Most financial advisors justify their value based on their ability to consistently select the best mutual funds or stocks, whether it be by selecting the best sector, asset class, active fund manager, or all three. However, not only is making these predictions an exercise in futility (not to mention that you'll likely get five different opinions if you ask five different advisors), but creating this unnecessary complexity creates an excuse to falsely justify charging unnecessary asset-based "management" fees when there is no managing to do.
Here is what Warren Buffett had to say regarding this issue in one of his annual letters to Berkshire shareholders, dated February 28, 2014:
"If "investors" frenetically bought and sold farmland to each other, neither the yields or prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.
Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.
My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S & P 500 index fund (I suggest Vanguard's). I believe the trust's long-term results from this policy will be superior to those attained by most investors - whether pension funds, institutions, or individuals - who employ high-fee managers."
So Buffett is saying that most people don't possess his level of skill. Do you really believe your "advisor" is so special that Warren Buffett's advice doesn't apply?
This article from Forbes provides a similar perspective:
"Here's the scam. The Basic asset allocation theory that caught on was based on some long-term data and showed the value of blending stocks, bonds, and cash. In fact, the Brinson, Hood, and Beebower study a lot of advisors chant about demonstrated that 90% or more of the variance in returns among large pension plans was explained merely by their allocation to stocks, bonds, and cash. Therefore, less than 10% is explained by all these expensive sub-classes. But advisors can charge more if their pie charts look more complicated touting the supposed value of "non-correlating assets" that tend to correlate a lot when you need them not to the most.
So advisors have a conflict of interest in this game by making things far more complicated than needed to justify higher fees. And, their friends that manage the expensive products they use to fill all these pie slices have a conflict of interest because they get to charge a lot more in management fees. Even low-fee Vanguard charges more than three times the management fee for their World Equity Ex-US ETF (VEU, 25 basis points) versus their Total Domestic Equity ETF (VTI, 7 basis points). Or, check out the HUGE weighting semi-passive fund DFA suggests to their expensive real estate and foreign funds where they earn double the fees (or more) of other funds they manage. The product vendors and research departments fool advisors to get more product fees and advisors often unwittingly end up fooling their clients.
To achieve diversification, you don't need to have a complex investment portfolio. The Vanguard LifeStrategy Funds, for example, consist of only 4 funds: A total domestic and international stock fund, and a total domestic and international bond fund which have nearly 18,000 stocks and bonds in total. A more aggressive investor only needs the two stock funds which have nearly 10,000 stocks. If 10,000 to 18,000 different securities does not provide diversification, I don't know what does.
In reality, it is actually investor behavior rather than fund selection that primarily determines wealth. Just think about how many people got out of the market in 2000 and 2008 only to get back well after the market had risen. And consider Morningstar's research indicating that while the CGM Focus Fund earned more than 18% average annual returns in a recent 10-year period, the average investor lost 11% annual during this same time period. This type of behavior simply demonstrates that people tend to sell at the bottom and buy at the top. Consequently, the value an advisor provides should not be based on fund selection, but rather on behavioral coaching.
Chris Carosa emphasizes the importance of investor behavior in his book "Hey! What's My Number?", and cites the primary questions that influence an investor's wealth: when to start saving, how much to save, and when to retire - all of which a good behavioral coach can help effectively answer throughout an investor's lifetime. He also cites a study from the Center for Retirement Research at Boston College which states:
"Assuming a CRRA (coefficient of relative risk aversion) of 5, the amount required to compensate a household for a retaining a typical portfolio (where 36 percent of assets are invested in equities) rather than switching to an optimal portfolio allocation (where 51 percent of assets are invested in equities), is $5,600, or approximately the additional amount the household would earn if it delayed retirement by one month. In contrast, when the comparison is between a typical portfolio and an all-stock portfolio, the household is better off by approximately $3,600, or under one month's salary. That is, an all-stock portfolio is even more sub-optimal than the typical conservative portfolio. The key message, however, is that the dollar amounts are small, suggesting that asset allocation is relatively unimportant for the typical risk-averse household. Even if the household is less risk-averse (CRRA equals 2), the story is similar. In this case, as shown in Table 10, the optimal portfolio is all in stocks. The cost of retaining a typical portfolio (57 percent in equities), rather than switching to an optimal portfolio (100 percent in equities), is $25,700, or just over four months' salary. As the optimal portfolio is 100 percent in equities, the cost of retaining a typical portfolio relative to an all-stock portfolio is also $25,700. In short, regardless of the degree of risk aversion, asset allocation is relatively unimportant for the typical household."
This blog post along with these two articles also do a good job explaining how an advisor should provide value:
Here are some highlights:
“A client called up his advisor, wanting to know what he should do in reaction to the plummeting market. “Nothing,” said the advisor. The next year, he called again, wanting to know what he should do in response to the soaring price of gold. “Nothing,” was the advisor’s response. In year three the client called again, wanting to know what he should do to take advantage of the soaring bull market. “Nothing,” said the advisor again. “Excuse me,” said the client, “but every time I ask your advice, you tell me to do nothing. Remind me again what I’m paying you for.” “You’re paying me,” said the advisor, “to keep you from doing something.”
Conflicts of Interest and Mutual Fund Advice:
USA Today Article:
But the biggest takeaway here is the power of patience and inactivity.
Investing requires, more than anything, patience and discipline. But it attracts, more than anybody, the impatient and impulsive.
Siegel's data is a good example of how the insatiable thirst to buy, sell, and fiddle with a portfolio can lead to lower long-term returns. Even in what appears to be a passive portfolio like the S&P 500, analysts are constantly thinking about what stocks to get rid of and what to replace them with. It sounds smart, but it often comes at the cost of performance.
So much of successful investing relies not on your ability to buy and sell stocks better than anyone else, but your ability to hold those stocks longer than anyone else.
As Warren Buffett put it, "The stock market is designed to transfer money from the active to the patient."
Just leave it alone.
Not every advisor understands the importance of behavioral coaching, and Farella said it took him a while to grasp the concept as well. Farella said he spent his first eight to ten years as an advisor convinced that his job was to outperform the market.
"When you first start out, you think you have to know more than everyone else, so prospective clients select you over another advisor," he said. "But I've turned that around. I don't know more than everyone else."
Farella said he and the other advisors at Rockbridge now know that investment selection is not their most important job.
"Earlier in our practice, we thought our value was in constructing portfolios to meet clients' goals," Farella said. "We do construct portfolios. But now I tell my clients that you hire us to keep you staying the course and not making emotional decisions when you can least afford it.
"I've got the message down so well, I don't care if they buy it or not, but if they do, they'll end up with us," he added.
Farella said that he and his colleagues stress to prospective clients that they as advisors take the long view and are not apt to time the market or react to headlines.
In summary, if investors simply grasped the importance of not trying to control what they can't control (where the market is going) and focused on what they can control (when to start saving, how much to save, and when to retire), then most advisors would go out of business. No wonder investors remain in the dark.
If you are a participant in your company’s retirement plan, here is a letter you can write to your human resources department or whoever is responsible for overseeing the plan which contains a list of questions that will help you determine the nature and extent of the fees that are being taken out of your retirement account.
To: Human Resources Department
From: Your Name
Re: My Retirement Plan
Dear ________ :
I am in the process of reviewing my retirement plan and I am trying to gain a better understanding of all the fees I am paying in my plan. I have the following questions:
- What are the expense ratios of the funds I own?
- What have I been charged each year since I've been a participant in the plan for recordkeeping, custodial, administration, and investment management fees in hard dollars? How do I find this information on my account statement?
- How are these fees being assessed? Am I paying a flat fee for these services? Or are these fees based on my account value or are they included in each individual fund? If the latter, do some funds have different recordkeeping, administrative, and investment fees than others?
- If I am not interested in utilizing the services of the investment advisor, can I opt out of this fee? For example, can I choose funds in each available asset class that don’t include investment advisory fees?
- I’ve watched a 60 Minutes, and Bloomberg TV News video and read an article in the Wall Street Journal stating each fund incurs significant trading costs that are not included in the mutual fund’s expense ratio which are deducted out of my account. I have also learned that these costs can be found in the statement of additional information. Can you provide that statement to me for each fund that I own?
- I have also watched a PBS Frontline video which raised a concern about financial advisors that do not act in a fiduciary capacity and therefore legally cannot provide advice in spite of referring to themselves as advisors. Does the financial advisor for our plan act in a fiduciary capacity? If so, does the advisor serve as a 3(21) or 3(38) fiduciary and is the advisor and/or record keeper (this is the party who provides our website, sends out statements, and keeps track of our balances) willing to charge a flat dollar fee so my fees don't increase as my account value grows?
- In addition, I have learned that there is a total stock market index fund available in retirement plans at a cost of 0.05%. Is this fund available in our plan?