What your clients may be asking about you behind your back
Hoboken, NJ (July 2014)—You probably haven’t given a lot of thought to how your financial advisor gets paid. Nor have you considered that a lot of the money pouring into his pocket rightfully belongs in yours. That’s a big problem, says Steven G. Blum. Because few of us realize that investing is actually a series of negotiations (much like buying a car or asking for a raise), we approach advisor relationships as “take it or leave it” transactions—which means over time we can miss out on many thousands of dollars…and sometimes a lot more.
“We tend to place too much trust in our financial advisors,” says Blum, author of Negotiating Your Investments: Use Proven Negotiation Methods to Enrich Your Financial Life (Wiley, 2014, ISBN: 978-1-118-58307-4, $40.00, www.negotiatingtruth.com). “In fact, we view the recommendations they make to us more like medicines prescribed by a doctor rather than transactions we should negotiate.
“Of course, not all financial advisors make their money through deceitful or underhanded practices,” he adds. “But if you aren’t paying attention to exactly what your financial advisor is doing with your money, no matter how trustworthy he or she may be, if you aren’t negotiating with him or her at every turn, you aren’t protecting your own financial interests.”
This negotiation process is important because it provides investors an opportunity to weed out unfair fees and other costs that eat away at their earnings. For example, a $1 million investment that is burdened by 1 percent more than it should be (an advisor’s fee or other hidden cost), if compounding at 7 percent per year, will be worth some $2 million less after 30 years than it otherwise would have been.
“Make no mistake: Wall Street is not about making you money; it’s about getting your money,” says Blum. “Thousands of financial jobs involve new ways to package or slice up the various real investments that already exist. Firms spend a lot of time explaining why three animals each with the head of a dog, the torso of a pig, and the tail of a fish are much better than one dog, one pig, and one fish. To protect your money, you must be knowledgeable about how the investment world works.”
Read on to learn how to overcome some of the investor challenges that could be costing you a lot of money.
Be aware that you’re on an uneven playing field. Knowledge is power, and in the financial industry that is especially true. The people on the other end of your investments have command of a great many tricks of the trade that are far beyond the knowledge of even very smart regular people. Because they know a great deal that you don’t, you are badly disadvantaged and very vulnerable to being manipulated. Among the consequences of this knowledge imbalance are overcharging, underserving, moving bad merchandise, guiding business to friends (or reciprocators), hiding fees, selling things that have no value, misleading, stealing, taking credit unfairly, and claiming random chance as skill.
“So, how do you avoid suffering as a result of this information asymmetry?” asks Blum. “One answer is to learn more, although in all fairness you’ll never be able to completely level the information playing field with those who work in that field every day. Also, be very careful about who you hire as your advisor. Look for people whose best interests require that they remain trustworthy.
“Really, there is no single answer,” he adds. “The best advice is not a prescription but a set of cautions and admonitions. Stay vigilant. Don’t trust imprudently. Be keenly aware of the problem of asymmetric information and constantly on guard to avoid being its victim.”
Watch out for conflicts of interest. In the financial services industry, these are varied and complicated. Not only are there money-related conflicts like commissions and fees, sales quotas, and pay-to-play schemes, but there are others, like time itself, that are not directly about money. Financial advisors are under constant pressure to bring in new clients and more revenue. Every hour spent serving you is time away from those other tasks. A financial advisor’s haste to move on to snagging new clients and the pressure he’s under to increase revenue could very well affect how he handles your money.
“The reality is most financial advisors’ interests are not well aligned with yours,” says Blum. “The incentives driving his behavior are likely to steer him away from the very best solutions for you. By the very nature of the system he works in, he has remarkably strong motivations to sell you things and ideas for his own advantage. His company wants to use your capital for its own benefit.
Conflict of Interest
“The problem of conflicts of interest is neither easily solved nor likely to go away,” he adds. “Careful attention to it, though, can give rise to dramatically better results.”
Be careful who you let on your team. Sophisticated financial firms, aided by top behavioral scientists, make every effort to win your confidence, allay your suspicions, and sit at your table as a trusted member of your negotiating team. They understand that it’s human nature to have a bias toward people we view as being “on our team.” Advisors know that if it appears that they are sitting on your side of the table they’ll have great advantage.
“The folks you should have on your team are those whose interests will be best served by acting for your well-being and keeping your trust,” explains Blum. “If you can find advice that incentivizes trustworthiness, is free of conflicts of interest, and applies all knowledge solely to the advancement of your interests, it would be guidance well worth taking. Unfortunately, these people aren’t easy to find. Indeed, it may require hard work and serious study to overcome the needle-in-a-haystack quality of the current marketplace. Such effort is worth undertaking, though, in light of the enormous amount at stake during your lifetime.
“As previously noted, you should always be wary. But don’t think of your advisor as an opponent. Work fruitfully with him to create win-win solutions where everyone comes out ahead. He may be part of your team, but you must use all your negotiating skills to deal with him carefully, negotiate with him actively, and afford him only the amount of trust that prudence will allow. The best piece of advice I could give you with regard to trust is to be wary but also keep in mind that you can still work well with someone without trusting them.”
Understand the other party’s interests. You deal with many people, directly and indirectly, when you invest. Their aspirations and intentions are often far less straightforward than your simple desire for a fair and generous return on capital. Start by acknowledging that some investment situations are a zero-sum game. When you buy a share of stock from someone, the more you pay, the more they receive. Pure market transactions are usually this way; you are locked in a contest to get the most favorable terms possible.
“When dealing with people and companies, though, the situation can be very different,” explains Blum. “Keep in mind that just because your individual advisor works for a company doesn’t mean that his interests perfectly align with his employer’s interests. Investment companies typically want new customers, maximized profits, control of capital, and client retention. However, individual advisors really want to retain old clients, free up time to get new ones, build networks, get referrals, keep bosses satisfied, rise to the top, and make money. When you’re keenly aware of these interests and goals, you can use them to create a deal that works to your greatest advantage.”
Choose your words (and how you dole them out) wisely. How can you let your advisor know of your requirements, interests, and inviolate standards in the clearest way possible? You need to tell them explicitly that any agreement must be better than your best alternative, meet your interests well, and be demonstrably fair. It will also have to be stated clearly in writing with all its terms verifiable. It cannot in any way “lock you in” but, rather, must give you the right to step away whenever you wish. How can you best communicate all this and more to your partners in a manner that keeps the door open for fair and honest dealing?
“Be warm and friendly in person yet firm and unyielding in writing,” advises Blum. “You will want to follow up all conversations with letters that summarize and confirm what was discussed. Those letters should make clear the firmness with which you are insisting on your needs. Be explicit in your written communications about your expectations, requirements, deal-breakers, and understandings. Choose language carefully, leaving no room for interpretation or discretion by those whose interests may differ from your own.”
Beat the Market?
Beware of “beat the market” promises. The rational market theory states that stock prices accurately reflect all the information that is known about a company at any given moment. This means that future price changes can be the result only of surprises or unexpected events. Since, by definition, surprises and unexpected events cannot be predicted, nobody can successfully know in advance about the future performance of a given stock.
“Taken to its logical extreme, a monkey throwing darts at the stock market page of the newspaper should be able to perform as well as anyone else,” explains Blum. “My Economics 101 professor introduced me to the theory by allowing my classmates and me to choose five stocks any way we wished, including asking anyone we knew, while he threw darts at the Wall Street Journal. He beat most of us.
“The bottom line is that an individual investor will have great difficulty doing better than the overall market by selecting individual stocks or bonds,” he clarifies. “Will some pickers be able to beat the market from time to time? Yes, but their success is primarily just a reflection of random chance. Anyone who tells you they can do it all the time is dishonest or deluded.”
Don’t pay for anything that isn’t fair or doesn’t provide value to you, period. Of course, nobody should be expected to work for nothing, and skilled assistance is worth paying for. On the other hand, excessive fees, even those that seem “reasonable,” can be extremely costly over time. That’s why Blum recommends following two rules when it comes to settling on fair compensation for financial advice. One, “Fair terms or no deal.” And two, never accept “we’ve always done it this way” as a reason to agree to pay an advisor a certain amount.
As you negotiate over fees and costs, you will surely encounter the argument that 2 percent of your capital is just a tiny amount to pay for good help. Be careful here, for it is a mistake to examine fees in relation to the amount of your capital. Rather, compare fees to your expected return on the capital. Let’s take a look at the 2 percent deal. One dollar, earning a return of 8 percent over 30 years, will grow to $10.93. Reduced by costs of 2 percent, though, an after-fee return of 6 percent will be achieved. And a dollar growing at 6 percent for 30 years will become $6.02. In this example, a ‘mere’ 2 percent fee reduces the return by almost 45 percent. When we put it that way, does it seem fair?
“And if legitimate investment services with excessive costs are bad, services that add no value to you are a terrible deal at any price,” adds Blum. “As mentioned, most stock-picking strategies perform no better than throwing darts at the Wall Street Journal. This means a great deal of the investment advice and services being offered are worth nothing to you. Financial companies seek payment for the playing out of random chance. Even if such firms spend millions of dollars on salaries, computer programs, and high-priced New York rents, their services are overpriced at a nickel.”
Long Term ‘Partnership’
Don’t get locked in. Avoid situations or deals that tie you into investments for long periods. Indeed, the shorter the better. For example, you would prefer a contract that permits you to quit without reason with five days’ notice to a contract requiring three months’ notice. A firm billing for services six months in advance locks the client in to a greater degree than does their competitor charging only after the work is completed. An agreement that can be terminated without penalty, whenever the client wishes, is superior to one that imposes an exit fee. That, in turn, is less onerous than one requiring significant notice as well as imposing a price to get out.
“Be especially careful about exit fees,” warns Blum. “They’re really penalties for trying to get your money back. For example, ‘back-loaded’ mutual funds sometimes charge 6 percent to get your money back in the first year, 5 percent in the second year, and so on. The right to your own money without penalty will not be granted until six years after the fund was purchased. Most variable annuity products have a similar ‘early exit’ penalty.
“As an investor-negotiator, you must examine carefully how any proposed commitments will actually work,” he continues. “It is your job to determine what will be advantageous and what might lead to disaster. If the terms of a deal under discussion are to your disadvantage, you should bargain hard to change them. Where change is not possible, or the other side declines to be flexible, you should walk away. Refuse to be bound in ways that work against you or make a good outcome unlikely.”
Know the risks that come with trading. To sharply reduce your costs, avoid trading in your investment portfolio. Remember, you don’t want to trade; you want to invest. And to do that prudently, you need to create a solid, diversified, low-cost portfolio and keep it. Of course, you will want to make minor adjustments as your circumstances change (and your circumstances will change; if nothing else, each year you are a little older and probably in need of a slightly more conservative asset allocation). Trading swells costs, causes tax recognition, and inappropriately wastes your mental energy.
“Trading is expensive,” says Blum. “Just consider what’s known as the spread. The spread is the difference between the price to buy and the price to sell. Take a look at your favorite stock right now; you will see a bid price and an ask price. The ask price is the amount you would have to pay (plus trading commission) to buy the stock right now. The bid price is the amount (plus commission, of course) to sell it right now. Notice that the ask price is higher than the bid price. Wall Street firms that make a market in the stock do very well by this spread, and regular buyers and sellers do not. Somebody benefits when you trade a lot, but that somebody is not you.
“Needless to say, the costs of trading are even higher if you are buying and selling anything that carries a (visible or hidden) sales charge. Be careful to avoid all the ways that the industry has found to hide those charges. Finally, you should never, ever pay a management or advisor fee to anyone who is in any way selling products or making any kind of commissions on the investments you make.”
“Let me reiterate that there are many very reputable people in the financial advising industry,” says Blum. “And by taking the right precautions up front, you will be able to find them. What’s most essential for investors to keep in mind, and what surprises many people, is that it is you the investor-negotiator who holds most of the power. It is a ‘buyer’s market’ for people who have capital to invest. On the other hand, those who are trying to persuade, entice, or sell you investments face overwhelming competition. You are actually the one in the driver’s seat, but only if you educate yourself about the process.”