The Mystery of Financial Advisors

As with many professional services such as lawyers, doctors, plumbers, and car mechanics, financial advisors provide expertise that their clients don’t have. Unlike those services, it can be a mystery to understand what financial advisors actually do.

How do financial advisors create value for their clients? It’s easier if you first understand two important ways in which they don’t add value:

1. Investment Selection (“stock picking”)

Advisors have no crystal balls to select stocks or other investment securities that will consistently outperform the market. Don’t be fooled into believing they have some special insight that will produce out-sized returns for you. 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.

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 put it best, “It’s tough to make predictions, especially about the future.”

Consider an investment guru’s newsletter strategy.

1. 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!
2. For the next week’s newsletter and all subsequent ones, he only re-sends to the readers for whom his prior prediction came true and repeats the same trick — he randomly declaims Buy! to half of them and Sell! to the other half.
3. After six weeks, his newsletter mailing list will have shrunk to only 1,000 readers but they’ll all think he’s brilliant because he will have correctly predicted the stock market’s movement for six weeks running.

Surely, no one could be that lucky?

So, if those two functions are not how financial advisors create value for their clients, what important roles do they play?

1. Determine an optimal asset allocation

This is the mix of different asset classes (e.g., stocks, bonds, international securities, cash, etc.) that make up your portfolio. Your asset allocation should be calibrated based on your age, income, savings, life 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. Remove emotion from investment decisions

When left to our own sentiments, we make ill-timed and rash investment decisions. Keynes famously referred to the “animal spirits” influencing our investment decisions. Warren Buffett has quipped, “We should be fearful when others are greedy and greedy when others are fearful.” We are all susceptible to bad decision making from these irrational responses.

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 by separating your emotional self from your investment decisions.

3. Minimize taxes and investment expenses

Seemingly small expenses are costly over long periods. A financial advisor should 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
• minimize unnecessary trading
• optimize your investments between retirement and taxable accounts
• defer capital gains but realize capital losses, when sensible

4. Provide other financial planning expertise

Managing investment assets is only one facet of a financial advisor’s role. For many clients, there are other vitally important financial planning questions such as:

• How should we best save for our kids’ college education?
• My spouse and I are nearing 60 and are in good health; should we buy long-term care insurance?
• We’re spending more than we should; how can we create and track a budget?
• I’m ready to retire; how do I know how much I can afford to spend in retirement?
• What’s an annuity and should I have one?
• Interest rates have come down and we want to refinance our mortgage; which option is best?
• I just got a big tax refund; should I pay off my credit cards, contribute to a Roth IRA, or do something else with the money?

Don’t engage a financial advisor because you think she can help you beat the market. She can’t. Instead, hire her if you need trustworthy guidance for these other services. As for how to pay for this service, that’s the topic of another note.