questions to ask your financial advisor (or yourself)

If I was going to trust someone to manage my life savings for the years and decades to come, I would make sure that all of these questions were answered beforehand:

(1) What is your investment strategy?
This should set your expectations if you ultimately decide to invest with this person; it also gives you a way to confirm that they’re sticking to the strategy. I would want a rough idea of how much turnover the manager expects in the portfolio, the number of holdings, any cap on position size, etc; the advisor should be able to clearly explain what it is that they will do for you. If you don’t understand what they’re talking about, ask questions and make sure that it is clear before you walk out of the door; if you’re still confused when you leave, I’d personally look elsewhere. You might find it odd that people wouldn't ask this; you would think it would be the first item addressed. In my experience, the issue is that this rarely goes deeper than a few sentences from the advisor hitting the high points, with no follow up from the client; there really should be more.

(2) What are your thoughts on active investing versus passive investing?
The person you’re talking with should be able to put this in terms you can understand (read around online before you visit with them if you’re unfamiliar with the debate or else asking won’t do you any good). If they plan on taking a passive approach, I have no problem with that: I still see a need for some clients to do this through an advisor (primarily for having someone to talk to). However, the fees in that scenario should be quite low; I think that anything above 50 basis points or so (0.50%) would be excessive - and even that might be a bit steep. If they make the argument for an active strategy, that’s fine as well; at that point, I’d ask the following:

What makes you think that you can outperform the major indices like the S&P 500 over time? What is your competitive advantage as an investor long term?
People all over the country and the world wake up every day hoping to make money in the stock market. Many are essentially gambling, while others have a near infinite set of resources at their disposal (or even insider information). I think that if you plan on being successful long term you must have something that distinguishes you from the herd; being different on its own obviously doesn’t guarantee success, but it is a requirement for performance that differs from the index (hopefully to the upside). I would simply want to know why they believes they can do better than the market over time. Hopefully this was touched on when you asked about their strategy.

(3) How do you make money from my account?
I’m a big believer in the power of incentives; I would want to be assured that my advisor’s interests are aligned with mine at all times. If someone is being paid to sell you a certain product or fund, you better take a hard look at whatever it is that they’re selling you. My personal opinion is that you would be better off taking your business elsewhere.

I want the fees generated from my account to be correlated with changes in the account value; that would call for either a fee based on the assets managed or a fee based on annual returns (like Warren Buffett’s arrangement when he ran his partnerships); I can’t think of any other way of paying my advisor / manager that I would be comfortable with.

(4) What type of returns can I realistically expect long term?
As with the first question, it’s important to ensure that you’re on the same page with the person who will be managing your money. If you’re only comfortable with limited volatility and they tell you 15% a year is attainable, there’s a misunderstanding that needs to be addressed. Just for clarification, I wouldn’t expect (or necessarily want) a specific number – a range is fine.

(5) How long have you been investing personally, as well as for other people? What have your returns been over the past ten-plus years, or since you started managing money?
This question is quite direct; suffice it to say that it’s worth dealing with a bit of discomfort to ensure that the person you’re about to entrust with your retirement money knows what they’re doing. While the returns are obviously front and center with this question, it also gives you a clear opportunity to consider another potential issue: closet indexing. If the long term returns for the manager are nearly identical to the index, it is worth considering whether or not you really should be paying this individual for “advice” that could easily be replicated for a few basis points on your own with Vanguard. I wouldn’t have thought this is nearly as common as it actually is (or has been in my experience reviewing prospective clients account statements).

(6) What benchmark do you judge your results against? Why?
Most people use the S&P 500, but some use other indices (for example, Wedgewood Fund uses the Russell 1000); simply ask for an explanation and make sure the response is logical if it’s anything besides the S&P 500. It’s worth remembering that if they show you their returns and the index is blended (some mix of stocks and bonds), take that into consideration if you’re looking at their returns from a stock only (or more heavily weighted) model / portfolio.

(7) Can you tell me about one of your worst investments in the past few years? What did you learn from the experience?
This sounds like something you might hear at a job interview, but I think it’s important (and fair game): I want someone who is willing to admit that they’ve made bad investments in the past, and more importantly, has learned from those mistakes.

(8) How much of your own money is invested in the same securities that you plan on purchasing for my account?
Again, this seems direct, or even impolite. My opinion, as someone who sits on the other side of the table from clients, is that this is fair game; in fact, I would be happy to be asked this (which gives you a good idea of what my answer would be).

Any advisor / money manager that’s offended by this or the other questions mentioned above should be avoided in my opinion. As for the answer, I think that at least half of the invested assets for the decision maker at the firm (hopefully the person you’re talking to) should be the same as what they put their clients in, and hopefully even more than that (for comparable asset classes – equities to equities). Maybe I’ve been spoiled by Warren and Charlie, but I think 90% or more sounds like a reasonable number. The person you’re giving money to should be personally investing in the same stocks that they’re buying for you – and in a big way.

Conclusion
This isn’t meant to be a complete list; I’ve focused on the issues that are often overlooked (in my experience) that prospective clients should be asking. I’ll reiterate what I said above: if the person you’re meeting with is offended or put off by your questions, look elsewhere.

The person managing your life savings must be someone that you can trust and ask difficult questions to. Hopefully these questions will help you find the person that’s right for you.