Business is built on trust. Good businesses always put the customer’s interests first.

Over time, the customer trusts that this business will deal with them fairly. If a customer repeatedly gets a good deal, they will want to come back to that business and they will recommend it to others.

In the financial advisement business, trust is the key.

Investment professionals pride themselves on building trust in same way other businesses do. Lately it seems like everyone offers “investment services.” Unfortunately most investors aren’t exposed to basic financial literacy experiences that allow them to easily decipher the good investment adviser from the bad.

Consequently financial service “sharks” are able to take advantage of this widespread “financial illiteracy.” These sharks hope you will buy into the notion that finances are just too complex and their offer to “take care of you” will make it all better. In the financial world these cynical sharks come at you with “safer” and “simplistic” investment products that really are complex and carry a nice fat fee for themselves.

In order to discern good from bad investment advice, investors should start by understanding their financial advisors legal obligations to you and how they compensated for providing you advice.

Fiduciary standard versus suitability standard

Class, sit up. Today’s financial literacy vocabulary term is: fiduciary. A fiduciary is someone who must legally put your interest first.

The first question in your evaluation of an advisor is, “Is my advisor a fiduciary?

An investment fiduciary is legally bound to put your interests first. A state registered or federally Registered Investment Adviser (RIA) subject to the Investment Advisors act of 1940 is a fiduciary.

A fiduciary financial professional who is advising you about investments has a legal obligation to recommend investments that are best for you.

On the other hand, investment brokers are working under a “suitability standard.” According to the Securities and Exchange Commission website brokers must ensure that an investment is “suitable” or appropriate for the investor given the investors willingness and ability to take risk.

Brokers can also be a fiduciary, but some brokerages shy away from allowing their brokers that much leeway because of the legal implications. Working with brokers in non-fiduciary capacity works best when investors understand that brokers are not required to put the clients’ interests over their own. Nor are they required to recommend a fund with low fee or to seek out the best product.

If investors understand this, then you can begin to understand who is working hard for you and who isn’t by asking some simple questions and closely reviewing services they provide.

According to Vanguard Financial, a major provider of index funds, advisors that have fiduciary duty to clients are subject to the highest standard there is, a law known as the “Trust” standard. The compliance obligations and documentation for fiduciaries is immense. If your adviser is a fiduciary, they will likely have implemented an Investor Policy Statement (IPS) that lays out investors goals, objectives and risk tolerances which gives a guide to work when investing your money.

The IPS gives an adviser a framework by which to follow to make sure they meet their fiduciary duties. They are obligated to find investments that are in your best interest.

Advisor compensation structures

Ask your adviser how they are compensated. This is one of the most important questions a financially literate person will ask. Fee only advisers directly bill their clients for their services. Most are independent RIA’s are not affiliated directly with a brokerage. They need to help keep your brokerage (commissions) fees down in order to show the value add of their fee. They tend to work with low fee brokerages such as Charles Schwab, Fidelity or TD Ameritrade who provide low fee brokerage and custodial services.

Fees based — not to be confused with fee only — advisers compensated by both direct fees and commissions. This is called the hybrid model because they are required to register as an adviser and a broker. Because they own mutual funds many investors don’t realize that their advisor collects both direct fees and commission. They don’t realize that they mutual fund companies compensate the broker and his or her brokerage via commissions for distributing their fund. Investors should be aware of this duel fee structure to make sure that combined rates charged aren’t excessive.