Investing for the future has never been easier or cheaper for individuals. Employer 401k plans make saving automatic and provide solid investment vehicles. For those who are more hands-on, the internet provides an unending fountain of information, insight and advice.
So, it’s no surprise that as a financial advisor I’m constantly asked why someone would retain my services. Potential clients want to know whether and how working with a financial professional will boost their potential returns – and by how much. I completely understand the question. Financial advice typically costs 0.5% to 1.0% of your portfolio per year. So, yes, people want to know if they are getting what they pay for.
An Estimate Of An Advisor’s Impact On Your Portfolio
Vanguard, one of the world’s largest investment companies, has been studying this question for 15 years. Based on research, analysis and testing, Vanguard has concluded that, yes, there is a quantifiable increase in return from working with a financial advisor. Vanguard calls this advantage the Advisor’s Alpha. When certain best practices are followed, the result can be an Alpha in the 3% per year range.
A separate study by Russell Investments, a large money management firm, came to a similar conclusion. Russell estimates a good financial advisor can increase investor returns by 3.75%.
Of course, not everyone wants or needs a financial advisor. Vanguard estimates that about one-quarter of private investors are truly “self-directed.” These people truly enjoy investing. They obsessively follow the markets and enjoy financial planning and projections. Perhaps most importantly, these investors have an incredible level of discipline that prevents their emotions from intervening with their long-term investment strategy.
Given that three-quarters of us aren’t “self-directed” when it comes to money, it’s good to know that there is help available that can really pay off – in the right circumstances.
How Vanguard Measures An Advisor’s Alpha
Vanguard has identified seven ways in which a financial advisor can add value to your investment efforts, and create that 3% Alpha. Here they are in increasing order of impact on your portfolio:
Suitable Asset Allocation. This might not actually add value on its own, but the next six best practices can’t happen without it. So, one could argue that this is actually the most important thing an advisor does for clients.
Guidance on Total Return vs. Income Investing. Again, this might not generate any additional return, but it could prevent disaster. While income investing works, an over-emphasis on meeting your annual income goal with dividends and interest might result in you taking on too much risk and getting too myopic in your asset choices. For example, if you need 6% per year an income-only approach could lead to owning nothing but junk bonds and utility stocks. The result would be a lack of diversification and over-concentration in too few areas. Total return allows for a focus on both income and growth – something that CIA (and I) firmly believe in.
Rebalancing – This can potentially add 0.35 percent per year to your portfolio. The goal here is to minimize risk, not maximize return. If you never rebalance you end up with something called drift. Let’s say you start with a portfolio with 60% stock and 40% bonds. If the stock market exceeds the bond market for a period of time you will end up with a far greater percentage of stocks, and more risk than you may have bargained for. From 1960 to 2000, for example, your 60% would end up being 90%, which is an entirely different proposition.
Cost effective implementation. This practice can return 0.40% per year. It’s about controlling expenses. You can find large cap mutual funds that charge 1% or 1.5%, and you can find ETFs that routinely beat those same funds and charge just 0.1%. An advisor can help identify assets that will meet your goals while pushing your costs lower. This one is really important. I’ve talked to hundreds of people who are egregiously overpaying for mutual funds and other assets – as much as two percent a year plus, in some cases. When you pay less for your underlying investments you end up keeping more money. Make lowering your investment costs a priority in 2017 – whether or not you work with an advisor.
Asset Location – This can earn you up to 0.75% per year. Taxes can be a huge drag on your portfolio growth. A skilled advisor can help manage your tax bill in a number of ways. He can offer insight on whether to hold particular assets in a taxable or tax-deferred account, and how to manage year-end market losses and gains to minimize Uncle Sam’s bite. The best advisors will dive deep to understand your overall current tax situation and the factors that will influence your bracket in the coming years.
Spending or Withdrawal Strategy. This one could net you up to 1.1% per year. The order (and timing) in which you withdraw funds from your various retirement accounts can have a huge impact on how much tax you pay. Vanguard says this is one place where an advisor’s knowledge and expertise makes a huge difference. Again, the best advisors will base their recommendations on intimate knowledge of your current financial and tax situations and your likely future circumstances.
Behavioral Coaching. This is the Big One, generating up to 1.5% per year of additional returns. As every good poker player knows, “scared money don’t make money.” The best financial advisors are able to keep their clients’ fears and emotional impulses in check by providing steady, fact-based advice and hand-holding when the markets get wobbly or crazy. The Russell study also identified this as the single most important benefit of working with a financial advisor.
I can’t emphasize enough the importance of this function. A Vanguard study of more than 58,000 self-directed IRAs showed that investors who made material changes to their strategy EVEN ONCE in the five-year period from 2008 through 2012 suffered an 8%-plus hit to performance.
A Morningstar study cited by Vanguard shows that investors commonly receive far lower returns than the very funds they are invested in. Why? Because they run to funds after they have done well and ditch other funds right before they do take off. Essentially selling low, and buying high. An advisor can coach away such counter-productive behaviors.
The Fine Print
As with most aspects of investing, and life, there are some caveats to predicting and measuring an Advisor’s Alpha.
No two investors (or advisors) are the same – Not every advisor will add value. Advisors have different philosophies, varying levels of skill and experience, and charge different fees. Every investor has a different mix of goals, risk tolerance and desire to be involved. Alpha is maximized where the investor and advisor are well matched.
Some steady, some lumpy. Some benefits of working with an advisor will add a little bit of value almost every year. Others might add significant value but in a relatively lumpy or intermittent fashion.
Measuring against the unknown – Advisor’s Alpha isn’t just about maxing out your returns relative to the very best index. It’s about maximizing your returns relative to your goals, and how you would ultimately fare without any advice or guidance. So the actual value that you get from using an advisor will never be known. Because it’s impossible in retrospect to know what else you might have done without an advisor, or with a different advisor.
Value is in the eye of the beholder – There are many intangible potential benefits to working with a financial advisor. While these aren’t factored into the Vanguard study, they are non-the-less legitimate and important. Peace of mind. Freedom from financial chores. Learning from a professional. These may not show up on your account’s bottom line, but for many investors, these count as gains.
The Vanguard study confirms and quantifies something millions of Americans already know from their own experience: An experienced, skilled financial advisor can be a powerful ally in your investment efforts, so long as you choose your partner wisely.