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March 01, 2016 at 07:00 PM
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.
