What your adviser doesn't know might hurt you

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NEW YORK (Money) -- Question: I have a continuing debate with a classmate of mine regarding why a financial adviser does not include calculations/spreadsheets when determining asset allocation. My classmate claims it is trade secrets. I claim that the adviser doesn't know how to do/explain the calculations and blindly plugs the client's financial information in a system and reports the answer. Who do you think is right?

The Mole's Answer: I loved your question, and tell your classmate that your understanding hits closer to the mark.

Even though the adviser in question appears to be a theoretical one, generally speaking such calculations are done by the adviser's back office with he or she having little understanding of how they were calculated or even what they mean.

More importantly, however, I'll show you (and your classmate) how to pick an adviser who actually knows something about finance.

First of all, you should know that the difficulty of becoming a financial adviser lies somewhere between tying a shoelace and getting a driver's license. You sit for some short exams that are, let's just say, not exactly rocket science, and you're in.

And there are at least a hundred credentials that advisers can get after their name to look impressive, though some take just a few hours to obtain.

In my opinion, the most important skill in making money as a financial adviser is the ability to sell. One tried and true sales method that we planners use is to brush up on some financial jargon, add pretty graphs and charts, and give you the illusion that not only is your portfolio doing well, but that we actually know what we are doing.

Of course you have the right to see how the pretty graphs were calculated, but we know there aren't many clients like you out there that will actually ask. Good for you, by the way.

In picking a financial adviser, I agree with you that actually knowing something about finance is kind of critical. I've written about this in Truth or dare for your financial adviser. I really didn't get to quizzing one's adviser about their financial knowledge in that column, so here are a few questions you may want to ask. Don't worry if you're not a financial expert yourself.

1. What's the annual standard deviation of my portfolio? The standard deviation is a measure of a portfolio's risk. A diversified portfolio of 60% stocks and 40% bonds has an annual standard deviation of roughly 9.8%. This translates into it having a 68% chance that it would vary from its expected return by no more than 9.8% (one standard deviation away), and 95% chance it would vary by no more than 19.6% (two standard deviations away). It's important the adviser not only shares the expected return of your portfolio, but shares measures of risk as well.

2. What asset classes in my portfolio have low correlations with each other? Asset correlations measure whether the assets tend to move up and down in sync. When it comes to correlations, we want to construct portfolios that have low correlations, as it can lower risk without decreasing the expected return. For example, Real Estate Investment Trusts (REITS) and precious metals tend to have low correlations to the U.S. stock market and make good diversifiers.

3. Do I have much uncompensated risk in my portfolio? Picking individual stocks or overweighting certain sectors, styles or countries creates uncompensated risk, or risk that doesn't increase your expected return. If your adviser responds that you don't have uncompensated risk, make sure he knows what it means and confirm that you are diversified across the globe.

4. Could you do a Monte Carlo simulation on my portfolio? A Monte Carlo simulation is a useful tool to look at the probabilities of success of meeting your financial goals. It's certainly not a perfect model, and I've seen it misused more often than used properly, but it does test the planner's knowledge of tools to measure our likelihood of success. If he does run a simulation for you, ask him what the handful of key input variables are. The right answer should be something like "expected return, standard deviations, savings rates, and inflation." If the only Monte Carlo he can think of is a place in the Mediterranean, you may want to be a bit concerned.

The second worst answer you want to hear is that they don't know the answer to the questions above. That means you're probably dealing with a financial salesperson.

It's even worse if the adviser says something like "I don't worry about these details and leave all of this stuff up to our back office." He is actually acknowledging that he doesn't know much about finance and is willing to bluff it out by claiming others in his firm do.

You don't necessarily have to see if your financial adviser can do all of the calculations behind all of the information she presents. Just use this simple quiz to get a glimpse of how much she knows, or doesn't know, about finance. Because what your adviser doesn't know about finance can really cost you.