August 7, 2006 –
If you’re frustrated from having one financial consultant after another financial consultant provide you with inadequate returns on your stock portfolio, you’re not the only one. Trust me, you have lots of company out there. Consider the fact that Smith Barney alone employs over 11,000 financial consultants in just the United States. How many of that 11,000 do you really think are superior financial consultants?
Finding a superior financial consultant isn’t always about the financial consultant. Sometimes it is also about you. Are you willing to also make the commitments to find a superior financial consultant? In this article, I’ll discuss one crucial behavior about financial consultants and two regarding the behavior of you, the investor.
So here are my three tips:
(1) Avoid mutual funds;
(2) Don’t be stingy if you find a superior advisor; and
(3) Be patient and ask lots of questions in your search for a superior financial consultant.
Avoid Mutual Funds
Let me tell you why I’m not a fan of mutual funds. Mutual funds have so many hidden fees that it’s often difficult to know exactly what your costs are. Besides upfront costs that can be upward of 5% for some funds, there are 12b-1 advertising , marketing and distribution fees that range from 0.25% to 1.0%, administrative fees that range from 0.20% to 0.40% and of course management fees paid to the mutual fund manager of 0.50% to more than 1.0% annually.
This doesn’t even include undisclosed “soft” costs of trade commissions that can add another 2.0% to 4.0% in costs. And yes you didn’t incorrectly read the first part of that last sentence. Many mutual funds charge you 12b-1 expenses that they incur from advertisements and commercials that urge you to buy their funds. So in essence you’re paying for the marketing that probably convinced you to buy the fund. Ironic isn’t it? And if you’re buying no load funds, chances are that your 12b-1 fees are higher than average.
Add to this, intangible costs such as the performance that is sacrificed to maintain the necessary level of liquidity to satisfy share redemption, and your costs become even greater. For a fund that turns over 100% of its assets annually, Roger Edelson of the University of Pennsylvania Wharton School estimated this sacrificed performance to be 1.5% of returns annually. Lastly, to add insult to injury, sometimes fund managers sell out of their biggest winners to meet liquidity needs, generating a capital gains income tax for you, the investor, even if the mutual fund lost money that year.
But this isn’t even where the negative traits of mutual funds end. If you have one of the many financial consultants that merely try to jump on the hot emerging market bandwagon by buying mutual funds in China, India, or any other country, I advise you to exercise extreme caution. When pullbacks happen in these economies as will inevitably happen, you are at high risk of losing money quickly.
In a mutual fund, you are at the mercy of the thundering sheep herd mentality that more often than not, will induce panic upon the release of bad news, and cause millions of investors to redeem their shares over a short period of time. If this happens, fund prices will plummet before you even knew what hit you. In mid-2006, we saw exactly this behavior respectively drive down the top performing Turkey and Russian mutual funds by 70% and 50% in a matter of weeks.
But if you choose to own just the best stocks in the best industries in these countries, your stock prices will be much more insulated and less volatile in such a scenario. While these stocks may still decline, they will most likely decline a lot less than a mutual fund will. Strong companies’ stock prices tend to weather country-wide economic downturns much better than fund prices, and if they are in the right niche, they may even continue to flourish. So avoid financial consultants that buy mutual funds. Of course, in all reality, if you have less than USD $50,000 to invest, then the chances of finding a financial consultant that does not use mutual funds is practically zero. In this case, you’d be best off managing your own money.
Be Willing to Pay Fees for Superior Advice
Superior advice is superior because a lot of hard work and time go into producing that advice. I remember talking to a potential client one time that had a million dollars in the stock market and was adamant about not paying fees. He just wanted to pay commissions on stock trades. When he showed me his statements (by the way he was with a major Wall Street firm that I won’t name), there seemed to be no structure or investment strategy in his portfolio. He owned a mix of mutual funds and individual stocks, and many times those stocks were traded as soon as there was a nominal 5% gain in any of them.
Furthermore, the statements by his financial consultants were misleading. The consultant handwrote on his statements that he was doing great because he was up 6% that quarter (which I believe just about matched the S&P 500’s performance that quarter). He told me that annualized, that the 6% translated into 24% returns. But when I explained that his net returns would be much lower because his portfolio’s quarterly 100% turnover rate produced excessively high short-term capital gains taxes that would undercut his net returns, he didn’t seem to understand. I guess his financial consultant didn’t bother explaining this small detail to him.
Superior advice costs money. And if your financial consultant is superior, he or she will be transparent about his fees and your costs, so that you won’t be confused about what your true gains really are. During my career as a private wealth manager, I encountered time and time again people that would rather pay 1.25% to earn 6% a year versus paying 2.2% to earn 25% a year. It doesn’t make sense but as I’ve stated time and time again, just because people have money does not make them bright. So don’t be stingy.
Be Patient and Ask Lots of Questions
If you persistently ask hard-hitting questions, you may get frustrated after talking to ten financial consultants, none of whom can answer your hard-hitting questions. My advice is to just be patient. Don’t give up and don’t settle for a salesperson that is trained to answer your hard-hitting questions in a manner designed to lead you to believe that he or she has answered your questions when he or she hasn’t. What do I mean?
For example, when you start drilling down about specific stock picks, a common sales technique to avoid your question is an answer similar to the following: “I’m not a stock picker. But don’t worry. I know how to find the best money managers in the country to manage your money for you, so you’re in great hands.” Don’t be misled by smokescreens like this. Remember that if your financial consultant truly understands how to find you the best money managers, then he or she must necessarily have discussions about geographical preferences, industry preferences, and specific stocks with those money managers. How can a financial consultant claim to select the best money managers for you but have no understanding of what stocks you own and what makes those stocks special?
To summarize, buy individual stocks over mutual funds, be willing to pay fees for an exceptional advisory if you are so lucky as to find one, and remember, the luckiness of finding an exceptional advisor is not really luckiness at all. It comes from your hard work, tough questions, and your unwillingness to be led astray by the professional smoke screens of financial consultants.
And of course, always follow the MoneyMitesâ„¢ to make more money!
Ok, J.S., you really gave me a hard time coming up with a related martial arts nugget on this one. The only thing I can think of is the three rules of engagement from Miyamoto Musashi’s classic “The Book of Five Rings.” So let’s start with these and see how I can relate it to your topic today. The three rules of engagement are as follows:
(1) You attack the opponent suddenly and immediately without giving any indication beforehand (otherwise known as the sucker punch)
(2) You bait the opponent into attacking and immediately kill him with a strong counter attack; and
(3) You and the opponent both suddenly attack without warning.
Aah, I just can’t find any parallels this week with the topic you gave me to work with. I suppose I could write about three tips for finding a superior martial arts instructor but I already wrote about that subject.