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Do you need a financial advisor to manage your investments? How do financial advisors make their money?
According to financial blogger J. L. Collins, most people don’t need a financial advisor to manage their personal finances. Further, he argues that financial advisors are costly at best and rip-offs at worst. They profit from people’s insecurities by making investing seem complicated and intimidating.
Here is why you’ll be better off managing your investments yourself, without the help of a financial advisor.
How Advisors Earn Their Money
Financial advisors include money managers, investment managers, brokers, and insurance salespeople (who sometimes masquerade as financial planners). To understand why you do not need a financial advisor and you’d better off managing your investments yourself, you need to understand how advisors make their money and its implications for the advice they give to clients.
An advisor gets paid a commission, also known as a load, whenever you buy or sell an investment. For example, major loads are charged for American Funds, but no loads are charged to buy Vanguard funds.
In addition, some funds charge a yearly 1% management fee for the advisors who sell the funds. Because they’re actively managed, these funds carry a high expense ratio and typically underperform low-cost index funds.
Advisors are motivated to put their interests ahead of client interests and push the investments that pay high commissions and management fees. For example, insurance investments such as annuities and whole or universal life pay advisors some of the highest commissions, therefore advisors aggressively recommend them.
The commissions and fees you pay an advisor are typically hidden so you don’t notice them. Further, advisors can make more money by buying and selling investments in your accounts (“churning”) to generate commissions. This is illegal although it can be justified as adjusting your asset allocations.
2. The “Assets Under Management” (AUM) Model
The second way financial advisors make money is by charging flat management fees, usually 1-2% of your total assets. While this is presented as more “professional” than the commission model, this undercuts the growth of your nest egg and, later, your income in retirement. Your advisor is basically skimming your investment returns, which could have earned you more when you reinvested them.
For example, if you had a nest egg of $100,000, and you invested it for 20 years for a return of 11.9% a year:
- You’d end up with $947,549.
- Factoring in a 2% management fee, your return would be 9.9% a year and after 20 years, you’d have $660,623—which is $286,926 less.
- In addition, you’d have given up the interest that $286,926 could have earned, compounded over 20 years.
Under the AUM model, your advisor’s personal interests can still influence her advice. For example, if you want to withdraw money for a child’s education, she may advise against it because her annual fee will decrease.
3. Hourly Fees
Many advisors shun this model because it generates less money for them than commissions and fees. When advisors charge an hourly rate, clients are more time-conscious because they have to write a check for each visit, and therefore are less willing to spend time with their advisor. In contrast, clients don’t notice commissions and fees as much. Still, advisors may charge as much as $200 to $300 an hour.
Paying an hourly rate is the most transparent way to buy financial advice—however, you still have to determine whether the advice is in your best interest.
Some advisors use a combination of these payment methods, making it even more difficult for the client to understand what she’s paying. Rather than trying to find the rare good advisor, you’re much better off going with an index fund that costs you less and returns more.
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Here's what you'll find in our full The Simple Path to Wealth summary:
- A simple road map to achieving financial independence and a secure retirement
- How to put your money to work for you as your “servant”
- Why you don't need a financial advisor to help you invest