How do financial advisors add value to their clients?
It is easier to understand by first noting how they don’t:
1. Investment selection (“stock picking”). Advisors have no crystal balls to select stocks, mutual funds, or other investment securities that will consistently outperform the market. Don’t be fooled into believing they have some inherent insight that will produce outsized returns for you. Doctoral dissertations have been written and Nobel Prizes have been won demonstrating that this cannot be achieved. Instead, you’ll be left with only regret and excessive fees.
2. Market forecasting (“market timing”). Similarly, advisors possess no magical abilities to divine future movements of stock markets and interest rates. As with sports radio, everyone is an ex post expert but no one can consistently make those judgments in advance. Yogi Berra may have said, “It’s tough to make predictions, especially about the future.”
Consider a single-elimination coin-flipping contest with 64 entrants facing off against each other. After one round, there are 32 survivors; after two rounds, there are 16; and after six rounds, we have a winner! Is she lucky or good? She might extol you with her strategic approach and well-honed skill but I think we’d likely conclude she was lucky.
Now consider an investment guru’s newsletter. He initially sends it to 64,000 readers with his stock market prediction for the week — cleverly, to half of his readership he says Sell! and to the other half he says Buy! For the next week’s newsletter and all subsequent ones, he re-sends only to the readers for whom his prior prediction came true and repeats the same thing — he declaims Buy! to half of them and Sell! to the other half. After six weeks, his newsletter mailing list will have shrunk to only 1,000 readers but they’ll think he’s brilliant because he will have correctly predicted the stock market movement for six weeks running.
The market forecasting business is not much different — hemming and hawing, and use of the conditional tense when talking about the future, but little memory of past predictions. Our country’s new chief economic advisor, Larry Kudlow, perfectly fits this description — bombastic, lacking expertise, and usually wrong. He should fit in nicely in the White House.
So, if this is not how financial advisors create value for clients, what important roles do they play?
1. Optimizing asset allocation. This refers to the mix of different asset classes (e.g., stocks, bonds, international securities, commercial real estate, cash, etc.) that make up your portfolio. Your asset allocation should be calibrated based on your age, income, savings, goals, and risk tolerance and then shifted over time as these inputs change. This is a critical need, and not intuitive to most laypeople.
2. Removing emotion from investment decisions. When left to our own sentiments, we can make ill-timed and rash investment decisions. Quoting Warren Buffett, “We should be fearful when others are greedy and greedy when others are fearful.” Instead, our gut instincts cause us to run with the herd.
A financial advisor can insulate you from these emotional reactions and remove the urge to do something when it is probably best to do nothing. Just as a client is not well served by having himself as his lawyer, you will benefit from separating your emotional self from your investment decisions.
3. Minimizing taxes and investment expenses. Seemingly small expenses become significant over long periods. A financial advisor who is committed to putting your interests first will minimize all of your investment-related taxes and fees as these are dead-weight losses to you.
To do so, your advisor should:
- invest in low-cost mutual funds
- optimize your investments between retirement and taxable accounts
- avoid unnecessary trading and realizing short-term capital gains
4. Providing other financial planning needs. Managing investment assets is only one facet of what a financial advisor should offer. For many clients, there are other vitally important needs such as:
- budgeting and saving strategies
- funding college
- optimizing insurance coverage
- planning for retirement
Don’t engage a financial advisor because you think she can help you beat the market. She can’t. Instead, hire her for trustworthy guidance in these other dimensions.
Questions about evaluating your advisor? Please get in touch.
PS: You may also want to read Where are the customers’ yachts? where I wrote about how financial advisors are compensated.
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