What constitutes a “bad” advisor?

For purposes of this article, I define “bad” as bad in the absolute, not a “bad for you, good for another consumer” definition. For example, we all have had dates that were horrible and really bad for us, but a wonderful match for someone else. No, in this post I am referring to an advisor that is pretty much bad for anyone. Thankfully that number is quite low, but you do not want to run the risk of being one of the unlucky that signs up with one.

As I have mentioned throughout this book, the vast majority of financial advisors are well-intentioned and honest professionals who seek to genuinely help their clients. Of all the advisors in the United States, 7 percent have some negative regulatory or legal event in their past, and roughly half of that 7 percent have very negative events…so much so that they likely should not be in the industry at all. Of course, statistics being what they are, it is very likely that there are some bad advisors who simply have not gotten caught yet, so likely the “bad actor” number could be higher than 7 percent. However, it is impossible to analyze the activity of close to two million financial and insurance advisors and their clients together, so we can only go by the public numbers we have to estimate the bad actor rates.

What this means is that 3 percent of the advisors with very bad history should never be hired. This amounts to sixty thousand financial and insurance advisors in the U.S. How do you avoid one of these advisors? In this post, I outline the steps in order of priority of importance in order to protect yourself from hiring one of these bad actors. To be clear, this is a descending priority list, with the first step as most important, the second step as next important, and so on. It is vital you take each of these steps to minimize the odds of hiring a bad advisor.

Please note these steps cannot guarantee that you will avoid a bad advisor, but will give you the highest odds of avoiding one. There are two reasons for this caveat: one, there could be advisors that right now are conducting a new type of harmful service that simply no one has considered or found yet, such as some brand-new scheme or fraud that is the first of its kind. Second, there have been cases where a good advisor turned bad and you could hire an advisor that is perfectly legitimate and doing a good job for you, but then changes how he or she does things. Such a case was Mark Spangler, who I mention later in this article.

Critical Steps to Avoid a Bad Advisor in Order of Importance

1. Verify the person is actually licensed

Make sure your advisor is regulated by at least one of the regulators that oversees retail financial advisors. The SEC regularly states that one of the most common types of frauds are those committed by persons who are not in fact licensed financial advisors. If you are ever approached with an investment proposal by an unlicensed person, always have a licensed financial advisor review the investment. Here are the regulators to check to ensure the person you are speaking with is in fact licensed:

1. FINRA BrokerCheck
2. SEC Investment Adviser Public Disclosure

If you cannot find the advisor in one of these regulatory databases, do not hire the advisor. It is nearly impossible to legally give advice or sell a security without being registered by some regulatory authority. There are some very narrow exceptions, but for 99 percent of Americans, if they are not registered somewhere, do not use that person.

2. Check their regulatory background

Once you find your advisor, look at the section of their record called “disclosures.” In short, this is where anything negative on the advisor is stored. The vast majority of advisors do not have any disclosures. That said, having a disclosure item does not mean the advisor is bad. However, the more disclosures an advisor has, the more scrutiny one should take in evaluating the advisor. Pay special attention to disclosures where the advisor had to pay fines to a regulator or had to personally compensate a client due to a complaint. If there are more than a couple such instances, you should take extreme care in evaluating this advisor. Finally, it is important to understand that there are plenty of occasions where an overzealous regulator will force a disclosure on an advisor, or a former employer can force a disclosure that are unfair and not an issue. This can make an otherwise great advisor look bad, so it is vital to understand the difference. Finally, there are occasions where an unreasonable client sued an advisor and it was far cheaper to simply settle the case and accept a disclosure than battle the client in court or arbitration. While I have always counseled an advisor to fight the client in these cases, the reality is sometimes the advisor simply cannot afford a legal battle that has an unknown cost and it ends up being the only disclosure over an entire career. These scenarios happened right after the market meltdown of 2008 and I saw first-hand wonderful advisors get unfairly blamed for a market correction

Here is a breakdown of categories of disclosures:

1. Client
   • A client can complain about an investment gone bad, theft, bad advice, or nearly literally any kind of grievance. When these escalate they can end up on the advisor’s record and stay there either in perpetuity or for some lesser period of time. In order to get on the record, usually the advisor’s employer or their regulator forces the disclosure. In the case of a Registered Investment Adviser, they are required to self-disclose, and if they do not, the penalties are quite severe.
2. Regulatory
   • Regulators like FINRA, the SEC, or state regulators, can examine an advisor and find they have violated a rule or law and require the advisor to disclose the violation. They can range from relative benign violations, like not keeping certain records, to very significant violations, like theft or insider trading.
3. Employer
   • An employer can affect a disclosure event when an advisor violates a company compliance rule, or any other rule or law. For example, if an advisor signs a client agreement instead of the client signing, that is forgery, which is illegal and not allowed by any regulators and—one would assume—against all corporate compliance departments. This usually gets an advisor fired and stays on the advisor’s record forever.
4. Personal
   • Bankruptcies, misdemeanors, felonies, and other personal negative events can be shown in an advisor’s disclosures. When you see these, apply common sense in evaluating them. For example, if an advisor was forced into bankruptcy due to uncovered medical expenses for a child or spouse’s life-threatening condition and there are no other disclosures, this may not automatically preclude you from working with this advisor. However, as a different example, if you see four misdemeanors in the recent past for driving while intoxicated (DWI) charges, clearly this advisor has personal control and judgement issues and you should find a different advisor to work with.

3. Check the website

First, an advisor should have a website or webpage on their employer’s main website. If they do not, that is a red flag and you should proceed with caution in evaluating the advisor. These days, given the highly regulated industry that financial advisors are in, most of their websites are standardized to a degree, scrutinized by their firm’s compliance officers and, frankly, somewhat boring and generic due to the enormous regulatory burden they are put under that regulates their advertising. What should be red flags on a website are statements that tout investment performance, guarantees, or individual client testimonials, the latter which are essentially outlawed—with some exceptions, notably someone who is only licensed to sell insurance, like fixed life insurance or health insurance. If your advisor has any such statements on their website, proceed with caution. If and when you speak with this advisor on the phone, ask them specifically about each of these items on the website and write down their answers. These specific questions are in thearticle on interviewing advisors.

4. Call the advisor on the phone

When you call an advisor for the first time (I do not recommend emailing an advisor for your first communication—you cannot learn as much in an email) simply tell the person who answers the phone or calls you back, “I am looking for a financial advisor; can you please tell me about your services?” Do not immediately tell them what you need, as a bad advisor may just mimic what you are saying. Force the advisor to tell you what they do for a living. To reiterate, there only a few high-level responses they can give you: they primarily invest money, they are a financial planner, they are a wealth manager (invest money and do financial plans), they are an insurance-focused advisor, or they focus on selling securities.

If a portion of their service is free, be very alert. For example, if an advisor does not charge for a financial plan and they sell investment products on commission, there could be an issue, especially if they have no professional, quality designations. Wealth management firms that both manage a portfolio and provide financial planning are fine if they do the planning for free, as they normally charge roughly 1 percent of your portfolio assets annually, and that can cover a full financial plan depending on your portfolio size. However, these firms almost always have a staff person that is credentialed to do the plan, so be aware if they do not. In this first call, a huge red flag is any mention of specific products, rates of return, or guarantees. Keep in mind that despite what you see in movies like The Wolf of Wall Street, the days of very young, glib, fast-talking sales people are largely behind us. These days many advisors are actually not that terrific on the phone, so be patient with their explanation of what they do and who they are. However, if you feel like you got a character out of the movie Wall Street or Boiler Room on the phone, feel free to hang up on them. Believe me, if you are one of the few unlucky people to get this type of person on the phone, they are used to getting hung up on!

5. How much do they charge and how do they charge?

It is important to understand clearly what the advisor charges. A bad advisor will not be able to give you clear and specific answers. There are only a few ways for an advisor to charge for their services: a percentage of assets under management, in the 1 percent range normally; commissions on the sale of an investment or insurance product; hourly fees; a flat fee; monthly retainer; and, only in the case of a hedge fund for the high net worth investor, a percentage of the profit. Advisors should be able to clearly give you exact figures for any of the ways they happen to charge. Some advisors will offer different way to pay them, and for each of the above methods, should be able to tell you near-exact figures over the phone.

For example, if you need life insurance because you just got married or had your first child, you should ask the advisor how much commission is being paid to the advisor and/or their firm. The advisor should have no problem telling you exactly how much commission he or she is getting on the sale of that product. In another example, if you need a financial plan, the planner should have no issue telling you what their hourly rate is and a rough estimate of the number of hours it should take based on your specifics. Of course, if you the client surprise the planner with brand new information after getting a quote, and more hours are needed, the planner should be able to articulate why the additional hours are necessary and you should understand this and not have a problem with the extra cost. As a final example, if you are buying a stock, bond, or mutual fund and a commission is being charged, the exact commission you are paying should be readily provided when you ask. If you cannot get a clear answer on how and what the advisor will charge you, do not hire the advisor; they either are fitting my definition of bad or are unethical.

6. Meet the advisor in their office

When you are comfortable, meet the advisor in their office—if they are in close proximity, of course, and you are not hiring an advisor far away. Bring another adult with you always. Your spouse, friend, sibling, or parent will be a useful second set of eyes and ears for your meeting. In the context of this post of ferreting out a bad advisor, when meeting in their office, keep in mind the odds are very low you are meeting one. This said, you do not want to be one of the 3 percent, so be alert for anything that gives you a bad “gut feeling.” To be fair, it is very difficult to spot a bad advisor during or after an office visit. I have been in hundreds of advisors’ offices over the years, and the spectrum of environments runs the gamut of tiny advisors whose office is in their basement with oil tank in full view, to suburban strip mall offices with mediocre furniture, to high-floor tower offices in New York, Chicago, or San Francisco replete with the most stunning views and furnishings right from a movie. Whether the office is minimal, or it is adorned with numerous degrees and “Top Advisor” awards, just pay attention to your surroundings. At the end of your meeting with the advisor, if anything gives you a bad “gut feeling,” do not move forward to hire the advisor. The odds are they are not bad, but rather you do not have chemistry, and going with one’s gut almost always works best. There are many advisors to choose from, so there is no reason to settle for someone that sets off any negative thoughts in the back of your mind.

7. Answering Questions

If an advisor does not fully answer questions to your satisfaction or tries to baffle you with BS and lots of industry jargon, you may be speaking with a bad advisor. At minimum you have an advisor that is a bad fit for you. Advising someone on their finances whether you are a billionaire, millionaire, middle income, or at the poverty level, is a serious endeavor. Any advisor should be patient and take their time to explain and answer questions to your satisfaction. If you have a great many questions prior to hiring an advisor, it is appropriate for the advisor to charge you by the hour, if need be, to answer your questions (if they are, in fact, basic questions).

8. Common Tactics Used by Bad Advisors

In this section, I will share some of the ways you can tell you may be speaking with a bad advisor. At minimum the tactics below are unprofessional, and that advisor should be avoided. At worst, these red flags could indicate you are speaking with an outright crook.

The Take-Away Close

A very old, and bizarrely effective technique working to this day is the “Take-Away” close, used to pressure someone to buy something. You will hear something like, “I don’t think I can accommodate you; I have too many clients.” or “I don’t think I can get you into this investment; it’s exclusive and time is running out,” or “I can only give you access to [x] dollars or [y] number of shares of this opportunity.” This is basically a psychological ploy to appeal to the basic instinct of being allowed into an exclusive club. There are only two scenarios where this tactic is not actually BS. One, if the advisor genuinely cannot take any more clients, and in that scenario he or she will tell in in the first fifteen seconds of your call and try to get off the phone fast to get back to working on their current client base. They will not try to keep you on the phone with “pregnant pauses” or other such emotional tactics. The second is in the case of a genuinely limited investment like an IPO, for example, where only a fixed number of shares are being offered or a private placement where only a certain amount of money is being raised. In both cases, there is sufficient legal documentation available that can be sent to an attorney to check out.

My Investment Model is Proprietary and Cannot Be Shared

Today’s advisors are well aware that transparency is needed, and very well aware that in this post-Madoff world there is distrust, and most will bend over backwards to share how they invest. If an advisor is reticent to share how they decide what stock, bond, mutual fund, or ETF to invest in on your behalf, you should be on high alert. The advisor, to be fair, may have a proprietary formula, for example, to tell them when a stock in undervalued and a great time to buy, but that can be explained in plain English. Secrecy in general is something to be very dubious about.

With Investments, Never Write a Check Out to Your Advisor

With investing, a check is never written out to your advisor. It is always written out to the firm which is the custodian of your assets. For example, for an advisor who is employed at Merrill Lynch, Morgan Stanley, UBS, Wells Fargo, the checks are made out to the firm. For advisors who are Registered Investment Advisers, they use an independent custodian like Charles Schwab, Fidelity, TD Ameritrade, or Pershing. For advisors who work for Independent broker-dealers like Royal Alliance, Securities Service Network, or Securities America, checks are almost always written out to the independent clearing firm, which is like a bank that the broker-dealer firm uses to hold securities and cash. The two largest of the roughly twenty clearing firms are Pershing and Fidelity. When speaking with an advisor, ask the advisor who the custodian of the money is, and if you are not familiar with that firm, Google the firm and call the headquarters just to be sure the firm is in fact separate and apart from your advisor. The only case where a check is written to your advisor or his firm is for hourly or monthly planning fees, and if the advisor works for a FINRA-registered broker-dealer, the broker dealer must permit that activity, and the advisor will have no issue proving he or she is permitted to offer planning services apart from the broker-dealer.

Small Firm, Proprietary Investments

A proprietary investment can take many forms, but often it is an investment partnership that the advisor has created himself and is the general partner of. It can be a hedge fund investing in public securities, it can be a real estate fund purchasing buildings, or it can be a venture fund investing in startups. Statistically, it is rare for an advisor to have such an investment vehicle. However, there are hundreds of legitimate advisors with such funds out of hundreds of thousands of advisors that exist. They are expensive to create, and here comes the major red flag: if the advisor is a small advisor in terms of assets under management (AUM), then something does not add up. For example, I personally know of several very mature RIA firms that are fee-only wealth management companies that also have their own investment partnership. They are quite legitimate, and these partnerships are small in dollar amount relative to the firm’s total AUM, which often exceeds a billion dollars. These firms can afford the high expense of auditors, accountants, bonding, and other costs to support this esoteric vehicle. Almost always, the RIA started the fund from client demand, in that the clients wanted to invest in an alternative asset that had the potential to provide greater returns over time. Those returns would be uncorrelated to the general stock markets. For a small firm to have a proprietary product and less than, say, one hundred million dollars, there are very good odds something is wrong. There are always exceptions, but extraordinary care must be taken to vet this type of firm. In addition, if the advisor has an active FINRA license with a broker-dealer, then the red flag just got dramatically more alarming, as a FINRA BD would almost never allow their rep to create an outside investment product. Again, there are always exceptions, but tread very carefully when you encounter this scenario.

Is Your Current Advisor Bad?

Mark Spangler was a Registered Investment Adviser, which by definition is a fiduciary. He was fee-only, meaning he had no broker-dealer affiliation and took no commissions. At one time he was the president of the only national fee-only adviser trade association, was on the cover of many trade association magazines, and spoke at many industry events. In fact, representing that trade association, he spoke for me once at a conference. He was very well-regarded in the industry and it is difficult to overstate the shock when the SEC charged him with running a Ponzi scheme in 2012. He lost close to one hundred million dollars of his clients’ money. The fraud was brought to the attention of the SEC by one of his partners, whose conscience would not let him ignore what was going on. To be clear, not all bad advisors are Ponzi schemers. However, the message is clear: take each step in evaluating your advisor very seriously and in the right sequence of priority, as outlined in this post.