How to Spot Lousy Investment Advisers

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You can easily hire people who claim to be good investment advisers. They hardly ever are. But there are several different kinds of downright lousy investment advisers, and it's worth learning how to identify them. (See also: Mediocre Advice Is Best for Investing)

I group them into three categories: The delusional, the liar, and the secretly mediocre.

The Delusional

The most common sign of the delusional financial adviser is that they can tell you about all the winning trades they've made, but they don't know the average annual return of their portfolio as a whole.

You'll find this same trait in a lot of ordinary investors, as well — they're full of stories of their investing successes. They may also have a few self-deprecating stories of investments that went wrong. But they simply don't know what their all-in return actually is.

For the ordinary investor, this is no big deal. But for someone selling their investment expertise, not knowing whether their advice beats what you can get following mediocre advice should disqualify them completely.

There is one important subcategory of lousy investment adviser that might not show this sign. I call them the "lucky so far." They're usually young with a pretty new track record. Typically, they're people who have a strong sense that one sector of the market — financial stocks, say, or precious metals — is the right choice for long-term investing. If they happen to get into the investment advising game right when their sector gets hot, they can produce outstanding investment returns, sometimes for a long time. Eventually the market turns against them and they lose a whole lot of their clients' money.

Of course there are a few legitimately superior investment advisers out there. It's really impossible to tell one of them from one of the "lucky so far," except that once they establish a record of shifting from this year's hot sector into next year's hot sector for several years in a row, somebody rich will notice and pay up to get their advice. One pretty good indication is that you won't be able to afford them.

The Liar

Just like the delusional financial adviser, there are many kinds of lying financial advisers. (Note that I'm not talking about scammers or fraudsters, just ordinary financial advisers who know their advice doesn't produce superior results, but hold themselves out as superior anyway.)

Probably the most common are the ones who used to be delusional, but eventually figured out that they weren't actually superior. Of course the honest thing to do then would be to find another career, but delusional financial advisers can make a lot of money, and that's hard to give up.

It's pretty easy to slip gradually into lying about your performance — just talk about your successes, and don't mention your failures.

The clearest sign of the liar is that they claim an "average annual return," but can't point to the specific trades that they or their clients made that produced this return. Instead, they'll point to lists of suggested trades — but if you have access to all the suggestions, it'll turn out that some of the bad ones don't make the list.

Another strong clue is vague advice, such as that you buy a stock "on dips," without specific numbers attached. This will make it easy for them to leave out losing trades (on the grounds that the dips were never low enough for them to enter the trade). They will also suggest that you use peaks in the market to "begin to lighten up" your position. If the stock continues to outperform, you'll find that they still list it in their model portfolio. Once it starts to lag, you'll see that they exited their position at the last high point.

Another common habit among the liars is to ignore trading costs — and the cost of their advice — when figuring the bottom line.

The Secretly Mediocre

When "index investing" first started getting big, financial magazines (and others who rated financial advisers) started comparing investment advisers' returns to the market averages. Lousy advisers often fell short, which was pretty embarrassing. A fair number reacted by shifting their advice to just the sort of mediocre advice I'm suggesting that you follow. That way, they'd at least match the market returns.

These investment advisers are giving you perfectly good advice, they're just charging you money to achieve performance you could get for free on your own.

You can spot the secretly mediocre advisers either by looking at their returns or by looking at their portfolio. In either case, it will end up looking a lot like the return or portfolio you could get from just following the indexes.

My Mediocre Advice

Genuinely superior advice from (extremely rare) genuinely superior investment advisers is generally so expensive it makes no sense to pay for it, unless you have a portfolio of millions of dollars.

Since Wise Bread is all about living large on a small budget, I figure it's pretty likely that you don't have the multimillion-dollar portfolio that would let superior financial advice pay for itself. In that case, I suggest that you just follow the mediocre advice I wrote about last time. Doing that, you'll get mediocre returns — which it turns out, are good enough.