Trust, But Verify

I recently read an article, “Trust, Stupidity and Fraud,” which discussed the so-called “unholy trinity” of financial planning.  The article, written by Australian attorney Peter Bobbin, forecast a rise in fraud within the financial planning industry.  In analyzing fraud, Bobbin stated that

Every fraud is made up of simple components.  Stupidity of the client plays an important role, but trust and betrayal of it is the key component.  Warning No. 1: Clients do stupid things because they trust their advisors.

While I agree with the sentiments regarding fraud in terms of trust and the betrayal of such trust, I feel that the remarks regarding a client stupidity is overly harsh.  I would replace “stupidity” with “inexperienced and lacking sufficient education.”  That’s what this blog is all about. providing information to investors to help them become more proactive in protecting their financial security.

While everyone would like to trust everyone else, blind trust is often harmful.  The quote, “trust, but verify,” was often used by President Reagan in connection with his relationship with Russia.  A little skepticism is never harmful, especially when it involves personal finances.  Any investor whose financial adviser who is offended by a client’s request for information or explanations should seriously consider finding another adviser.

As an attorney, investment/wealth management adviser, and a former compliance director, I openly admit that I have a viewpoint that is quite often significantly different from other industry professionals.  Some find it odd that I advise both investors and investments advisers.  My goal is to improve the overall quality of advice being provided to the public in order to prevent unnecessary financial losses.  I feel the best way to do that is helping both the public and the industry.

That being said, there are two current financial planning/wealth management practices to which the “trust, but verify” definitely apply, portfolio construction and portfolio management.  Here is a simple test I suggest to everyone who has had, or is planning to have, a financial plan and/or portfolio optimization plan prepared for them.  Ask the planner to provide you with a plan that provides you with projected risk, return and correlation of returns information based upon the actual investment products being recommended.

Seems like a logical and a reasonable request, right?  But do not be surprised when they tell you that they cannot provide such a report.  The problem lies in the fact that most financial plans are prepared using software programs that can only prepare plans based on generic asset classes.  These generic asset classes do not take into consideration common investment concerns such as fees, expenses and taxes, items that can drastically reduce the return to an investor.

Given the failure of investment advisers to provide a “real world” analysis of their investment recommendations, I have always wondered how advisers can verify the suitability of their recommendations and the consistency between their investment recommendations and the representations in the plan that was used to convince a client to buy/sell investment products.  In fact, when I question advisers about this and ask them why they do not provide “real world” analyses, especially since there are Excel programs that can provide such analyses for their clients, I generally get the blank, “deer in the headlights” look.  I am not alone in my question, as Nobel laureate Dr. William F. Sharpe has also questioned the failure to provide analyses based on an investor’s actual investments.

Furthermore, I have always found it strange that advisers use generic data to provide recommendation, information analogous to passive, index funds, then attempt to sell clients actively managed investment products, despite the fact that studies have consistently shown that the majority of actively managed investment products underperform their passively managed counterparts.

The second “trust. but verify” topic is portfolio management.  Time and time again I see cases where a client says their adviser explained portfolio losses by saying that “it’s the market, everyone is losing money.”  We have a separate white paper on our site that deals with this situation (under the “Market Myths” tab) on a more detailed basis.

The bottom line is that everyone is not losing money.  The reason people supposedly hire investment mangers is to avoid large and unnecessary investment losses.  There are a number of sound, proven techniques that can be used to protect an investor’s portfolio.  The courts have rules that the failure to implement or discuss such strategies with a client can constitute a breach of the adviser’s fiduciary duty to a client.

There are still a number of investors and investment professional who adhere to the antiquated buy-and-hold approach to investing.  To quote Will Rogers, “even if you’re on the right track, you’ll get run over of you just sit there.”  A buy-and-hold approach blindly ignores the facts that history has clearly shown the market is cyclical, with definite bull and bear markets.  If anything good has come out of the 2000-2002 and 2008 bear markets, hopefully it has been to reinforce to investors that buy-and-hold makes no sense and that successful investment management is a reasoned, yet dynamic, process.

When I am asked what one piece of advice I would give investors. my response is “be proactive.”  Ask questions and keep asking questions.  To paraphrase Denzel Washington from the movie “Philadelphia,” insist on explanations that a four-year-old can understand.  Do not fall victim to the “truth bias”, blindly accepting anything told to you by someone who appears to be knowledgeable and have authority.  Do not be intimidated by spreadsheets, calculations and the almighty pie charts.  Here is a little inside secret.  Redo the first few lines of one of the spreadsheets and discover for yourself the “oops” quotient often found throughout these plans.

Trust, but verify.  Willful blindness simply exposes an investor to unnecessary risk of financial loss.  If you do not act to protect yourself, then maybe Bobbin is correct after all.


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