What you need to ask before deciding on a financial adviser

Thinking about hiring a financial adviser? What you need to ask a potential adviser before making it official. 

When you hire a new housecleaner, figuring out if he did a good job is pretty easy — just look under some furniture for evidence of shoddy work. Unfortunately, it's much more difficult to determine if your new financial advisor is doing a good job, since it's more difficult to understand the vagaries of the financial industry than it is to figure out whether or not your home has been adequately dusted.

In addition, only some of the titles that financial advisors use are regulated in any way, shape, or form. The non-regulated, generic titles are pretty meaningless. That means an insurance agent, an investment advisor, a Certified Financial Planner (CFP), and the next Bernie Madoff can all legally call themselves financial planners or financial advisors.

So how do you find a financial advisor who is worthy of your trust? There are five simple questions to ask that will help you separate the tricky, incompetent, inexperienced, and inappropriate for your needs from the reliable and trusty advisors who will help you achieve your financial goals.

1. How Are You Compensated?

This is the most important question you will ask a potential advisor. That's because different types of advisors are paid in different ways, which can seriously affect your bottom line. Even those with a good understanding of the financial world can be excused for feeling a little overwhelmed.

In general, there are three ways that a financial advisor can be paid.

Commission

An advisor paid via commission will only make money when you purchase a particular product through them. Commissions can be problematic because your advisor may have a conflict of interest — the commission can be a bigger incentive for them than making sure you have an appropriate plan and product for your goals. That said, there's nothing wrong with working with a commission-based advisor, as long as you understand exactly how they will be paid based on the various products offered.

Fee-Only

These advisors are paid directly by their clients, which means their advice may be more objective than that of commission-based advisors. However, you will still need to know how you pay their fee, since it may be taken as a percentage of your account value, as an hourly rate simply for advice, or as a flat fee.

Fee-Based

Though fee-based advisors sound similar to their fee-only colleagues, these advisors are compensated directly by their clients and through commissions from the sales or recommendation of products.

Not only will asking about compensation protect you from out-and-out scammers who would rather you didn't understand how they are paid, but having this discussion with a potential advisor can help you compare apples to apples while interviewing multiple candidates.

2. What Licenses and Certifications Do You Hold?

This question will help you to understand exactly what type of advisor you are interviewing. There are four different types of financial advisors, and it's important for you to know exactly what sort of advisor you are hiring.

Financial Planner

This is the most loosely defined of all types of advisors, since there is no regulatory body that oversees self-proclaimed financial planners. However, if you meet a Certified Financial Planner (CFP), you know that she has completed an education requirement, passed an examination, has at least three years of experience, and has agreed to the CFP Board's standard of ethics.

Insurance Agent

An insurance agent has been licensed within their state to sell life insurance products, including everything from traditional life insurance to annuities. Some financial planners are also licensed as insurance agents, which means they can give you general financial advice, as well as sell you insurance products.

Registered Investment Advisors

These types of advisors offer both investment advice and portfolio-management services. They are also the most regulated of financial advisors, since registered investment advisors have a fiduciary duty to put clients' interests above their own. That peace of mind comes with a cost, however — registered investment advisors tend to work with extremely wealthy clients who have very complex financial situations.

Registered Representatives

These advisors, also known as stockbrokers, generally work for or are affiliated with a broker-dealer — a company or firm that trades securities for clients.

It's entirely possible that your advisor has multiple licenses and certifications, which means that he may be governed by several regulatory agencies.

3. What is Your Area of Expertise?

Just as doctors specialize in various aspects of medical expertise, financial advisors can have specialties. Some advisors might focus on helping younger clients build a retirement nest egg, while others help older workers transition to and manage their money post-retirement, and still others might handle estate planning more than anything else. Generally, a young client just starting to build her nest egg would not want to work with an advisor who is more geared toward helping the already-retired. Though choosing a financial advisor with an incompatible area of expertise is not as big a mismatch as going to a dermatologist for a heart attack, why would you want to settle for an advisor who specializes in something other than your specific needs?

4. What is Your Investment Philosophy?

Your potential advisor should be able to explain what they consider to be important in investing, and based upon their answer, you might find yourself nodding your head or feeling silently horrified. If any aspect of the advisor's answer to this question is unclear, ask them to explain. Better to feel foolish because you are asking questions, than to feel foolish because you lost your shirt.

5. What Do You See as My Financial Goals and Objectives?

No, this isn't just a gotcha question to see if your prospective advisor has been paying attention. It's also a good way to help you to better understand exactly what you are hoping to achieve in a realm that might be unfamiliar to you. Many new clients are not able to state their objectives in clear terms. A good advisor can help you specify and articulate exactly what you want.

Ignore Your Intimidation

Many of us feel intimidated by finances, which can lead to some truly unproductive behavior. Rather than try to figure out the world of finance all by yourself or accept the guidance of the first advisor you meet who seems to know what he is talking about, take the time to learn more about who your prospective advisors are and what they can do. Investing time in the interview process will help you make the most of your money.