Money is a tough skill to master. The brightest economic minds in the world can’t figure out the investment markets, world political leaders with an unlimited supply of brilliant advisers can’t keep their country out of crippling debt, Bank of America, the 2nd largest bank in the world holding 12% of all American citizen’s money has lost 55% of its market value in less than one year, and the average American is more than $10,000 in debt with states like Delaware averaging more than $20,000 in debt per resident.
Money isn’t easy to manage yet very few people seek help. Less than 20% of Americans have a financial adviser, only 17% have a financial plan and only 56% of affluent Americans seek financial help.
If we as a nation and world can’t manage our money, why aren’t we seeking help from a financial adviser? Sadly, it’s because people don’t trust advisers. Some studies show that as much as 70% of people who have or had a financial adviser don’t trust their recommendations. Some of the problem may come from the type of adviser that a portion of that 70% employed.
Let’s set up a hypothetical situation: You are a doughnut salesman. Each morning you receive various deliveries from different doughnut makers and at 6am you open your fully stocked store. People come in and ask you for a recommendation of your favorite doughnuts and you normally recommend Joe’s Doughnuts. If the customer doesn’t like those, you recommend Bill’s and as a last resort, once all of the other doughnuts have sold, you sell Jake’s.
What your customers don’t know when they’re asking for your opinion is that Joe takes 10% off of your bill if you sell all of his doughnuts within 5 hours. Bill gives you an 8% bonus and Jake doesn’t believe in that so he doesn’t pay anything. It’s in your best interest to push Joe’s doughnuts. What if the reason that Joe’s doughnuts have a higher payout is because they don’t taste as good as Jake’s? Jake may know that people love his doughnuts so he doesn’t need to offer incentives to sell his product.
The doughnut shop owner on the other side of town purchases doughnuts without any type of incentive so it’s in his best interest to only purchase the highest quality doughnuts. His opinion is not financially motivated and he only has to think about the good of his customers. (And by the way, his customers love Jake’s doughnuts)
If you understand our doughnut business, you understand the difference between commission based financial advisers and fee based advisers. Commission based advisers have an incentive to recommend certain products and although it would be unfair to say that all commission based advisers think about their best interest before yours, they have to stay in business and they have to feed their families. It would be difficult to pass up the higher commissions on one product versus the lower rate on another. Often, commission based advisers also receive a fee but that isn’t the same as a fee based adviser.
Fee based advisers receive a set fee based on an hourly rate, a flat fee for certain services, or a percentage of your assets. For ongoing management of your money, the adviser may receive 1.5% or 2% of your portfolio as a fee. The advantage of this arrangement is obvious. The more money your adviser makes you, the more money they make. (The happier the doughnut store owner makes his customers, the more doughnuts they will buy.)
Counting on somebody to think of your best interest over his or her payout is not a chance you want to take. By hiring a fee based adviser, you remove nearly all of the motivation to think of their best interest over yours. Of course, you should be highly selective of any adviser and just like any service oriented person you should rely on word of mouth and other positive reviews.