Financial Advisor

Discussion in 'Economics' started by DannyT, Nov 6, 2009.

  1. DannyT


    Hi guys,

    I am an economics undergraduate writing an essay on creating a reward scheme that provides an incentive for my financial advisor to deliver the level of effort on planning my selection of risky investments that creates a return (dependent on effort and some random exogenous variable) that is best suited to my risk averse preferences.

    My question for you guys is if any of you have had experience with/are financial advisors? You see i have read that FA are paid on a Commission only basis, fee only, or fee based. Now since i have to establish a reward scheme i am working at the moment on a fee only FA. Now as i understand it they are paid a % of assets under management + hourly rates + planning fees + re planning fees? (is this correct?) Assuming it is, what is it that prompts the FA to re-plan the position? I've ruled out a periodic re-plan based purely on time as i don't think that could be efficient. So it must involve the return on the investment and some sort of boundary. Since it is for a risk-averse principal i guess that the most efficient re-plan is when the risk value of the portfolio changes past some sort of boundary? (clearly a re-plan of the investment every time risk changes is neither efficient for principle or agent)

    So yeah if any of you guys have experience of what prompts a financial advisor to re-plan a portfolio let me know. How knowledgeable are they of the changing risk of the portfolio?

    Any reading on either the mathematics behind the risk factor of a portfolio would be nice.

  2. esmjb


    they can work on a commission only basis in which they charge jacked up fees to do a trade or most commonly they work for a % of assets under management. under the latter there are no other fees involved. if you tell him you want to change your risk exposure every 4 months he will and it wont cost you extra.
  3. DannyT


    Thanks ever so much for the speedy reply!

    Ok so is it fair to say that under the commission scheme they have a conflict of interest?

    So if they were only to adjust my exposure to risk every 4 months i have two questions;

    1) What happens if my exposure changes significantly after one month? will he notify me and for an additional fee alter my plan to one more suited to my risk-averse preference? Is it possible to place say a boundary on the value of risk i am exposed to s.t. if the risk value of my portfolio exceeds the risk i want to be exposed to it triggers a consult with my financial advisor and a re-plan?

    2) What is his incentive to make sure this re-adjustment to exposure is a good one? I mean if there is no additional charge how do i know that he has put in an effort that will maximise my Utility and not self maximising his utility since he will gain a disutility from the extra effort involved in re-planning this structure with no obvious reward from it.

  4. Persdawg


    you'll have to sign a consent form acknowledging the account/allocation changes unless he has full discretion over your acct. if he does, I don't know why he would need to provide any documentation support the would have already filled those out at inception I would think.
  5. DannyT


    ok but what is his incentive to manage my account to the best of his ability if i have already paid my fee?

    Also Chevalier and Ellison 97 showed that because mutual funds recieve a fixed percentage of assets under management as compensation they will have an incentive to take whatever action increases the total assets of the fund and given the most observable statistic of a funds performance is its year end => funds that trail the market have an incentive to increase their risk if they are trailing the market and funds that are ahead have an incentive to lock in. Irrespective of clients wishes. I would like to know if the same sort of incentive to increase assets under management exists for a financial advisor (given that for fee only ones it clearly will) then it is not unreasonable that the financial advisor will also have an incentive irrespective of the clients risk preferences?
  6. ok but what is his incentive to manage my account to the best of his ability if i have already paid my fee?

  7. DannyT


    which is why for the purposes of this i will be arguing against this idea of a one time fee and then thats it in favour of some form of payment schedule that contains a variable dependent on output because otherwise i really can't see this arrangement being even close to pareto efficent
  8. I have worked with financial advisors before. Some work on a commission basis and should be avoided IMO. They love to sell you variable annuities and other items that are bad investments, but pay them big fat commissions.

    I believe that the best financial advisors work on a fee only basis. Those that do, typically charge a percentage of assets being managed, without any additional fees for planning or hourly rates, unless they also advise you on estate planning, insurance, etc. They maintain that they have an incentive to put you in the best investments, because the more they can make your account grow, the more money they make.

    When you say re-plan, I assume you mean re-balance your portfolio for the best returns. Many financial planners use an asset allocation plan based upon your risk tolerance. If you are younger, have a longer term time horizon and are open to more risk, they will typically put you in more equities (stocks and stock mutual funds) and fewer bonds. If you are going to retire soon or do not like risk, they will put you in more bonds and fewer stocks. Again, based upon your time horizon and risk profile, they will diversify your stocks into large cap growth and value, medium cap growth and value and small cap growth and value, as well as as foreign stocks. Bonds can be diversified into corporate, high yield (junk), foreign, government, etc.

    Many financial planners believe you cannot time the market, so they buy and hold. If one asset class does well, like large cap growth stocks and one does poorly, like corporate bonds, typically once every 6 months to a year, they will sell some of the growth stock and buy more corporate bonds to re-balance your portfolio. By keeping you invested in a a broadly diversified portfolio, they believe that you will have more consistent returns.

    Personally, I think that the best financial incentive for a financial planner is for them to receive a percentage of the GROWTH of your portfolio each quarter, not a percentage of the NET VALUE of your account. In other words, they only make money if your account grows. They won't get paid if your account loses money. I have not been able to find anyone good enough to work that way, which is why I now manage my money myself.