Using Investment Advice, Part 1

Advice bombards all investors. Some is good, some is bad, and much of it is indifferent. In this three-part column, I'll show how to use the advice you receive so you can be a more effective investor. In analyzing any advice, investors have to consider the adviser, personal character issues, and the nature of the investment proposed.

In Part 1 today, I'll focus on the adviser.

Sought-After Qualities

The first issue is always one of trust: Do you trust the competence and business ethics of the adviser? No one is perfect, but has the adviser made sound decisions in the past in areas similar to where the adviser is proposing advice now? What's the adviser's track record? If he's a professional, does he have a clean record with the regulators and his current and past clients?

Even if the adviser has a great track record, did he get it accidentally? In a past job, I had the fun of interviewing a large number of money managers. We had a need for a large-cap growth manager, and our manager adviser brought in a manager who had a stellar, though short, track record.

The principal of the growth manager was a former pro athlete who had developed an entirely quantitative, momentum-driven management method. The presentation was short, and I asked a few questions about earnings quality and how the process might do in nongrowth-driven markets. I received a very terse set of "we can do no wrong" answers.

After the presentation ended, I pointed out three companies in their portfolio that I knew had weak earnings quality. They politely blew me off. I wasn't impressed with their processes, and my colleagues were not impressed with their demeanor. Then I had my accident; the next week, two of the companies I pointed out blew up. Their accident followed soon after, which was a significant loss of assets under management. The accident of their prior performance evaporated. Persistent good performance happens for the reasons that the adviser specifies in advance, not by accident.

Even if the advice giver is competent and ethical, what incentives does he have in the situation? Full disclosure allows you to decide whether the adviser's judgment might be shaded by other concerns. Then you can take that into account in making your decision.

Is the adviser cocky? In my experience, pride goes before a fall. One way to measure this is to see whether the adviser admits to errors. The best advisers admit fallibility, and even try to reduce your expectations. You want realistic advice from someone you can trust. Big claims may draw some clients in the short run, but in the long run, clients are kept through dependability.

Next time, in Part 2, I'll examine how your character affects how you evaluate the investment advice you get.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.