A few days ago I ran into a former neighbor that I hadn’t seen for a year or so. At that time he had been owner of a small business struggling to survive. I asked him if things had improved. He said he sold the business a few months ago and took a position with an investment firm. I was a little surprised, because I didn’t realize he had any experience with the financial markets. It turns out that he hasn’t had any investment experience and he holds no securities licenses. The firm he works for is also unlicensed and unregistered. He explained that the licensing is not needed because the firm does not provide specific investment recommendations. Instead, they tell investors about five or six investment options and then have the investors choose from among them.

Although I like this person, I am worried about his potential clients. There are literally hundreds of thousands of available investment options. I doubt this man knows the difference between a commodity future and a variable annuity. So when he consults with people about their investments, how will he know what is appropriate for them and what is not? Even if he is not actually managing their assets, how will he be able to filter through thousands of possibilities to present the best choices?

Unfortunately, this situation is not uncommon. There are plenty of ignorant people willing to advise other people about how to invest their money. So how does an investor separate the wheat from the chaff?

First, let’s consider the issue of licensing and registration. There are plenty of licensed and registered advisors who are unethical and untrustworthy. There are also people who know a lot about investing and the financial markets without being licensed. Licenses and registration do not provide any guarantees about an advisor’s knowledge or record of success. But the licensing and registration process offers a measure of protection for investors if the advisor does something illegal or unethical.

If a licensed advisor absconds with a client’s money, or invests the money in something inappropriate, or does something else that is misleading or wrong, the client can make an official complaint. Whether the governing body is the Securities Exchange Commission, the National Association of Securities Dealers, or a state insurance board, the consumer has recourse and protection. If the advisor or firm is unlicensed, the situation is much murkier and a wronged investor is left to pursue the matter through police and the courts.

In addition to dealing with licensed advisors and firms, here are some other items investors should consider when choosing a professional investment manager:

How long have you managed actual money with your current firm/system?

Managers change firms and systems for many reasons, but most of those are bad for clients. You want someone who has been with his current firm at least three years. Five years is better. Ten is better still.

How much of your money is invested in the portfolio you recommend for me?

If a manager is unwilling to put his own money into his own investment system, do you really want him to manage your finances? Be specific. Ask if he has the same type of account you will have and what percentage of his assets are committed.

What do you need to know about my financial situation?

A responsible investment manager is going to ask some specific questions about your investment experience, your investment history, your employment, your annual income, your income needs, etc. He needs this information to make certain his recommendations are in line with your needs and your risk tolerance. Federal regulations require him to ask for such information. If he doesn’t want to know your specific needs and expectations, it is unlikely he will be able to satisfy you. When it comes to investing, one size does not fit all.

Can I get referrals from people who have been clients for three or more years?

Privacy regulations prevent money managers from releasing information about a client without his consent. But any reputable money manager should have many clients willing to give permission for a potential client to call and ask about their experiences.

Where is your office? Can I come for a visit?

Successful investment managers usually do well financially. A small, run down office is a bad sign. Conversely, a big, fancy office is certainly no guarantee that the manager can do what he promises. If a money manager works out of his house, that could raise a lot of red flags.

What happens if you are wrong?

All investment advisors have losing trades. How they handles the losers is generally more important to the bottom line than how many winners they choose. A good manager should be able to provide specific details of how he handles trades that go against him. Listen to the explanation, then check the actual account statements to see if he does what he says.

Tell me about your performance.

This is the thing every investor asks about first. Unfortunately, it is also the most misleading. Numbers can be hyped and twisted in unlimited ways to give distorted views of performance. Years ago I was working for a U.S. company in Russia shortly after the collapse of Communism. I asked for an accounting report of our in-country operations. The accountant, who had spent the previous 20 years working for Communist bureaucrats, asked me what I wanted the report to show. “What do you mean?” I asked. He explained that he could create a report that showed either a profit or loss, and even a level of profit or loss, depending on what I needed. I was a little stunned at the time. Now I am convinced he went to the same school as many of the people who calculate investment performance for unscrupulous advisors.

How are you compensated?

It might seem like a brazen question, but you have a right to know. Will you pay a management fee, commissions, or both? Is he investing in mutual funds that charge front or back-end loads? No one manage investments for free. If an advisor says you won’t have to pay a management fee, then he is likely being paid by the companies he is recommending, creating a potential conflict of interest.

Who has control of my money and who will be the custodian?

In most legitimate situations, investment advisors are not the custodians of your money. Usually an account is set up at a third-party institution like a fund company, brokerage or bank. The advisor has discretionary authority to tell the custodian how your money is to be invested, but has no access to withdraw money from the account (except for management fees). This lessens the possibility that an advisor who is also a crook can clean out your account and flee to Central America. If an advisor ever tells you that you can just put that million-dollar check in his name or the name of his investment firm, all kinds of alarms should start flashing in your head.

I hope I haven’t given you the impression that most investment advisors are scumbags and scoundrels. But I am always surprised that some of the same people who double-check every grocery receipt seem to have no qualms about giving control of a half-million dollar investment account to someone they know little about.

I’m not including any market commentary this week because the situation has changed little since last week. Major averages seem content to remain in a trading range.

Have a great weekend.