When an advisor recommends a particular investment, how do you know it’s right for you? Financial writers, myself included, say you need to ask questions. The trouble is, according to a recent survey, most investors ask the wrong questions.
The survey, funded by Dimensional Fund Advisors and conducted in March 2014 by Advisor Impact, polled 1,229 investors. The respondents were almost evenly split among female and male. Most had an investment net worth of over $500,000 and almost half had an annual household income of over $100,000.
Investors were asked, “When your advisor makes an investment recommendation for your portfolio, which, if any, of the following are important for you to know?”
For 70% of the respondents, the most important information was the risk associated with the investment. At face value, this seems to be quite logical. What investor is unconcerned with risk? Behavioral economists tell us that most of us are far more averse to a loss than an equal chance of a gain.
The issue is in understanding the definition of “risk.” To simply ask an advisor, “What risk is associated with this investment?” is like asking the butcher at Safeway to tell you about the risk associated with eating meat.
The butcher, thinking about the chance of choking on a bite and dying, might say there is almost no risk. Yet this answer wouldn’t necessarily apply if the customer were thinking about the risks associated with saturated fat, mad cow disease, hormones, contamination, or allergic reactions.
To answer the question fully, the butcher would need to ask a lot of questions and address the many potential risks associated with eating meat. The chances of that happening at a busy meat counter are highly unlikely. The consumer will probably be left with a skewed understanding, perhaps overly positive or negative, of the associated “risks”.
The same is true with investments. A few of the risks associated with most securities include economic, political, default, legal, interest rates, business cycle, managerial, and diversification. Rarely does an investor understand the nuances of all the various components of risk. Many advisors don’t fully understand them or explain them, either.
The second most important factor, which 58% of investors wanted to know, was what return they could expect from the investment going forward. Again, the answer to this question won’t be very helpful; there is no way the advisor can know this, unless the investment’s return is guaranteed (like a certificate of deposit or a fixed annuity). Even then, no return is completely guaranteed, even those that are guaranteed. There is always a risk factor that can terminate any guarantee, the biggest being the bankruptcy of the guarantor or political interference.
The third most important thing investors wanted to know was the amount of the fees associated with the investment. I was surprised, though, that even though this question ranked third, less than half—47%—of the respondents thought it was important. Fees paid to advisors and middlemen are an essential consideration. They are one of the few things investors can actually control, and the fees you pay can single-handedly turn a great investment into a poor one.
Even if you’re among the minority who inquire about fees, there is no guarantee you will get a straight answer. I’ve had many life insurance and annuity salespeople swear to me there are “no costs whatsoever” charged by their companies to the customer.
To become an informed investor, then, your first step may be to learn what questions to ask. It’s also important to keep asking those questions until you get clear and satisfactory answers.
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