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How to Cure Advisors’ Crisis of Confidence

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I talk often with advisors of all sorts and from a wide variety of firms. Many of them are profoundly disillusioned. When the markets are strong, they are disappointed that they didn’t capture enough of the upside. When the markets are weak, they are apoplectic that they didn’t avoid the downturn. When markets are sideways, they’re just plain frustrated. And when they try to anticipate these movements and actually succeed — a very rare event indeed — their next moves inevitably don’t keep up the good work.

This profound disillusionment is well earned, of course, and is predicated upon three primary problem areas: execution, expectation and erroneous priorities. The basis for these problem areas can be established in surprisingly short order.

In terms of execution, money management has been an abject failure pretty much across the board (as evidenced by the failure of the vast majority of money managers to beat any applicable benchmark), even for the mega-rich (as evidenced by awful hedge fund returns generally), and investor behavior makes that dreadful performance even worse (as evidenced by investor asset-weighted returns). Our inflated expectations make matters worse still because investors expect outperformance as a matter of course and investment managers tell them to expect it, implicitly and explicitly.

Existential Anxiety

At the client level, erroneous priorities include a failure to manage to personal needs and goals and “plans” that change with every market movement. It shouldn’t surprise anyone that clients with huge appetites and tolerance for risk when markets are rallying frequently want to go to cash at the first sign of trouble.

At the advisor level, the priority problem is even more fundamental and encompasses each of these problem areas. Much of what tries to pass as “financial advice” is actually glorified (or even not-so-glorified) stock picking, despite its abysmal track record. In my experience, most advisors and their clients think that the advisor’s primary function is to pick good investment vehicles. They are essentially transactional salespeople.

Advisors are well aware of the failings of investment management, of course. That’s a big reason why their disillusionment is so existential. They have been let down again and again by managers promising that they have (finally!) come up with a formula for success only for reality to crush those promises.

Even worse, and consistent with that conundrum, a 2012 study from the National Bureau of Economic Research concluded that financial advisors reinforce behavioral biases and misconceptions — the problems outlined above — in ways that serve the advisors’ interests rather than those of their clients.

Still, many of these advisors keep hoping against hope. They routinely tell me that if they took a data-driven, evidence-based approach that actually had a reasonable chance for success, their clients wouldn’t need their services. And not so coincidentally, that’s a big reason why so many advisors are terrified by the proposed Department of Labor fiduciary rule with respect to retirement accounts.

But I strongly disagree.

Proper advisor priorities begin with a recognition of what is important and what is achievable. The NBER study referenced above, “The Market for Financial Advice: An Audit Study,” significantly did not consider advisors who work as comprehensive financial planners or investment managers acting as fiduciaries. It did not control for the quality of advisor.

Salespeople sell, of course. But not all financial advisors are transactional salespeople. One academic study, “Planning for Retirement,” by Terrance Kieron Martin Jr. and Michael Finke, examined different outcomes for clients working with comprehensive planners and those working with salespeople. That distinction is difficult to isolate. With that caveat, the conclusion is still clear: Comprehensive planners help clients achieve improved financial outcomes.

A Morningstar study, “Alpha, Beta, and Now…Gamma,” took a somewhat different approach. Rather than attempting to measure the influence of actual financial advisors, the Morningstar study aimed to quantify the potential value provided by better financial decision-making — what the study calls “gamma” (a confusing usage, since the term has an unrelated definition in academic finance) and Vanguard (as I discuss below) calls “advisor alpha.”

According to the Morningstar study, a good advisor can add the equivalent of a 1.82% annual arithmetic return to clients through five specific components (listed in decreasing order of impact): dynamic withdrawal spending; tax efficiency via asset location and withdrawal sourcing; total wealth asset allocation (including human capital and Social Security decisions); adding guaranteed income efficiently; and asset allocation based upon future spending needs and liability matching.

Not surprisingly, the study found that making smarter financial decisions leads to better outcomes. More specifically, on a utility-adjusted basis, better planning allows for an increase in retirement income of 29% over the base case. Moreover (and significantly), one of the study authors readily acknowledges that there are other sources of value, including risk management, estate planning and other forms of financial planning.

As Wade Pfau puts it, accurately and succinctly, “Financial advisors who only focus on selecting investments will really struggle to add value.” On the other hand, “there is immense value in comprehensive financial planning and good financial decision making. It’s important to remember and easy to forget that the end goal of comprehensive financial planning goes beyond choosing investments.”

Vanguard has been looking at this subject since at least 2001, and put out a report in 2014 titled “Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha.” In summary (though I encourage you to read the entire report), Vanguard sees “advisor alpha” as being built upon “the best practices of wealth management” and as having a potential value of roughly 3% per annum (after fees, which are presumed to be about 1% annually).

Vanguard separates these best practices into three categories: portfolio construction, behavioral coaching and wealth management. In general, “[t]he potential benefits of using a financial planner include increasing wealth, protecting wealth and smoothing consumption.” These categories are further broken down, of course, but you get the gist.

Value Propositions

My point here is not to try to quantify the value advisors provide with any specificity, but rather to point to the areas where they can really make a difference. So here goes.

Encouraging consistent and increased savings. More than 60% of Americans have less than $1,000 in a savings account. Indeed, more than 20% of Americans don’t even have a savings account and nearly 30% don’t have an emergency fund. Still, people are getting a bit better about saving for retirement. The average total contributions to 401(k) plans now top $10,000. But it still isn’t enough. Many young workers are putting off saving until they’re older and (presumably) making more money, a mistake that mitigates the tremendous power of compound interest and which requires them to save much more later on just to catch up. At the simplest level, the average worker saves just 8% of pay in a 401(k) plan. That isn’t nearly enough. One’s savings rate is far more important than rate of return in determining how bright the future is likely to be. However, we are far more likely to obsess over squeaking out a bit more performance from our investments rather than thinking about ways to save more. A good advisor can rectify that.

Managing expectations and behavior. We are all prone to behavioral and cognitive biases that impede our progress and inhibit our success. We are prone to flitting hither and yon chasing after the next new thing, idea, strategy or shiny object. A good advisor can mitigate these tendencies by helping to manage our cognitive and behavioral tendencies. Doing so is vital, not the least of all because we tend to disbelieve that we are susceptible to them. As the great Benjamin Graham sagely warned, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.”

Financial planning. In my experience, individual investors have a great deal of trouble establishing appropriate, realistic and manageable goals. Often they don’t even know what they should be concerned with or what they should include as part of a list outlining what they want or need to accomplish. A good advisor will.

Moreover, good comprehensive financial planning is imperative for good financial health. Yet consumers often mistake investment management with financial planning. Financial planning is much broader, involving far more than the managing of investments. It involves budgeting, goals, appropriate insurance, comprehensive planning for lifestyle, retirement, legacy, Social Security planning, broad and granular risk management, asset location and withdrawal planning, asset allocation, tax planning and more.

It also involves crisis prevention and management. Great investment management can be undone in a hurry with poor financial planning. A good advisor — a good financial planner (as Michael Kitces points out) — can work to help individuals formulate, monitor, adjust and meet their personal and financial goals. Real expertise is required to do so.

Another crucial thing a good financial planner can do is to help to protect aging clients from the impact of inevitable cognitive decline. Research confirms what most of us have seen among our families and friends. The ability to make effective financial decisions declines with age. Thus those age 60 and up unnecessarily lose nearly $3 billion to fraud annually. To put it starkly, research shows that financial literacy declines by about 2% each year after age 60. Despite that decline, our self-confidence in our financial abilities remains undiminished as we age. That’s a scary combination that a good advisor can guard against.

Ultimately, a good advisor can and will influence and even change one’s behavior. In a world where personal financial issues have become increasingly and often unnecessarily complex, a good advisor can help you figure out what is true and what isn’t, what works, what matters, what is useful, and what can go wrong. There are few enough people with the expertise sufficient to begin to do that for themselves. Nobody can do it objectively. That’s why good advisors are an absolute necessity.

Portfolio rebalancing. Rebalancing among investment types, such as an equity portfolio, for example, will likely improve performance by taking advantage of mean reversion. Rebalancing across investment types (to return, for example, to a desired weighting of stocks and bonds) will likely lower overall return — without it the equity allocation will typically grow due to the higher risk premium — but will make sure one’s portfolio is consistent with one’s risk tolerance. There is no definitively best way to do this, but a good advisor will undertake to rebalance portfolios so as to be as cost effective and tax efficient as possible.

Good financial advice is both invaluable and rare. It requires far more than selecting investments. It requires substantial expertise and the ability to manage emotions and expectations. We shouldn’t ever be afraid of saying so and we should never shy away from providing the kinds of service that will demonstrate it beyond doubt.

— Check out Why Are Advisors Feeling So Blue? A Psychologist to FAs Explains on ThinkAdvisor.