index funds and that he'd rather bet on monkeys throwing darts than work with a Wall Street financial advisor and the fees they charge. He’s even made a famous $1 Million bet on index funds. He won that bet and gave the winnings to a charity.

Why should you pay more simply because the stock market grows?

Now that we know financial advisors rarely correctly time and outperform the market, let’s focus on the fact that the market goes up. Here’s a 90 year historical graph of the U.S. Stock Market. Feel free to learn more about past stock market returns here.

Line chart of the 90-year price history of the US Stock Market. The line trends upward in an exponential fashion from approximately 1930 to present day. The y-axis of the chart is labeled 10, 100, 1000, and 10,000 at each mark so the chart appears more linear than exponential.
90-year price history of the US Stock Market. Source: macrotrends.net

As you can see, the market and your investments will undoubtedly grow as they always have. Now, let me ask you. Why pay an advisor an increasing fee simply for this fact?

Comprehensive planning vs. AUM focus

Having a fee directly based on portfolio size may initially make sense. However, once you realize the main factor of your portfolio performance is the performance of the stock market and that your financial advisor doesn’t have a crystal ball or the means to pick the next hot stocks, you quickly begin to wonder.

Now that this advisor has spent so much time focusing on portfolio performance and fancy charts showing their cookie cutter portfolios in the best perspective possible, you may wonder when this financial advisor has time for all the other components of financial planning. While portfolio and asset management may still be important, it’s only one part of a comprehensive financial plan. When does the advisor take the time to help you plan for retirement, optimize your taxes, prepare your estate, review your employee benefits, or help you decide on large purchases? Is this advisor even worth the ever-increasing fee they charge?

Conflicts of interest

Not only can advisors who charge a fee based on portfolio size be expensive and not transparent of the work being done, they can be conflicted as well! Conflicts arise from incentives to increase the portfolio they manage or incentives to avoid reducing the portfolio size. This is because their fee is directly based on the portfolio size.

Here’s a few conflicts that can arise from this:

Increase portfolio size

  1. Advising to roll over 401(k).
  2. Delaying retirement when you’re able to.
  3. Taking social security instead of delaying it.

Discouraging withdrawals and decreasing portfolio size

  1. Dissuading paying off a mortgage or auto loan.
  2. Advising against life insurance or long term care insurance.
  3. Investing in higher returning, but riskier investments than necessary.
  4. Advising against charitable giving.
  5. Buying a larger or second home.
  6. Taking vacations.
  7. Funding children’s college.
  8. Not giving early gifts to children.

Ditch the AUM: Why you need a flat fee financial advisor

Advisors who charge a flat fee do not have the above mentioned conflicts of interest. Instead their fee directly reflects the amount of work they do. Maybe that’s why most professionals, like attorneys, accountants, doctors, and dentists, charge that way as well? This sounds a lot more fiduciary than an advisor focused on portfolio performance and asset management. Use our quiz to match with a fee-only, flat fee financial advisor near you.

Up next

In "Avoid Commissions, Choose Control: Why Choosing a Fee-Only Financial Advisor Benefits You,” we’ll discuss a second type of typical financial advisor, commission advisors. These advisors focus on selling you financial products that often provide them large commissions, even when the financial products aren’t in your best interest.