Investing Basics

20 Questions to Ask Your Prospective Financial Advisor (Part 2)

Choosing a financial advisor is one of the most important decisions you will make. They are going to be managing your money and in many ways, your future, so the need to choose wisely cannot be overstated. It's not enough that the person and/or firm you select have the right qualifications. After all, just because something looks good on paper doesn't mean it can deliver in practice.

Every portfolio is unique, as each pertains to the unique life goals and financial achievements of the individual investor, AKA you.

Your advisor needs to be well-versed in the workings of the market, and capable of developing and implementing a strategy that is tailored to your needs. In addition to evaluating an advisor's qualifications, prospective investors need to assess whether or not the style and skills of a potential advisor align with their financial goals.

Here are 9 questions you can ask that will reveal:

  • What sort of investment strategies the advisor tends to favor
  • The investor's knowledge of the market, past and present
  • The advisor's commitment (known and unknown) to trying to protect your investments

1. Do you understand CVaR? (Some won’t know what VaR is, You may need to RUN!)

Value at Risk (VaR) is the most commonly used assessment for risk used by banks and brokerage house operations when assessing how much in dollars they or their clients might lose in the markets on a daily, weekly or monthly basis.

The worst market performance in one day was the October 1987 crash where the market was down 22.6%. While this worst case only happened once in over 30,000 trading days since 1896, it’s considered the max possible loss (until something worse happens) for one day in the U.S. stock market, and in the stock portion of a well allocated portfolio. That’s 3/10,000’s of a percent chance of happening. That is definitely a “tail event”, or a very unlikely chance of happening, yet it’s imminently possible; both at once.

VaR is a “most of the time” measure; under “normal market conditions”. With stock market returns it’s exemplified by the following graph where VaR is under the gray 95% part:

Stock market crashes live in the 2.5% zones or only where CVaR (Conditional Value at Risk) is able to measure their damaging effects. If the firm doesn’t know or use CVaR (or how much money you may lose when it gets really bad) it means they are potentially ignoring that possibility, and you may be at greater risk than you think.

Most of the time the stock market’s daily, weekly, yearly and multi-year fluctuations are in the 95% zone. This is what VaR measures. Most if not all firms and their financial plans for you measure on a VaR basis. In other words they model (your financial plan is a model with data inputs) what can happen most of the time.

For many years, specifically after the World War II String of mini crashes from 1945-2000 long deep stock market drawdowns were extremely rare. So rare in fact that one might begin to model financial plans only using the 95% of possibilities or eliminating the tail risks from planning all together.

That is a huge mistake.

One firm told me their measure of risk to the downside goes back 6 months. So what that means to you is if that 6 months was very good, you’d have no measure of downside risk in the plan, even though it’s possible, and potentially a false sense of safety about your plan. This means you may not be operating correctly or making proper investment decisions.

A head of wealth management at another firm told me that they had no idea what CVaR was. So what that means is that in their assessment of risks to client portfolios Conditional Value at Risk or how bad (how large are losses) is it when things get real bad (during crashes) was not a consideration. So stock market crashes were not considered relevant at that time. And how could they be if the head of wealth management had never heard of the term?

One type of tail event is when markets are crashing. The other is a melt up (vs melt down) when we’re making money really fast, hourly like 1999. No one really has a problem with that, right? These are typically thought of as happening rarely.

As you may have seen in our other material, in some time periods crashes are very rare. Meaning a couple times over 50 years (once every 25 years). In other time periods crashes are very common, meaning 8 or more in 50 years (once every 6.25 years).

It looks like we’ve gone into the latter type of time frame again. What if we have? Then an ability to use and rely on CVaR may be much more important to understand and use, as a firm, advisor, and investor.

Conditional Value at Risk (CVaR), also referred to as average value at risk during expected tail loss, is a risk assessment tool that expands the scope of the Value at Risk (VaR) assessment. VaR only accounts for portfolio losses of the middle 95% of a range of possibilities under normal market conditions. CVaR accounts for the additional tail-end gains and losses beyond that range.

In our chart, again, you can see the tails:

2. Do you use it in your strategy planning?

As such, CVaR is a more comprehensive measurement. Using a CVaR assessment and strategy may show a higher level of diligence and prudence, and capability, possibly even a greater dedication to trying to help you protect your assets as best as possible.

Some advisors won’t know what methodology their firm uses. This is a great question. The answers are very telling. It may take them a while to get back to you on this. If they don’t ask again.

3. How far back in time does your risk assessment planning model go?

To have a solid grasp of market dynamics and the associated risks, an advisor has to take a considerably long-term view of market history. If they tell you that their risk assessment model is based on a last six-month analysis, that's bad. If they tell you they look all the way back to 1896, that's outstanding.

You can judge the quality of the advisor's risk assessment based on where they fall between those two ends of the spectrum. In Squire's experience, any assessment that doesn't go back further than 1926 is missing far too many major market events to be of any real use.

Note the start date of the long term chart on the wall or desk.

4. Do you do a large amount of indexing?

Indexing is a passive investment strategy that adjusts the weights of assets in an investment portfolio so that the performance matches the performance of a chosen index. The principle of following an index is that you earn roughly the same returns as the index.

5. How much?

Index returns are based on being invested in the market at all times. It's a buy-and-hold strategy, so if they're committed to 100 percent indexing, you need to understand what this means. You'll be in the market for the best days, but you'll also be in the market for the worst days, including the crashes. If you don’t want to participate fully in stock market crashes you need a strategy with less indexing.

6. Are you willing to split my account into three or four accounts or buckets(i.e. split my IRA into several that operate differently)?

If the financial advisor insists on managing everything through one account, they probably manage all of their clients this way. It's inefficient, and may not net you the best results. Not all of your goals can be served by the same strategy. Splitting your account into investment "buckets" enables you to employ different strategies to achieve different ends.

7. Are you willing to put some of my cash or large stock holdings into a no-fee brokerage account?

No-fee brokerage accounts can save you money on assets you already own that are good. Almost every investor has assets that are worth keeping, even if it's only one or two, and there's no sense continuing to pay fees on these.

If a financial advisor is willing to do this, then they're willing to put your interests first. This means they'll be open to exploring ways not only to grow your money but to save you money. An attitude that factors heavily into the questions below.

8. Do you have a stock market crash management plan?

This is arguably the most important question for you to pose, and every answer the advisor has provided up to this point should offer a clue as to where they stand. If they don't plan for crashes in advance, walk away. Todays' markets are volatile, and that volatility could continue for years, even decades, to come. You need a crash management plan. It's that simple.

If they do have a plan, they should be able to cite firm parameters. For example, perhaps they recommend that their clients sell if the market goes down more than 15 percent. They may have several crash plan options. One of those should be a willingness to sell and go to cash if necessary.

This is also vitally important. Once you settle on an advisor and hand them your cash, are they going to move to invest it all on day one regardless of what's happening in the market? Or are they going to wait and invest it at the optimal time?

This is particularly important if the market is heading towards or at an all-time high.

9. When do you determine to get in or out of the market?

How do they navigate market tops and market bottoms? Do they have guidelines in place for when to buy in and when to sell? For example, perhaps their rule is that they won't invest your money if the market is within two percent of all-time high.

If they tell you that they don't have a strategy of when to get in or out of the market, or that they buy, hold and rebalance then they're likely not going to consider the major events or market trends that could positively or negatively affect your portfolio.

There are a lot of things to consider when choosing a financial advisor. Combine these questions with those outlined in 20 Questions to Ask Your Prospective Financial Advisor (Part 1) and pose them to each advisor that's in the running. The right advisor will welcome your questions and respect your diligence.

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