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How Much Is an Advisor Worth? Eric Nelson Does the Math

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Many a client relationship failed to materialize because the prospect balked at paying the annual advisory fee.

It’s an understandable concern, from the prospective client’s point of view, since he wants to invest in order to make money, yet the only immediate certainty is that he will be paying out money from his hard-earned investment assets.

Among those who have sought to help advisors address this sensitive topic are Vanguard, whose “advisor’s alpha” is meant to quantify the value of investment advice, and Mornginstar, whose “gamma” calculation similarly attests to the value an advisor adds.

Enter Eric Nelson of Servo Wealth Management with his reckoning of the value he believes he adds to his own client relationships.

The Oklahoma City-based RIA and regular investment commentator sees five areas where he as an advisor can add value over what a do-it-yourself indexer might achieve on his own. If all five of those areas apply, Nelson reckons the value he can add totals 5 to 7 percentage points.

The first advantage is the pro-growth allocation his clients will receive. Investors following rule-of-thumb investment advice would choose a bond allocation roughly equaling their age.

But at the later ages at which people get serious about investing, a 40-year-old saving for retirement at age 66 would average about 50% of his portfolio in stocks for the next 20 years or more. But Nelson generally counsels pre-retirees to assume a more growth-oriented allocation — 80/20 stocks-bonds being typical.

Looking at every 25-year period since 1926 and averaging the results, the higher growth allocation averaged 10.6% versus 8.8% for the age-in-bonds 50/50 split.

“And in each case, there wasn’t a single 25-year period where the higher stock allocations underperformed the lower stock allocations,” he writes.

Nelson’s pro-growth orientation would thus add 1% to 2% to the results of conventional do-it-yourselfers.

A second way that conventional investors shoot themselves in the foot is through speculative behavior through their own stock or fund picking. Nelson cites a Vanguard study showing that the average large-cap mutual fund underperformed the Vanguard S&P 500 Index Fund by 1.2% a year since 1976; $10,000 invested in the fund at that time would be worth $356,276 by 2011, compared with just $226,253 in the average stock-picking active fund. Nelson’s avoidance of this sort of stock-picking would thus add at least another percent to his client’s wealth, which would change portfolio results to the tune of over 30% over the stretch of time observed in the Vanguard study.

Avoiding stock-picking may be all well and good, but another key investor decision is the composition of the funds in which they invest. So an active management-avoidant do-it-yourselfer might conventionally choose a total market index fund.

But Eugene Fama aficionado Nelson strictly adheres to the Nobel Prize winner’s research conclusion that smaller and more value-oriented stocks generate superior long-term returns.

Nelson shows that from 1979 to 2014, retail “asset class” (i.e. small/value-tilted) portfolio averaged 12.6% compared with 11.5% for a total market mix; the results were starker in the difficult decade from 2000 to 2009 when the asset-class balance returned 4.1% to the total market’s 0.4%. But over the long term, Nelson says a more favorable portfolio balance can add a percentage point to investors’ portfolios.

But those results stem from “retail” (i.e. available to all comers) funds. Nelson naturally uses Dimensional Fund Advisors funds (for which Fama consults), which consciously seek to squeeze out the maximum degree of small/value tilting in their portfolios.

Comparing DFA fund returns to their respective indexes across five asset classes, Nelson shows the DFA fund came out ahead every time, often by as much as a percentage per year (and in the case of its U.S. small value stocks category, by nearly 2 percentage points).

“Including index fund expenses, the differences would be even greater,” he adds.

The advantage of using better tools thus adds another percentage point to his value-of-advice tab.

Finally, Nelson reckons he can add another 1% to 2% by virtue of the discipline he as an advisor can bring to the prospective client.

Making a point familiar to most advisors, he writes: “On their own, even the smartest investors are often unable to stick with their plans over time. Many investors become greedy after several years of above-average stock gains and fearful in the throes of a bear market, causing them to buy and sell at precisely the wrong time.”

As evidence for this he adduces the well-known Morningstar research showing that actual investor returns lag mutual fund investment returns because of these poor buy/sell decisions. A similar study by Vanguard showed that performance-chasing investors underperformed buy-and-hold investors by 2.8% per year.

In contrast, Nelson spends the time necessary up front and on an ongoing basis to encourage investors to stick with their plans barring major life changes that might warrant a revision of the plan.

Taken together, these five factors are meant not only to demonstrate the value Nelson can add as an advisor, but also help prospective clients understand the potential costs of not working with an investment professional.

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