What Kind of Advisor Do You Have?

Imagine that you are traveling in a foreign country. You’re feeling lousy, so you go to a health clinic. A man at the front desk says you must choose between two types of physicians.

The first type of physician will interview you and give you a thorough physical exam before prescribing whatever treatment or medicine is most likely to give you a successful outcome.

The second type will take less of your time and probably will cost you less money. This person will listen to your symptoms and might check your blood pressure if that seems to be an issue; but you can’t expect her (let’s presume for the sake of convenience that all doctors in this country are female) to do a full checkup. You are told she will likely recommend a treatment or medicine in which she has some financial interest, but isn’t obligated to let you know whether or not that is the case.

This is puzzling to you. The man at the front desk takes out a sheet of paper and draws a circle. Then he draws a small semicircle inside the right side of that bigger circle, and another semicircle on the left side. “This circle represents all the possible treatments and medicines that are available,” he says. He labels the right semicircle “Things that could hurt you.” He labels the left semicircle “Things that will be best for you.” Then he explains: “We have two different laws that govern our physicians here. The doctor who will give you a full checkup is required to know enough about you to determine what you need. She must recommend whatever will be best for you, something from the left semicircle. If she might make extra money as a result of what she recommends, she has to tell you that.

“The only requirement of the other type of physician is that she must avoid recommending something in the right semicircle, something that will hurt you,” he continues.

This seems mighty strange to you, but after a few more questions, you get the picture. One doctor’s job is to do the right thing for you. The other’s is to avoid doing something that will hurt you.

If you were that traveler, which type of physician would you choose?

Although this is an imperfect analogy, investors in the United States are essentially in the same position as this traveler. It’s too bad most of those investors have no idea that is the case. In order to walk you through the example of the traveler, I made up a helpful front-desk attendant who explained the rules of the game. But in real life, there’s no such helpful attendant waiting to give that kind of objective guidance to investors.

TWO TYPES OF INVESTMENT ADVISORS

A good guide would start by pointing out that in this country, there are two separate laws that govern investment professionals. These laws effectively separate these professionals into two camps. Every savvy investor should know this distinction, though it’s a fuzzy one.

In the first camp are individuals whose primary job is selling products. They are brokers or broker/dealers, though they use various titles such as “registered representatives,” “investment representatives,” “financial advisors” or “financial consultants.” These titles, also used by some professionals in the second ‘camp’, are not a reliable guide. Brokers work in a sales-oriented culture in which the function of giving advice and making recommendations is restricted by law to an incidental role. They are required only to avoid selling “inappropriate” investment products. (See the circle in Figure 1.) This is loosely equivalent to doctors who are required only to avoid doing things that are obviously bad for patients. Brokers are free to operate with financial interests that conflict with the interests of their customers, and they don’t have to disclose those conflicts.

Figure 1

The investment industry’s second camp is made up of individuals whose primary job is giving advice. Legally, they are known as registered investment advisors. They often use titles such as financial advisor or consultant. Some are brokers. Whatever they call themselves, these people are held to a higher standard. They are required to disclose any potential conflicts of interest. They also must know their clients’ circumstances enough to recommend only investment products that serve the best interests of those clients.

Picture yourself as the imaginary traveler trying to choose between two types of physicians. If you are pretty sure you know what’s wrong and you just want merely a quick fix, you’ll probably go to the less expensive doctor. But if you don’t know what’s going on and you think you may need some serious attention, you’ll probably want a doctor who does a thorough examination before rushing to recommend a product or treatment. When you’re choosing somebody from whom to get financial advice, wouldn’t it be nice to know that the advisors in one camp are behind one door, all the others behind a second door? In reality, it’s not that simple. But if you know how to decode a few signals, you can be your own front-desk guide.

Formal designations don’t necessarily point you to a fiduciary. A CFP certificant or Certified Financial Planner has undergone a rigorous training program for personal financial planning. But a CFP can be either a broker or a registered investment advisor. It gets even more confusing, because some brokers are also registered investment advisors – putting them in both camps. Their legal responsibility to clients is diluted by their employers, the broker/dealers, who allow them to sell only certain products.

I think this, along with a compensation structure that rewards brokers for selling some funds instead of others, violates the principle that registered investment advisors must not have conflicts of interest with their clients.

THE KEY: FIDUCIARY RESPONSIBILITY

You are much better off with an advisor who has assumed fiduciary responsibility.

Recall for a second that mythical physician who must take the time to know you well enough so you’ll be given only recommendations of “things that will be best for you.” That doctor is on the hook legally, and this gives you two advantages. First, that responsibility will guide that physician to take your needs very seriously. Second, if something does go wrong, you have legal recourse that you would not have with a doctor whose only obligation was to avoid harming you. To understand the difference between those two physicians, you’d need to know something about the laws that dictate how they operate. The same is true of brokers vs. fiduciaries.

You should at least be aware of two quite different laws: the Securities Exchange Act of 1933 and the Investment Advisers Act of 1940. It’s easiest to understand them one at a time.

 

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