- One common piece of advice to potential financial advisor clients is that they ask their potential money manager about their "investment philosophy."
- Just what an investment philosophy is depends on the individual advisor.
- Some advisors claim questions about investment philosophy are irrelevant.
Choosing the right financial advisor is one of the most important decisions an investor can make. If you hit it right, it becomes a positive experience. But if you choose wrong, it can be a nightmare.
When interviewing potential advisors, the Financial Industry Regulatory Authority and other industry sources recommend that investors ask them to describe their "investment philosophy." But do these answers actually help or just confuse people? Semantics can be an issue when a term or phrase, such as "philosophy," is not universally understood the same way.
For Trent Porter, certified financial planner and owner of Priority Financial Partners, the question of investment philosophy brings to mind the active-versus-passive debate.
Porter tells potential clients that he focuses on not guessing the market by buying index funds that buy broad swaths of the market; keeping costs as low as possible, such as fewer transaction costs and not paying analyst fees; and focusing on tax efficiency, by relocating assets from tax-inefficient types of investments to tax-advantaged accounts.
For his part, Vid Ponnapalli, CFP and founder of Unique Financial Advisors, explains investment philosophy as a set of guiding principles underlying the process of choosing appropriate investments for a given situation.
For example, an advisor could describe a philosophy such as a focus on long-term investing in a globally diversified portfolio and encourage choosing only low-cost exchange-traded funds, he said.
"The advisor could also explain that his or her choice of investments depends on other factors, such as the risk tolerance, risk capacity of the investor or the current income tax situation of the investor," Ponnapalli said.
He added that answers to these questions will help potential clients in various ways, such as:
- Verifying if their priorities match those of the advisor.
- Becoming more aware of the risk/return relationship in investment management.
- Understanding their own risk tolerance and risk capacity.
- Being assured the advisor's investment choices are based on a solid foundation, as opposed to a random selection.
In response to questions on investment philosophy, Shikha Mittra, CFP and president of Retire Smart Consulting, finds it more relevant to explain the overall client-facing process, not just the investment phase, per se.
For Mittra, "philosophy" relates to how she manages clients' funds, which should be the last question to ask, she said.
"We as professionals rely on strict proven processes customized to the investor's need," Mittra said.
She described her basic process to provide context on where investment philosophy questions should fit in. Her first step is to determine the client's needs, goals, risk tolerance, time frame, interests and other data to create an investment policy statement. This document would then dictate how she will manage the portfolio.
"It's a blueprint, a guideline with the responsibilities of the client, the advisor and the custodian," Mittra said. "It's also a tool to communicate with each other, a basis of understanding that prevents clients from guessing how the money should be managed."
Only after this comes the implementation phase — where the notion of investment philosophy comes into play — followed by the monitoring phase, she said.
Some advisors question the value of inquiring about investment philosophies altogether.
"It's a question that's vague enough that I could answer it a million ways," said Ed Kohlhepp, CFP, founder and CEO of Kohlhepp Investment Advisors. "I don't know if the prospective client would gain any knowledge.
"I could say, 'strategic, tactical allocation, active, passive', etc., and their jaws are going to hit the ground," he added.
Kohlhepp said that a similar type of dubious question is asking how an advisor has performed, since every client's portfolio performance is different.
"People also ask about fees, but what are you getting for the price?" Kohlhepp said. "Don't use just performance and fees to compare advisors.
"You need to look at the long-term [relationship] and understand that our investment philosophy is unique to each individual based on their unique situation," he added.
Doug Kobak, CFP, principal of Main Line Group Wealth Management, said that "in the big picture, process is what you do, and philosophy — or strategy — is how you do the asset management."
Regarding his investment philosophy, Kobak tells potential clients that "I don't believe in investing and forgetting."
"My methodology is, one, a belief that at different periods of time, some asset classes are more in favor than others, and two, we rank the major assets against each other and invest in the strong ones," he said.
Furthermore, said Kobak, it's important for clients to understand what's in an advisor's "toolbox" and how those tools are used.
So how do investors compare varying answers from different advisors?
"You need to find a person who has a process and strategy that resonates with you," Kobak said. "If you walk out of the meeting thinking, I have no idea what they're going to do, you should realize that just because it's complicated doesn't mean it's better."
— By Deborah Nason, special to CNBC.com