There’s been a certain movement in financial circles to re-examine compensation models of investment advisors.  One of the central proposals to such reform includes moving from a commission based model, with connotations of the hard sale, to a hourly and fee based model, which has a more advisory undertones. Yet, the legal industry, built on foundation of the billable hour, is in naval gazing mode about a broken business model which includes clients revolting over high billable hours and the perception of inefficiencies related to this billing model.

How can one industry suggest partially moving to a compensation model that another industry notoriously associated with it is thinking of abandoning?

The ultimate issue is not the compensation scheme but the value given by the consumer to advice.

…and therein lies the problem.  Value is ultimately a subjective concept. For example, imagine two investors who pay the same advisor the same compensation annually. The “active client” calls the investor every other month for an hour, has meetings several times a year and goes to all the free seminars (and eats all the free food). The “passive client” perhaps meets the advisor once a year partially due to benign neglect and partially because the active investor is monopolizing all the advisor’s time.   Assume the same return annually.

If I am the active client, I may actually be mad. The advisor gave me all this time and energy and I got the same performance as the passive client! But the passive client thinks he got conned because the advisor never gave him any time but got compensated anyways. In other words, the advisor is in a no-win situation because value is ultimately in the eye of the beholder.

This example also magnifies the problem in the financial industry since advice is often equated with performance. Ultimately, this is a misguided barometer of the value of advice since performance has a contextual and individualized risk/reward factor. A desired performance may require a greater than required risk tolerance.

If we presume there is a certain class of investors who will never be happy with the value of the advice they receive and eliminate them from the equation, and we can somehow make the value of advice something to be judged objectively, the question becomes two-fold: (i) what is good advice? and (ii) to paraphrase Dale Rathberger, where can different classes of investors get good advice?

To answer the second question first, and let’s not worry about the plight of the high net worth individual, advice is ultimately best appreciated when the recipient understands the larger context of the advice. Speaking from legal experience, you can set out all the options to a client but if the client does not even appreciate the larger “game”, the advice ultimately falls on deaf ears.  Thus, for those younger investors or investors with modest portfolios, I would flip the question around to “before seeking good advice, what do you need to know about finances?”

Fundamentally, know yourself. Managing money is like majoring in psychology and minoring in finance. Emotional control is more important than product selection.

I would also suggest learning simple book-keeping. Balancing books is key to household management. Revenue recognition skills (simply put, revenue must match an expense) is crucial to analyzing a stock or a real estate investment property.  There is a reason why entrepreneurs are more likely to be millionaires: by running a business, they understand how money works.  Going to any advisor with a blank slate is a sign of an easy mark for an unscrupulous advisor.

As to what should constitute good advice objectively (if this standard even exists), the focus should be on advice focused on the strategy and not the product. Some average investors believe good advice should constitute an advisor finding them a magic bullet product to cure all their financial woes. The problem is it fails to consider larger strategic considerations as to a proper strategy, sticking to that strategy and adjusting the strategy accordingly. The basis of a good strategy gets back to my initial point above- know yourself well (which is the most important question you have to ask about money- what do you want?)

If you doubt yourself or constantly seek unrealistic solutions, can you blame any industry of taking advantage of you?

The hard reality is that the investment industry is like anything else in life- 80% of good advice comes from 20% of advisors. To somehow believe that the entire financial industry would be fair and virtuous to its clients, when life is neither of those, is to suspend one’s notion of reality. However, a focus on knowing yourself, being educated and always keeping an eye on the larger picture will most likely help you weed out the 80% of bad advice givers and lead one to appropriate advice being given.

I am off until September on a mini-blogging vacation. Enjoy the rest of the summer. Keep safe and have fun.

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