How you should measure the performance of your financial advisor (Part 1)

****This is a two part series on how to measure the performance of your financial advisor.

Is your financial advisor performing well? It's a very simple question. It's so simple, it's actually kinda challenging to answer. In a perfect world, financial advisors would tell you exactly how to evaluate their performance, and some actually do this. And some advisors want you to hire them for the same reason they don't want you to fire them.

Let's change industries for a moment. If you were to hire a painter to paint your house, how would you determine whether or not the person did an acceptable job? I'm sure there are lots of ways, but they all boil down to results. You want to see results. I'm sure you can probably lose some sleep if the person didn't call you back and/or communicate with you appropriately, but ultimately you care about the paint on the house. Does the painter have to be smarter than everyone else? Does the painter need to pick some obscure paint that he designed himself? Would you keep a very personable painter that does a terrible paint job? There's standard way to measure results. The paint needs to be on the house, without streaks, and that's pretty much it.

There are a ridiculous number of ways to measure the performance of any individual you hire, but I would argue that the end result is the most important thing. As much as I want to think 50 different things matter when evaluating your financial advisor, I think only two things really matter. Don't get me wrong, I want the person to communicate brilliantly with you, remember your birthday, and know financial and tax laws. But if your advisor does everything right except the two things below, are they really doing a good job?

Before I unleash the first important measure for you, I too understand this post seems to go against perspective you've received from me in the past. In fact, this post seems as though I'm contradicting my 5 qualities that make a great financial advisor post. But you should take a second to understand why I'm not contradicting myself. I think you should seek someone with the qualities we discussed in previous posts, but you should ultimately measure their performance for you, based on the two measures we'll discuss over the next couple of days.

1. Performance in relation to the Index- I'm going to get killed for this (by industry folks), but if your advisor can't consistently beat the index, what's the point of paying for management fees? I certainly realize there are several investment objectives to consider, but if someone's objective is growth, and the advisor's recommendations don't beat the S&P 500, then why not just invest in an index fund which replicates the S&P 500?

This is where you start to learn the differences between active and passive management. An index fund is a passive investment that has the same holdings as a given stock market index. A stock market index is used to judge and evaluate a particular portion of the market. There isn't a svengali pushing buttons and pulling levers. The stocks or bonds within an index fund don't change frequently. Nothing is sold at highs or bought at lows. As my daughter says, "you get what you get, and you won't throw a fit."

Actively managed funds are the opposite of this. The positions (stocks and bonds) within the fund can change with varying degrees of frequency. The goal is to buy low and sell high. Investment professionals use either fundamental analysis or technical analysis to decide what will or will not make money. As you can imagine, all of this activity (analyzing, buying, and selling) costs money. So not only does your advisor need the actively managed fund to beat the passively managed index, but it also needs to beat the passive fund by the amount of fees you are paying on the active funds. Otherwise, by this performance measure, you should just buy an index fund.

Every investment strategy is an educated guess. Yes, an educated guess. Unless you are buying a product with a guaranteed rate, you are putting your money at risk. And even guaranteed rate investments have their risks. Your advisor also measures the amount of risk he/she takes against the index. Your tolerance for risk will dictate how aggressive your investments are, in relation to the index. It's quite possible that you don't have the risk tolerance that's needed to even invest in an S&P 500 index fund. If this is the case, then you shouldn't bust your advisor's chops if he/she can't beat the index, because in this instance, the index has a different risk level. Your risk tolerance and time horizon should be important factors that your advisor uses to create your investment portfolio.

Your advisor must bring value. They may or may not be able to beat the market, and if they consistently can't, then they probably aren't doing that good of job. Tomorrow I will discuss the second way in which you should measure the performance of your financial advisor. Not to sandbag you, but I think it's the most important measure of success.

Read Part 2 here.