I’m not a big fan of reality TV shows, but I have to admit that I enjoy watching The Apprentice. What I think I enjoy most about the show is the no-nonsense way Donald Trump approaches the decision of who to fire. He doesn’t look at how hard they try, how smart they are, how they dress, or what school they went to. In the end, it simply boils down to getting the job done.
Maybe you’re in a relationship right now with a financial advisor. Perhaps it’s a friend of the family, someone your colleague recommended, or a relative. Whether you’ve been working with them for a long time, or just a short while, now may be a good time to evaluate their performance. Does your financial advisor try to impress you with how hard they work, with how well they dress, with how many degrees they hang on their wall, or does your financial advisor get the job done? Here are three things to consider:
#1 What is your benchmark?
In order to determine if your advisor is performing at an appropriate level, you must start by creating a benchmark. If your primary objective is to create current income with a secondary objective of preserving capital, then you really should not care how well the Dow Jones Industrial Average is doing. Here are some appropriate benchmarks for different kinds of investments (listed from conservative to aggressive):
|Cash||90-day U.S. T-Bill|
|Bonds||Barclays Capital Aggregate Bond Index|
|Real Estate||Dow Jones U.S. Real Estate Index|
|Large Cap Stocks||S&P 500|
|Small Cap Stocks||Russell 2000|
|International Stocks||MSCI EAFE|
|Commodities||Dow Jones-UBS Commodity Index|
Your benchmark may be a blend of the indices listed above. For example, if you have 60% of your portfolio in large cap stocks and 40% in corporate bonds, the appropriate benchmark would be 60% S&P 500 and 40% Barclays Capital Aggregate Bond Index.
Be sure to ask your advisor for the R-squared value of your investments. The R-squared value measures the appropriateness of a benchmark. This value ranges from 0 to 1. The closer your investment gets to 1, the more appropriate the benchmark.
#2 How well did the portfolio perform against the benchmark?
You should be meeting with your advisor at least once a year to review your portfolios performance against the benchmark. During this meeting you should ask your advisor about the beta statistic for your investments.
The beta statistic is a measurement of how sensitive your investment is to changes in the market. A beta greater than 1 means your investment is more volatile (i.e. more risky) than the market, while a beta less than 1 means your investment is less volatile (i.e. less risky) than the market. It is important for you to understand this so that you can give credit (and blame) where it is due.
For example, if the market goes up, and your investment has a beta greater than 1, you would expect your investment to outperform the benchmark because you are taking more risk. But before you walk away thinking that taking more risk is an easy way to achieve outperformance, just remember what happens when the market drops. In a declining market you would expect an investment with a beta greater than 1 to underperform.
The opposite is true for investments with a beta less than 1. To help you remember, here is a cheat sheet:
|What to expect in a …||Beta < 1||Beta > 1|
If your investments are underperforming when they should be outperforming, you need to find out why. Ideally, you want investments with a beta below 1 that outperform the benchmark in any market.
#3 How did your advisor’s fees impact the performance?
Financial advisors need to make a living like the rest of us. They provide a valuable service, and for that they deserve to be compensated appropriately. However, their compensation may impact the performance of your portfolio. There are a number of ways advisors may be compensated, so here are just a few:
Under a fee-based compensation structure, your advisor will typically charge a one-time or hourly fee in order to provide you with investment recommendations. Since this fee is charged regardless of your investment decisions, it will not impact the performance of your portfolio (just the balance in your checking account).
When your advisor is compensated on commission, they are paid when you buy an investment. This is equivalent to charging you for providing investment recommendations. Since the cost is netted out of your purchase, it will reduce your portfolios performance. The greatest impact will occur within the first several years, but over time its impact on performance will diminish.
Under an asset-based compensation structure, your advisor typically charges an annual asset management fee. This fee compensates your advisor for providing ongoing investment recommendations and financial service. Since this fee is charged annually, it will have the greatest impact on your portfolio’s performance.
The decision to hire, retain, or let go of a financial advisor is not an easy one. Start by setting a benchmark. If your advisor is able to meet and/or exceed the benchmark, they may be getting the job done. If not, is it because you are using the wrong benchmark, you are investing too aggressively or too conservatively, or because your advisor is charging too much? Discuss this with your advisor, and if you are not convinced that they are getting the job done, then maybe it’s your turn to sit up and say: YOU’RE FIRED!