What's a Financial Advisor Really For?

Ellis, on the investment committee of Rebalance and chairman of Essentia Analytics, suggests that investors should wise up and limit their major investment decisions to 20 during their lifetime.

In the interview with Ellis, a successor trustee of Yale who co-chaired the university’s investment committee with David Swensen, he points out that the average investor can be their worst enemy but that investing in index funds can protect them. Ellis himself has only one non-index stock investment: Berkshire Hathaway, which has resided in his portfolio for more than half a century.

Here are excerpts from our conversation:

THINKADVISOR: “Most actions of most investors and most investors’ helpers do more harm than good,” you write. Please explain the latter.

CHARLES ELLIS: The advisor is more of a psychological comfort than a financial benefit. Say, you talk to [them] often, and [they] always have good suggestions.

But that’s bad news because most suggestions will probably, on average, be mistakes.

What do you think the advisor’s role should be, then?

I’m a big fan of having a financial advisor work with you when your personal circumstances change, and I would recommend paying them a very high hourly fee.

What I don’t feel good about is anybody charging a percentage of your assets year after year after year. That’s very good for the families of the advisors, but it’s not a good deal for the individual investors.

What service should an advisor perform?

You want them to go through the reality of your financial life and your life situation with you.

For example, if you were just divorced or if you had an important change in your job and were earning a substantially larger income, pay attention to that.

“Most investors will enjoy better long-term results if they limit themselves to just 20 major investing decisions, about one every three years, over their lifetime,” you write. “Results will be even better if the decisions are made only because there are significant changes in the circumstances of the investor’s life, not in the market,” you say. That part relates to the previous question, but please elaborate.

Most investors make their decisions primarily because of what they see happening or think is happening or fear might happen in the market. That usually turns out to be a mistake.

What’s the typical individual investor’s thinking?

They tend to be really excited after things have worked out, when they’re ahead of the average or trend.

When things go back to the norm, they get upset: Everything looks just terrible in the economy, the Middle East, this, that and the other.

They get discouraged because the market is going down, down, down; and they feel they need to stop their losses and get out.

So they take action, which means they’re losing and losing each time they make a decision.

This takes about 2% a year out of their returns. They’re really losing 2% to behavioral mistakes and 2.5% to inflation. [Thus], many returns get squeezed to less and less.

How can index funds avoid that?

By matching the market, they enable investors to avoid costly behavioral economics mistakes. They charge much lower fees, minimize operating costs and save on taxes.

But the great thing is that they’re boring. There’s nothing to tell your friends about, nothing to get excited about.

So you just ignore what’s going on [in the market, economy, geopolitics], and that really protects you.

Probably the biggest advantage of index funds comes from benign neglect.

You make the point that the share of U.S. stock market active mutual funds fell by 40% from 2012 to 2023 but that the share of index funds more than doubled from 8% to 18%. So “the reliance on index funds has finally surpassed active mutual funds,” you conclude. What are the implications?

When I got involved in investment management in the 1960s, active mutual funds outperformed year after year. But the world has changed.

The stock market, with its [advanced] technology, is increasingly skilled at doing the work it’s supposed to do: finding the right price.

That’s good for the average investor in ETFs and index funds.

McKinsey [& Co.] did studies, finding over and over again that usually, low cost and high quality go together.

You write that investors should model “the troika of Save, Invest, Spend.” That is, spending should be “one of three equally important interactive components of successful long-term investing.” You explain that an effective spending rule “converts the price-volatility returns of the market into a far smoother, more predictable stream of payouts and enables your long-term investment strategy to focus on achieving higher… returns.” What’s a good spending rule?

The spending level is personal preference. The process to get the right [level] is the rule that Nobel Laureate James Tobin [conceived and developed] for Yale University’s endowment. Individuals can use a simplified version.

Where do you begin?

First, average the year-end values of your assets over the prior several years — preferably more than five — to dampen the impact of market fluctuations. Then calculate a prudent withdrawal — likely 4% to 5% — each year.

With a sensible spending rule, you’re free to concentrate on achieving significantly higher long-term results without the need to be overinvested in low-return bonds.

When might it be advisable to have bonds?

If you want something to draw on to fill the gap between dividend income and your spending intentions, you might want to have bonds for two, three or four years.

I don’t recommend it, but it’s not a terrible idea.

“A principal focus of long-term investing should always be on the power of compounding,” you write. Please explain.

Your Power Curve is the result of compounding returns on your investments over time.

If you start early enough, compounding has a snowball [doubling] effect: one, two, four, eight, 32, 64, 128. That leap from 64 to 128 is fabulous.

So the sooner you get started, the better your chances are to have that enormous impact down the line.

But many young people can’t or won’t visualize that far ahead, so they don’t start to save early. What should an advisor tell them?

It depends how much you save and put into the process of snowballing.

The other thing is how well you keep doing it. By the time you get to doubling [at higher amounts], you’ll have real money.

The key to happiness at the end of compounding is to get started early, and the other [part] is to stay with it.