Choosing a financial advisor is a crucial step in securing your financial future. But not all advisors are created equal.
While most financial advisors work in your best interest, this is not always the case. Some may be on the payroll of an insurance company and earn a commission by selling you expensive products that you don’t need. Others may simply follow outdated investing principles, engage in risky behavior, or lack the experience necessary to create a well-rounded financial plan.
We’ll dive into the reasons why an advisor may give bad financial advice and how to avoid these warning signs.
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The importance of reliable financial advice
Money affects almost every aspect of our lives. So if you receive vague, biased or even downright incorrect financial advice, it can have long-lasting consequences for your life.
Risky bets within your investment portfolio can lead to mediocre returns, higher costs and a larger tax bill. At worst, bad investment advice can delay your retirement and derail your other financial goals.
When you hire a financial advisor, you are trusting that person with the most intimate details of your life. While no advisor can predict the future or make the right investment decision 100% of the time, you want to work with a professional you trust and who will put your interests above their own.
Why financial advisors can give bad advice
Before we get into the types of bad financial advice you should avoid, it’s important to understand why a financial advisor may make inadequate recommendations. Not being a counselor and a lack of experience are the two most common reasons why a professional may give you bad financial advice.
A fiduciary duty means that the financial advisor is ethically or legally obligated to act in your best interests. However, some advisors may not be fiduciaries, meaning they may recommend products or strategies that will benefit them more than you. Likewise, advisors who earn commissions or fees by selling certain products operate under a conflict of interest, so their advice is biased.
An advisor’s level of experience also affects his ability to make good financial recommendations. Novice advisors may lack the knowledge and insights needed to navigate complex financial situations, leading to poor or vague advice. It is best to look for an advisor with a few years of experience in the financial areas you need help with.
Common examples of bad financial advice
Below is bad financial advice you might receive from a financial advisor, along with examples of what an advisor should have told you.
Recommend only the most popular investments
Some advisors may encourage investing in trendy, risky assets or sectors with the promise of quick profits and huge upside. While the lure of rapid growth is tempting, it’s important to remember that what’s popular today may not be profitable tomorrow.
If you’re investing for retirement, it can be detrimental to allocate large portions of your portfolio to popular stocks or other risky investments. Instead, you should opt for a long-term perspective rather than chasing short-term trends. A mix of asset classes, including shares, bonds and alternative investments, provides a much more solid foundation for your portfolio.
Downplaying the risks of investments
Minimizing the risks associated with an investment can lead to significant losses. Every investment involves risk, so be wary of an advisor who does not recognize the potential downsides of a security.
A reputable advisor ensures that you get a clear understanding of the risks and benefits of an investment. They will provide you with the prospectus and all other information you need to make an informed decision that fits your financial goals.
Using your home as part of your investment strategy
Using your home equity as a financial instrument can be a double-edged sword. While tapping into your home’s equity or using it as leverage may seem like a way to accelerate wealth creation, it exposes you to significant risks.
The mortgage debt is secured by your home, so if you don’t make the payments, your lender can foreclose. If your home’s value drops, you could also find yourself “underwater,” or owing more money on your home than it’s worth.
Your home is a place of safety, and compromising it for potential profits is never a good idea. While gaining home equity can be a viable way to access cash for home improvement projects and a number of other needs, it should not be used as a way to free up cash for investments. A reputable financial advisor should not recommend this strategy. Instead, explore safer investment options that won’t put your home at risk.
Exit stocks as you approach retirement
Long-standing investment advice is to invest heavily in stocks when you’re young and then switch to bonds as you approach retirement. While it’s important to adjust your portfolio allocation over time, quitting stocks completely as you approach retirement can hinder your ability to beat inflation and maintain long-term growth.
Bonds can help offset stock market volatility, so they are an important part of your portfolio. They simply shouldn’t make up your entire portfolio. A good financial advisor will help you find a balance between growth and capital preservation.
Excessive trading
Some financial advisors may encourage frequent buying and selling of investments in pursuit of quick profits. However, each transaction incurs costs, including fees and capital gains taxes. These costs can add up quickly and negatively impact your overall portfolio return.
Be wary of an advisor who trades regularly as they may generate commissions at your expense. Excessive trading can also lead to well-performing stocks being sold too quickly while losses mount, a practice known as “cutting off the flowers and watering the weeds.”
Promote only actively managed investments
Some financial advisors may promote actively managed mutual funds, which have higher costs and may not outperform lower-cost options, such as passively managed index funds and exchange-traded funds (ETFs).
While actively managed funds have their place, they should be chosen carefully. There will always be a few active funds that outperform their benchmark in the short term, but few can do so consistently over the long term.
A good financial advisor should be prepared to explain why he chose an active investment fund instead of a cheaper option. If they don’t offer this information directly, don’t be afraid to ask.
Poor portfolio diversification
Concentrating your investments too heavily on one asset class or sector can expose you to unnecessary risks. A lack of diversification can leave your portfolio vulnerable to market volatility, supply chain shortages and other sector-specific risks. For example, if you’re heavily invested in construction companies and REITs, your portfolio could take a nosedive if the housing market crashes.
Find a financial advisor who understands the importance of spreading your investment dollars across different industries and sectors. It will make your portfolio better equipped to weather the ups and downs of market volatility
Ignoring individual circumstances
Imposing one-size-fits-all recommendations without considering your financial situation can lead to bad results. Your financial journey is unique and your advisor should tailor their guidance accordingly. Offering generic investment advice is often a sign of an inexperienced advisor.
A trusted financial advisor will take the time to understand your circumstances, including your financial goals, risk tolerance and time horizon. They should create a personalized financial plan that suits your needs, not impose outdated or vague advice.
Avoid bad financial advice
One of the best ways to avoid bad financial advice is to ask questions and do your own research when something doesn’t feel right. There are many online educational resources available, and it never hurts to get a second opinion.
If you work with a financial advisor who has given you bad advice, remember that you are in the driver’s seat. You can always part ways and find a new financial advisor who better suits your needs.
Here are some important tips for choosing a financial advisor:
- Identify your needs: Before meeting with a financial advisor, you should have a clear understanding of your financial situation and what you hope to achieve.
- Check their references, reviews and ask for references: You can research an advisor’s background using FINRA’s BrokerCheck.
- Make the most of the first consultation: Use the initial conversation to gauge an advisor’s investment philosophy and personality to see if it aligns with yours.
- Understand their fee structure: Ask how the advisor is compensated. Whether it’s a fixed amount, an hourly rate or based on assets under management: make sure it fits your budget. Avoid commission-based advisors.
In short
While most financial advisors have your best interests at heart, it’s important to recognize warning signs that could indicate bad investment advice. It can help you avoid common pitfalls, such as chasing good investments or neglecting diversification. Remember that your financial journey is unique and a trusted advisor will tailor their guidance to your needs without putting your money at risk.
