Let's face it. Investing, especially in the crazy market we're in now, can be harrowingly scary! It can test the limits of our own psychology — oscillating between extreme fear, extreme greed and a range of emotions in between. It doesn't help that you're often dealing with huge sums of money that often represent your life savings.
You don't want to mess it up, and so many people choose to hire an advisor. In this post, we'll discuss whether that's a good idea, when you should consider getting one and when you shouldn't. I'll be sharing the specific experience I had when using an advisor ("Sharia Portfolio").
Let's dive in.
How Does A Financial Advisor Make Money?
Let's start by defining what an advisor is first. An advisor is someone who's licensed to provide financial advice, usually by a regulating body in the country in which they're based.
Advisors make money by charging fees. This usually takes the form of a percentage of the assets they're investing for you (Assets Under Management, or "AUM" for short). These range from 0.75 — 2%, usually dropping the more you invest.
Some advisors also get kickbacks from trading commissions — they'll route your orders through a particular broker, and receive a portion of the commission the broker receives whenever a trade is placed from your account. This is pretty shady behavior, especially if it's something the broker doesn't disclose to you during your intro call.
Let's discuss the pros and cons of hiring an advisor. This list is compiled based on our research, as well as first-hand experience using a Shariah-compliant advisor ("Sharia Portfolio") which we'll mention in the examples.
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Why You Shouldn't Get An Advisor
In 2008, Warren Buffett bet a million dollars that the dullest, most mindless investment (a simple S&P500 fund) would outperform the carefully chosen investments of some of the world's most intelligent financial managers. Protege Partners LLC took him up on the offer, and Buffet won the bet by a landslide.
In his words:
Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.
I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.
Most financial advisors manage investment portfolios that try to beat the market by picking individual stocks or other assets. These types of portfolios are called "actively-managed" because the advisor is actively making decisions about what to buy and sell. On the other hand, some investment funds, called "index funds," simply track a market index, such as the S&P 500. Over the long term, index funds tend to perform better than actively-managed funds because they have lower fees and are not subject to the same performance pressures. As a result, people who invest in index funds are more likely to reach their financial goals than those who invest in actively-managed funds.
I don't know what financial advisor you're considering, but chances are they'd lose the bet too.
Financial advisors typically charge fees in one of three ways: asset-based, hourly, or commission-based. Asset-based fees are a percentage of the assets under management, so the fee would be higher for a larger investment portfolio. Hourly fees are based on the number of hours the advisor spends working on your financial plan. Commission-based fees are based on the products the advisor sells to you, such as insurance policies or investment products. Some financial advisors may charge a combination of these fees. It's important to understand how your financial advisor is charging fees, as well as the total cost, in order to make an informed decision about whether to work with that advisor.
Another thing to look out for are hidden fees. This can take many forms, but one common example is hidden trade execution fees. Unforuntately, many advisors choose trade execution brokers that charge higher fees, in exchange for a referral fee that kicks back some of the client fees to the advisor.
Also, it is not uncommon for financial advisors to recommend ETFs (exchange-traded funds) that are issued by the same firm that manages the advisor's investment portfolio. This practice, known as "self-dealing," can result in hidden fees for the investor.
For example, "Sharia Portfolio" might suggest clients invest in their SPUS or SPRE funds without disclosing that they charge 0.5% of the assets invested in this fund yearly as part of the fund expenses.
This demonstrates how self-dealing can create a conflict of interest for the financial advisor. The advisor may be more motivated to recommend the in-house ETF because they will receive a portion of the expense ratio, rather than recommending the best ETF for the investor's specific financial needs. As a result, investors should be aware of this potential conflict of interest and ask their financial advisor about the fees associated with any ETFs they recommend.
High Tax Bill
Using a financial advisor can sometimes result in a higher tax bill because the advisor may make frequent trades in the client's investment portfolio. This can generate a large number of short-term capital gains, which are taxed at a higher rate than long-term capital gains.
Why You Should Get An Advisor
There are several reasons why you might want to hire a financial advisor.
Managing Your Psychology
If you have a hard time controlling your FOMO (fear of missing out), a financial advisor can help you make more disciplined investment decisions. Financial advisors can provide guidance and support to help you avoid making impulsive decisions that could harm your financial well-being.
Another reason to hire a financial advisor is if you need someone to talk to about your money. Financial advisors are trained to provide financial advice, so they can help you understand complex financial concepts and make informed decisions about your money. This can be especially helpful if you are new to investing or don't have a strong understanding of finance.
Additionally, a financial advisor can be a great source of support during times of market volatility. They can help you understand what's going on in the market and provide guidance to help you stay the course with your investment plan. This can be especially valuable if you are feeling anxious or uncertain about your investments.
Of course, hiring a financial advisor does come at a cost. Most financial advisors charge a percentage of your assets under management as a fee, which can range from 1% to 2% or more. This means that the cost of using a financial advisor can be significant, especially for larger investment portfolios. You should carefully consider whether the benefits of hiring a financial advisor are worth the cost before making a decision.
The Short Answer: No
It is true that many people are capable of managing their own money without the help of a financial advisor. A study by the Consumer Federation of America found that individuals who take a DIY approach to investing tend to outperform those who use a financial advisor. This is likely because individuals are more attuned to their own financial goals and risk tolerance, and may be less susceptible to biases and conflicts of interest that can affect financial advisors.
However, the decision to hire a financial advisor or not ultimately comes down to an individual's ability to handle their own psychology when it comes to money. Managing one's finances can be emotionally challenging, and many people may struggle with fear, greed, and other psychological factors that can affect their decision-making. A financial advisor can provide objective guidance and help individuals stay on track and avoid making emotional decisions that could hurt their financial situation.
What Can I Do Instead?
If you're just getting started, take a look at this post where we talk about how to make your first investment. Otherwise, choose a halal fund that suits your goals as your primary investment vehicle.
Before Hiring An Advisor
If you decide to hire a financial advisor, make sure to ask for the following:
- Set a benchmark you'd like to beat: Establish a clear goal or performance benchmark to help determine if the financial advisor is meeting your expectations.
- Ask for a 12 month trial period: Consider having a trial period before committing to a long-term relationship with the advisor to see if they are a good fit for your needs.
- Ask detailed questions about how they are compensated: Understand how the advisor is paid, including any fees or commissions, and how that may impact their recommendations.
- Check reviews: Research the advisor's reputation and read reviews from past clients to get a sense of their experience and level of satisfaction.
- Get written confirmation of the all-in costs (including trading costs): Request a written statement of the advisor's fees and all costs associated with their services, including any trading costs.
- File a complaint with the authorities if you are deceived: If you are deceived or encounter any unethical behavior from the advisor, file a complaint with the appropriate regulatory authorities to protect your interests and hold the advisor accountable.