Money Magazine
Money Magazine's undercover financial planner

When it's time to dump your broker

Lousy short-term performance doesn't necessarily mean your financial adviser is a dud. But there are some red flags that may tell you it's time to pull the plug.

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By The Mole, Money Magazine's undercover financial planner

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Simple benchmarking calculation
Fund name Your allocation 2007 return Benchmark calculation
Vanguard Total US Stock Index (VTSMX) 60.0% 5.49% 3.29%
Vanguard Total International Stock Index (VGTSX) 30.0% 15.52% 4.66%
Vanguard Total Bond Index (VBMFX) 10.0% 6.92% 0.69%
Total 100.0% 8.64

NEW YORK (Money) -- Question: A year and a half ago, I gave my broker $6.5 million to manage. I have been disappointed with the results. What is a reasonable amount of time to give him before I pull the money?

The Mole's Answer: As common as this question is, I think it's the wrong one to ask. I'm going to show you why, and what are some better questions to ask in determining whether it's time to pull the plug with this broker.

First of all, most brokers, advisers, money managers, and planners are likely to underperform the market because of fees and added costs eroding returns. But with so many professionals out there, it's inevitable that a few of them will get lucky and have great performance for five or ten years. It would be mathematically impossible that all would underperform the market. But it takes about 25 years to really determine whether you've found a truly skilled money manager like Warren Buffett.

Though it might take decades to determine whether you have a great manager, it can take far fewer years to determine if you have a bad one. Even Warren Buffett can underperform for a year or two, but a truly skilled manager is unlikely to underperform over a five-year period.

So you could simply benchmark your broker's performance by taking your portfolio and determining how much of your $6.5 million was in each of three categories - domestic stocks, international stocks, and bonds - and then dividing those percentages by the annual returns of a low-cost index equivalent.

For example, a portfolio that was 60% domestic, 30% international, and 10% bonds would have earned 17.73% in 2006 and 8.64% in 2007 if it were just invested in the low-cost index funds (see chart). If your actual returns beat those numbers, your broker beat the market.

Note: Go to Morningstar to get performance of these funds over longer periods.

So if your portfolio underperforms for a year or two, it doesn't prove that your manager is bad, but it's an early indication that he's not likely to be one of the few that does beat the market over long periods of time.

One alternative is to wait about five years, doing the calculations annually and, if there is significant underperformance, you can be statistically confident that your manager is not one of the very few that will outperform the market in the long-run. The obvious problem with this is that you may have lost out on hundreds of thousands of dollars in returns by then.

My strong recommendation is not to wait. In addition to benchmarking performance for the relatively short time you have been with this broker, here are some better questions to ask to make your decision now:

1. What are the total fees I have paid for my account on an annual basis? Ask him to include all fees rather than just the fees that he or his firm is making. Make sure it includes commissions, asset-based fees, fees of the underlying investments, and hidden trading costs such as those of the mutual funds within the account. If you are paying more than 1% annually, your odds of beating the low-cost equivalent indices may be worse than winning the lottery.

2. Is your broker frequently moving your money into investments that have performed well in the past? Look at the turnover in the account. Frequent buying and selling within a portfolio is known as performance chasing and is statistically likely to increase costs, lower your return, and raise the amount of risk in your portfolio. A turnover of more than a third of your portfolio in any one year is a warning sign that you are not with the right guy.

3. What's the track record of the firm? Getting performance data on a brokerage firm is nearly impossible. Every firm has won some award for something, but that is very different from having systematic strong performance on a risk-adjusted basis. One thing I'll often do for clients is to look up the average Morningstar rating of the mutual funds within the brokerage firm. You can do this by going to Morningstar Fund Family Ratings. If the firm's mutual funds aren't stellar, then you may want to question why their award-winning research isn't being used by their own mutual funds.

Bottom line: Answers to these questions are likely to be far more predictive of what your performance will be than just past returns alone, and heck of a lot easier than waiting five to 25 years before deciding to pull the plug.

Are you on track for an early retirement? Tell us why at Include your financial details and your family could be profiled in a future column of our Millionaire in the Making series.  To top of page

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More from the Mole in Money Magazine:

Truth or dare for your financial adviser: Put your prospective planner's frankness to the test with these four tough questions.

When to tell your planner you'll sleep on it: Why you shouldn't rush to act on advice, no matter how good it sounds.

Retirement: How much you'll really need: Sure you could live more cheaply in retirement. But some costs will go way up.

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