Self-Reflection and Picking the “Right” Advisor

Filling out the risk questionnaire is one of the first acts of becoming a client of an investment advisory. Whether filled out through written form or conversation, the questionnaire helps firms (and their regulators) understand what a client believes his risk tolerance to be. It asks questions such as:

1.     How long is a “long-term” investment?

2.     What would or did you do with your investments during a market crisis?

3.     How stable is your income?

4.     Are you willing to accept volatility in stock and bond investments?

5.     What is your knowledge of investing?

6.     Are you more concerned with preserving or growing your capital?

Questionnaires typically range between 5 and 20 questions. Advisors that are less concerned about a regulatory review will address the concerns in conversation, while others will have a client formally fill out a form. The questionnaire is a good idea, but like theory and reality, there’s often a marked difference between a client’s perceived preference and his or her revealed preference. 

A thorough more suitable questionnaire, in my view, comes with a psychiatrist, a couch, and a 90-minute appointment. In the absence of that session, my advice for someone interested in investing with an investment advisor is to engage in self-reflection before meeting with an advisor. Think of the advisor as an extension of yourself and understand the firm’s investment process. Determine exactly what it is you want and confirm their process is consistent with your values. As in most things, short term outcomes may be spurious, but good investment processes have good results over time. Given that the relationship between you and your advisor(s) is likely to be a long one, make sure that how the firm approaches investing and how you would approach investing, if it was your full-time job, is similar. 

A first step should be understanding if you want a performance or a relationship driven advisor. 

Performance driven advisors try to optimize your returns. They believe that markets and their underlying securities are inefficiently priced and that by smartly allocating capital, outsized returns can be made. Whether it’s on an asset class basis (stocks vs. bonds) or an individual stock selection basis, you’ll be able to perceive it at every level, in every meeting, in every communication. The portfolios they suggest for your investment portfolio are likely to have relatively few investments, less than 30 or so, and while they may be wrong and underperform the market over a particular time period, they are striving to provide exceptional performance. Their advice about asset allocation across different investment classes may be rule based but is also informed by their assessment of the relative values and risks inherent in the current price level of those assets. They care about your portfolio’s performance and likely have a significant amount of their own money invested similarly.

Relationship driven advisors offer a different solution. They have eschewed performance evaluation and seek to offer clients piece of mind while growing their investment portfolios. Asset allocations are based on a defensible statistical model and match other clients with a similar statistical profile. In case of underperformance, there’s typically a Wall Street Journal-like article that explains why the investment was a good idea initially and how it’s failing is a product of circumstance rather than judgement. Investments should be expected to be diffused over many different securities or several mutual funds and ETFs rather than concentrated in a few securities aimed at outperformance. Investment portfolio performance can be expected to be “fine”. They are a superb choice for many people, but they’re also the reason that investment advisory has a reputation for underperformance after fees. If you think this kind of solution is right for you, my suggestion is to find a large firm. After all, with this approach you’re unlikely to be unique, so make sure their data set is large to enable them to provide the “right” asset allocation for you.

As with many things, most advisors are somewhere in between the two poles. I hope in defining those poles I might provide a partial framework to help people who engage advisors evaluate their choice.