Seeking Advice 101 (Part 1)

Key Points

  • The financial services industry is broad and varied, so it behooves consumers to have a grounded understanding of how the industry works and how it is compensated.
  • Commissions have the potential to create a conflict of interest between the seller and the buyer. Therefore, buyer beware!
  • When it comes to financial advice, a fee-only fiduciary can be invaluable.

The financial services industry represents over 20% of the economy. The industry helps shift capital from where it is to where it needs to be. And the industry continues to evolve day-by-day. Let’s begin this series with an overview of how things are at present.

Consumer Beware

Broadly speaking, there are two forms of financial advice that consumers generally require. The first is Financial Planning Advice; the second is Investment Management Advice. Financial Planning is all about how to budget, save, and plan for the future. Investment Management is all about making savings and putting the money to work for future use.

Financial Planning covers many topics. Households need to budget their day-to-day expenses. And there are two categories of such expenses; the first is non-discretionary items (e.g., rent, food, cable, internet, health-care premiums, student loans, etc.). These are items are necessities, and often do not change much month-to-month. Then there are discretionary items (shopping, vacations, long-term savings, etc.). These items are often not essential, but they are nevertheless important. Households also need to plan for the future, such as for college savings, long-term care, retirement, and inheritance.

Investment Management typically involves figuring how best to invest savings so that future goals can be met. For example, if you plan to retire in 30 years, not only will you need to diligently save over this time, but also, you’ll need to put those savings to work so that your capital can grow over time. And often such a service includes portfolio management and risk management of the invested capital to ensure that performance is in line with expectations.

There are two common paths to receiving financial guidance.

  1. The first is through an independent broker-dealer. A broker-dealer can not only present you with an assortment of products and advice to suit your goals but also, the broker-dealer can supply the investment products to meet these objectives.
  2. Then there’s a Registered Investment Adviser (that’s me!). This type of professional focuses on providing Financial Planning advice or Investment Management advice, or both.

Over the course of this series, we’ll compare and contrast these approaches in more detail. And we’ll also come to understand that there is not likely a one-size-fits-all solution for everyone. It really does come down to individual tastes and preferences. So let’s see where this understanding takes us.

From the Top

When individuals typically think of investment advice, they think of a stockbroker. In the past, if you wanted to know about the latest and greatest investment, you would give your broker a ring, and they would tell you all you needed to know about which stocks were hot and which ones should be avoided. And then based upon your approval, these brokers would buy and sell shares of a given stock for your investment account.

Stockbrokers require a financial education and the passage of several industry exams. In the United States, registered brokers must hold a minimum of the FINRA Series 7 and Series 63 or 66 licenses, and must be sponsored by a broker-dealer. And typically, these professionals earned their livings through commissions. Suffice it to say then, the more you trade, the more they make.

Today, things are much different. The role of a stockbroker has changed dramatically since the proliferation of the internet. These days, discount broker firms, such as Interactive Brokers, E-Trade, and TD Ameritrade dominate the majority of customer interaction.

Whereas in the past, a single trade could cost hundreds of dollars, these discount brokers now provide trades with almost no commissions, and very low fees. And the end result is that lower service fees have made the stock market available to more investors, which overall is a good thing.

Given these secular changes in the market, over time, brokers began to broaden their scope by offering financial and investment advice. However, as you may imagine, there is a fundamental concern with offering investment advice and then selling investment products for a commission. The obvious concern is that a given broker may be incentivized (perhaps even subconsciously) to offer products that have either high commissions baked into them or are not entirely suitable for a given client.

In the end, the best of interests of the client may end up taking a back seat to the broker’s best interests. For example, how comfortable would you be with your physician’s advice if you knew that he or she received a kick-back from the pharmaceutical company for each prescription for a given drug?

What Now?

And so we have another option, the Registered Investment Advisor (RIA). An RIA is a person or firm that advises individuals on investments and manages their portfolios. RIAs typically provide financial planning advice to their clients as well. These firms have a fiduciary duty to their clients, which means they have a fundamental obligation to provide investment advice that always acts in their clients’ best interests.

The highest legal duty of one party to another, being a fiduciary requires being bound ethically to act in the other’s best interests. —Investopedia

Regulated directly by the Securities and Exchange Commission (SEC), RIAs are considered to be acting in a fiduciary capacity, and so held to a higher standard of conduct than registered representatives of broker-dealers. This fiduciary standard mandates that an RIA must always unconditionally put the client’s best interests ahead of his or her own, regardless of all other circumstances.

But not all RIAs are the same either. Some RIAs are owned by broker-dealers (known as dual-registered RIAs). And other RIAs can still accept commissions for the products they sell. And as mentioned above, commissions and advice can present a pretty big conflict of interest. So what can be done about this pretty big concern? After all, if you’re looking for advice, you want to keep any conflict of interest to a minimum, right?

The Gold Standard for Financial Advice

So now we have the fee-only Registered Investment Advisor (that’s me!). A fee-only RIA leads with the understanding that commissions can provide a serious conflict between acting as a fiduciary and providing the best advice possible. That is why there are a subset of RIAs that brand themselves as fee-only, as opposed to fee-based RIAs that can still collect commissions.

These fee-only RIAs go out of the way to state that they will not accept commissions of any kind to eliminate the possibility that a commission may influence the advice they provide. So beyond being a fiduciary, a fee-only RIA will only accept fees from their clients themselves.

So if you’re in the market for financial advice, understand that there are many options out there, but not every option may be the best for your bottom line.

If you’re ever in need of guidance, these blog posts may be of help. But be sure to contact a financial, tax, or legal professional for guidance and information specific to your individual situation. And as always you can reach out to me directly here with questions or concerns about your personal situation.

Finally, if you want to see how your risk appetite stacks up, check out my free risk assessment here.