When investors select a financial advisor, one of their most frequent questions is, “What performance can I expect if I select you?” Very few financial advisors, who want to sell you investment products, are going to say, “I don’t know”. They feel compelled to give you an answer about their track record because a non-answer could cost them a sale.
Can you trust the performance numbers they give you? The answer is a resounding “No”.
Valid Track Records
Legitimate track records have five primary characteristics:
- They are written. Verbal performance data is a sales pitch.
- The formula, that calculates performance, is GIPS’ (Global Investment Performance Standard) compliant.
- The track record is for all clients so the advisor does not select higher performing accounts and exclude lower performing accounts.
- An independent third party, who is a recognized expert, audits the track record.
- The financial advisor practices full disclosure. For example, have all expenses been deducted from the track record?
Every legitimate track record has a disclaimer at the bottom of the page. It says past performance is not an accurate indicator of future performance. Consequently, you should be very cautious when you select an advisor or buy a product solely based on past performance.
Performance expectations are a major marketing challenge for financial advisors. They know a high percentage of investors select advisors who create believable performance expectations.
Consequently, creating expectations is a highly evolved sales skill. Advisors are adept at creating performance expectations that are supposed to reward investors for the risk and expense they incur when they invest their retirement assets in the securities markets.
Most investors do not question 2% expenses and the risk of large losses if they believe they will earn annual returns of 15% or more.
The Hot Fund Approach
Some advisors create fake track records using the performance of mutual funds and other types of money managers. They claim they selected the funds or managers before the performance occurred knowing you have no way to validate undocumented sales claims.
Your risk is the advisor selected the funds after the performance occurred. Anyone can do that. Therefore, the advisor is not the expert he claims to be. In fact, he is an aggressive salesman with questionable ethics and a fake track record.
Another popular sales tactic is to use references to create track records. For example, an advisor tells you his clients average an annual return of 18% per year. You contact three advisor references who all claim they have averaged 18% a year since they began following the advisor’s investment recommendations.
Do not make decisions based on the input of references. No advisor will provide a bad reference who does not confirm his sales claims. He may have a personal relationship with his references. Some advisors coach references to make the right comments.
Seven Paladin tips will help you develop realistic performance expectations.
1. Look at performance data. Ask the right questions to determine if the data is legitimate or a sales ploy.
2. Do not assume future returns will be the same as past returns.
3. Develop a long-term investment strategy that is based on conservative performance principles that focus on diversification, risk management, and reasonable expenses.
4. Avoid short-term strategies that are based on crystal ball predictions.
5. Diversify your assets into multiple asset classes for two reasons. A percentage of your assets are invested in higher performing classes and you reduce your risk of large losses.
6. Make sure your exposure to risk matches your tolerance for risk. Your principal risk is not volatility. It is large investment losses.
7. Every dollar of expense is one less dollar you have available for reinvestment and your future use. Require documentation for reasonable expenses that are fully disclosed to you.