Everything You Need to Know About Your Financial Advisor
You may face a choice when considering a financial advisor — do you want a relationship manager or a financial wiz?
Some advisors are better at managing their clients than they are at managing their clients’ finances. To determine if your financial advisor is most suitable for your needs, you should understand four different dimensions about your financial advisor:
- How do they add value to their clients?
- How much does it cost to engage a financial advisor?
- How much do these fees cost you in the long-run?
- How do you evaluate a financial advisor to determine if s/he is worth it?
The Value of Financial Advisors
How do financial advisors add value to their clients? It is easier to understand by first noting two ways in which 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. The stock market is simply too efficient to achieve excess returns without taking more risk. Instead, you’ll be left with only regret and excessive fees.
If you think higher fees do produce higher net returns, then I refer you to Warren Buffet’s now-famous bet from ten years ago. In Buffet’s own words:
“I argued that active investment management by professionals — in aggregate — would over a period of years under-perform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients — again in aggregate — worse off than if the amateurs simply invested in an unmanaged low-cost index fund…
I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds — wildly-popular and high-fee investing vehicles — that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers — who could include their own fund as one of the five — to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
What followed was the sound of silence…”
Only one person was brave — or foolish — enough to take the bet and he selected five hedge funds to compete against Buffet’s index fund.
Buffet announced the ten-year results in a prior annual report and it was a rout. The Vanguard index fund had an average annual return of 8.5%. The best performing hedge fund could only achieve an average annual return of 6.5% and the worst of the five had an average annual return of 0.3%. I have no rational explanation for why any investor would opt for those high-cost, but low-performing funds.
John Bogle, the Vanguard founder, explained it best, “When it comes to investing, you get what you don’t pay for.”
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 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?
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.
Removing Emotion from Investment Decisions
When left to our own sentiments, we can make ill-timed and rash investment decisions. Again, 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.
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 (or ETFs)
- optimize your investments between retirement and taxable accounts
- avoid unnecessary trading and realizing short-term capital gains
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.
How Much Does a Financial Advisor Cost?
Financial advisors don’t work for free and their compensation structure can have a significant impact on your financial health.
Clients typically pay their advisors one of three ways:
- Commissions from selling financial products such as stocks, bonds, mutual funds, insurance, annuities, etc. These commissions may be implicit (e.g., how a car salesperson is compensated) or explicit (e.g., how a residential real estate broker is compensated).
- Assets under management (“AUM”) fee. The advisor charges a percentage of the assets being managed, typically in the range of 1%. Generally, when you pay an AUM fee, transactions are made on a commission-free basis, but that is not always the case.
- Hourly rate. As with other professional services, the advisor simply charges by the hour, for the time devoted to managing your needs.
The first two structures are the most common, but both can be conflicted, costly, and likely to have hidden fees. The commission model conflicts are straightforward — the advisor’s income is based on transactional volume, rather than doing what is in the client’s best interest. The conflicts with AUM fees are less obvious.
I’ll offer three examples:
1. The AUM model may seem to unify the client and advisor’s interests but it doesn’t.
For example, imagine the client has $500,000 of assets under management with an advisor. The client asks for advice about paying off a $200,000 mortgage by drawing down assets. If she does so, the advisor’s fees will decline by 40%. This can be an awkward situation for an advisor to consider.
2. Further, why should a larger portfolio warrant a proportionally larger fee?
Does a $1 million account require double the time or expertise of a $500,000 account on the part of the advisor? I would think the effort is nearly identical for the two.
3. Bond returns are much lower than stock returns.
This is another subtle shortcoming with the AUM model, especially in this era of low-interest rates. A portion of your investment portfolio will almost certainly be invested in bonds where the after-tax returns are ~2.5%. If your advisor is charging a typical 1% AUM fee, that means you only receive 1.5% of the 2.5% investment returns — 40% accrues to your advisor! You contribute 100% of the capital, absorb 100% of any losses, but keep only 60% of the gains. Does that sound unbalanced to you? It does to me. This imbalance is particularly important for older clients who typically have a larger proportion of their portfolio invested in bonds.
Advisors using an AUM model will often say your interests are aligned because the advisor’s fee only grows when your assets grow. This is true but meaningless. Remember that the advisor takes no risk, and is paid whether your assets grow, shrink, or under-perform what could have been achieved by passively investing in a low-cost index fund.
From the advisor’s standpoint, the first two models have a big advantage — the fees are hidden. Clients often neither know how they compensate their advisor nor how much, and some even think the service is free. These fees do not appear on a monthly invoice but instead are automatically deducted from the account and may require forensic accounting expertise to uncover from an account statement. Hidden fees can be substantial and it’s easy for advisors to avoid a conversation about them.
An hourly rate or fixed fee model is your best option as the total amount of fees will be significantly lower and the cost will be transparent. Unsurprisingly, many advisors are unwilling to provide their services on that basis. Even some clients are reluctant because it may seem that the fees are higher because they now become visible and explicit.
Don’t be fooled by this optical illusion — ask for an hourly or fixed fee arrangement with your advisor. You will incur substantial savings.
This perfectly captures the title of a dated but still relevant book about Wall Street. From the introduction:
The title of his book, Where are the customers yachts? refers to an old joke: a tourist is being shown all the fancy boats in the harbour, and is told, “These are the bankers’ yachts, and these are the stockbrokers’ yachts.” When he asks, innocently, “Where are the customers yachts?” he is told that there aren’t any.
How Does a 1% Financial Advisor Fee Become 22%?
When it comes to your savings, small fees have big effects.
How costly? To keep it simple, I’ll assume you diligently save for your retirement on a regular basis and that you will earn an average return of 7% per year over your lifetime before incurring any fees. Expenses of just 1% per year going to mutual funds, financial advisors, sub-advisors, 401K plans, commissions, trading spreads, or anywhere else, will turn out to be much more over time.
After 20 years, these fees have eroded ~10% of your savings and after 40 years of savings, you’ve given up 22% of the wealth that you otherwise would have accumulated. No one is more clever than the financial services industry in how they extract these hidden fees. You’ll never know it happened.
How Should You Evaluate Your Financial Advisor?
Do you have a financial advisor? And if so, do you know if your advisor:
- Is charging a fair fee?
- Is trustworthy?
- Has the right expertise?
- Has implemented a sound investment strategy?
Here’s the framework I use to assess a client’s financial advisor:
1. How — and how much — you pay your advisor
- Does the fee structure align your financial interests?
- Are the fees reasonable and transparent?
2. Can you trust your advisor?
- Does the advisor act as a fiduciary?
- Has the advisor had any disciplinary proceedings?
3. Does your advisor have financial expertise?
- Does the advisor have relevant credentials such as a CFP (certified financial planner)?
- Does your advisor offer expertise on other personal finance topics such as Social Security, annuities, retirement planning, or college financing?
4. Is your asset allocation and investment strategy optimal for you?
- Does the advisor implement this strategy in a cost-effective manner?
- Does the advisor compare your performance to a relevant benchmark?
There is a lot to consider when engaging a financial advisor. Make sure you understand how your advisor adds value to you, whether s/he offers the services you need, if the fee structure is suitable for you, and importantly, if you can trust your advisor to look out for your best interests.