by Jack Waymire
Typically, I talk about what you should look for when trying to find a financial advisor. But in this article, I want to discuss what you should watch out for – red flags that could save you from working with a bad financial advisor.
What is a red flag?
You’ve heard the saying, “Where there’s smoke, there’s fire.” That is particularly true with financial advisors. When you see a red flag (smoke), it means there is a potential problem (fire), and in this case, that may be a good reason to select a different advisor.
At a minimum, a red flag should be thoroughly researched to determine how the problem might impact you. The sooner you identify a red flag, the less time you waste researching an advisor who is not right for you.
Some red flags are obvious (bad reviews), while others require a sharp eye to spot (phony certifications).
You have to be able to recognize red flags to avoid them. So, let’s look at some of the most common sales tactics that fall into the red flag category.
Everything is Verbal
When interviewing a financial advisor, it is safe to assume that 80 percent of the information provided to you is verbal. Most of the time it is communicated in the form of a sales pitch, which means you have no record of what was said to you.
However, when an advisor does not provide you with any documentation to back up the claims he or she made, this is a red flag. Documentation protects you and creates liability for them and their firms.
If all of the advisor’s information that describes his or her credentials, ethics, business practices, expenses and services is verbal, you should probably look elsewhere. You should always receive some kind of documentation for your records.
You’ve Never Heard of the College or Colleges an Advisor Has Attended
Surely, you’ve heard of diploma mills – people can buy fake degrees so they look more educated than they really are. These degrees could be a BA/BS, MS, MBA or even a PhD.
Sadly, bad advisors use this deceptive marketing strategy to try to impress investors, knowing most investors won’t check the accreditation of the institutions that issued them or sold them.
If you don’t recognize the name of the college that awarded a degree, use the Internet to double-check the accreditation of the school. Even better, see if you can confirm the advisor obtained a degree from this institution. There have been instances of advisors falsely claiming to have degrees from brand name schools.
It should be a major red flag if one or more degrees were earned by schools you have never heard of.
Fake certifications are like fake diplomas. Advisors know investors want financial experts handling their assets, so they need a way to “prove” they are experts. One tactic is to buy certifications that have no significant prerequisites, curriculum, testing or continuing education requirements.
You may see advisors who have several acronyms after their names. For example, John Doe, BBA, MBA, PhD, CFR, CAP, CRU, DGM. In this example, John uses 21 letters after his name, but do any of them make sense to you? The media has coined a phrase for this particular sales tactic: Alphabet soup.
Alphabet soup is a collection of letters that don’t mean much to the typical investor. You probably have no idea what the letters stand for or what the advisor did to obtain the credentials. Advisors who use fake or junk credentials are betting you will not take the time to research the initials that appear after their names. But there are free, fast, easy and confidential ways to research credentials online.
Licensing and Registration is Unfamiliar
Red flags can also be found in an advisor’s licensing and registration. Everyone claims to be a financial advisor, but advisors who hold securities licenses (Series 6, Series 7) are really sales representatives. I say that because their licensing limits them to selling investment products for commission.
The industry allows people to use the titles that help them sell the most products. Salespeople use titles like “financial advisor” or “financial planner” to reduce your sales resistance. But real financial advisor registrations are limited to Registered Investment Advisors (firms) or Investment Advisor Representatives (professionals). These registrations permit them to provide financial advice and ongoing services for fees.
Several Complaints on a Compliance Record
You want an advisor who has a clean compliance record – no complaints, no fines, no reimbursements to clients, no sanctions, no censures, no suspensions and no administrative actions.
To be fair, you have to know the seriousness of the regulatory action before you judge the ethics of the financial advisor, because a majority of complaints are frivolous and not a reflection on an advisor’s ethical treatment of clients. You are going to have to be the judge of the importance of disclosures for events that happened several years ago. For example, if an advisor had a significant complaint 10 years ago but has had a clean record ever since, how important is the event that happened 10 years ago?
A compliance record with one or more complaints that resulted in reimbursements to clients by the advisor should be a major red flag. Regulatory actions that resulted from ethical breaches should also be considered red flags.
Fiduciary Status Not Provided in Writing
Another potential red flag is a person who claims to be an advisor but is not a financial fiduciary. This is the case for sales representatives who hold securities licenses (Series 6 and 7), but are not registered as advisors (IARs) or firms (RIAs).
These representatives are held to a lower ethical standard that is called “suitability.” This standard does not require them to put your financial interests ahead of their own.
Sales reps are supposed to make suitable recommendations that are based on your age, tolerance for risk and current circumstances, but this deliberately vague standard is very difficult to enforce. For example, three representatives could provide very different recommendations that are all deemed suitable. How do you enforce a standard when there is no right answer?
Any advisor who is not a financial fiduciary is more likely to have potential conflicts of interests. A professional who claims to be a financial advisor but will not acknowledge in writing that he or she is a financial fiduciary should be a red flag.
When an advisor offers to buy you lunch early in your decision process, there is a 90 percent probability the advisor is using this sales tactic to create a competitive advantage. Subconsciously, you may feel indebted to the advisor because he or she bought lunch, a round of golf or provided tickets to a basketball game.
Go to lunch after you have selected an advisor.
If a commission-based sales rep tells you his financial planning service is free, you can be certain that it is not. This misrepresentation is used to create competitive advantage. The rep is being paid by his broker-dealer or a third party (load mutual fund family) to sell you investment and/or insurance products.
The product company adds the marketing expense to the fee that it deducts from your assets. This is why so many commission products (load mutual funds, annuities) have very high expense ratios.
Advisors Who Don’t Explain How They’re Compensated
The way an advisor is compensated and the amount should always be a concern – it is your money after all. Any advisor whose only method of compensation is commission is a sales representative. It is up to you whether you are comfortable following the investment recommendations of a sales representative.
If an advisor’s only method of compensation is a fee (hourly, fixed, asset-based) then you are dealing with a real financial advisor.
There are also hybrid advisors who can be compensated with fees and commissions.
You should not select an advisor who is unwilling to provide full disclosure for his or her compensation.
Advisors Who Don’t Disclose Expenses
Expenses are critical because every penny is one less that you have available for reinvestment.
Expense disclosure is a primary form of transparency. Some advisors practice it and some don’t. Some advisors volunteer the information. Some force you to ask the right questions.
Regardless of how you obtain the information, it should be in writing.
Expenses are a sensitive topic because layers of fees can be deducted from your accounts. If an advisor fully disclosed all of the fees, you may not buy what he or she is selling. But if an advisor refuses to document every penny of expense that will be deducted from your accounts each month, quarter and year, this is a red flag.
References are highly questionable when they are used to support the sales claims of financial advisors. The role of the reference is to influence your selection decision.
No advisor will knowingly provide a bad reference, and you don’t know if you can trust what you are hearing. For all you know, an advisor has coached his or her references to make the right comments. References produce more risk than benefits. They may cause you to make the wrong decision.
Also watch out for other professionals (CPAs, attorneys) who act as references. They may have reciprocal referral or reference relationships with advisors.
No Performance Reports
Another cautionary note is an advisor’s ability to provide monthly or quarterly performance measurement reports and meet with you to review them.
This is an essential service for real financial advisors. It is one of the reasons they charge a recurring fee for their advice and services.
On the other hand, commission sales reps are not paid to provide this type of service. They are paid at the time of the sale. In general, they are not paid reoccurring compensation to provide ongoing services.
The only exception may be the sales rep who is paid a trailing commission. He has some incentive to stay in touch with his clients.
High Return for Low Risk
This sales pitch is the foundation for thousands of financial scams. An advisor claims he or she has developed a magic formula that produces high investment returns for little or no risk.
Bernie Madoff used a version of this scam when he promised his black box could produce moderate returns for virtually no risk (no negative return years). There is a relationship between risk and reward. The higher the reward you are seeking, the more risk you have to accept. Risk is measured by the volatility of your returns, in particular your losses in down markets.
The opposite is also true. If you want lower risk, you have to accept lower returns.
No doubt you have seen celebrities promoting or endorsing a particular investment product or service.
What should you conclude from a celebrity endorsement? The product company can afford to pay the celebrity. Plus, the endorsement has nothing to do with the quality of a product or company. In fact, you may want to automatically reject firms that use endorsements to influence your financial decision-making.
The SEC has taken a page or two from our book when it recommends you always do your homework before you make any financial decision, and that includes selecting the right financial advisor.
Many red flags are based on common sense. However, many of the red flags are obscured by slick marketing tactics. You should always do your research before hiring a financial advisor. Never ignore a red flag. At a minimum, conduct some additional research. Remember, you should always trust what you see, not what you hear, when you select an advisor.
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