How does your financial advisor decide what to invest your money in?

Financial professionals are obligated to offer their clients a suitable investment, but there are many things that can affect which suitable investment your advisor will recommend.

Licensing is one constraint that has the potential to affect a recommendation; some advisors are only licensed to deal with specific types of products such as segregated funds or mutual funds.  In some situations an advisor may be mandated or strongly encouraged to deal exclusively with proprietary products produced by their firm - this can be seen with bank advisors or firms that operate with a captive sales force.  Once an advisor has established the pool of investment choices that they are able to offer you, how do they narrow it down?  Many financial products will pay the advisor for recommending them to a client, and some products pay more than others.  If there are two similar products to choose from, it is possible for an advisor to be swayed by higher compensation.

If we eliminated all of those outside influences, then what would they invest your money in? It's still not an easy question to answer.  Some advisors might pay for research to find the fastest growing companies, or the most undervalued companies.  Maybe they would recommend a dividend strategy, or a portfolio of bank stocks.  They might cite the latest economic data with the intention of directing you towards the most profitable country to invest in.  There are countless ideas and methods of investing that an advisor might pitch, and they will likely be based on some level of prediction.

When you are building your investment portfolio, you don't need to be able to predict the future.  It is important to be very wary of making investment decisions based on the financial news or Jim Cramer's latest tip.  There is a wealth of data and peer reviewed academic research that can serve as a guide in building a robust portfolio that does not rely on prediction.  It is possible to use the whole market as a tool rather than trying to guess which company or geography you should invest in, and by building a globally diversified and rebalanced portfolio the emotion is removed from making investment decisions.

So next time your advisor makes a recommendation, make sure you know what they are licensed to offer you, how they are being paid, and the logic behind their final decision.  If there seems to be a conflict of interest, or they start talking about how China's economic growth is going to affect their favourite stocks, run far, and run fast.