Dr. Daniel Crosby is a behavioral finance expert, frequent FPA speaker and President of Nocturne Capital. In his new book, The Laws of Wealth, Crosby touches on ten laws for managing investor behavior and also sets forth a new paradigm for asset management known as rule-based behavioral investing or RBI. An excerpt of the second chapter of The Laws of Wealth is included below.
Law #2 – You Cannot Do This Alone
In an era of seven-dollar trades and fee compression, some have been quick to dismiss the traditional advisory relationship as a relic of a bygone era. Years ago, brokers and advisers were the guardians of financial data, the keepers of the stock quote. Today, investors need only an iPhone and a free online brokerage account to do what just 30 years ago was the exclusive purview of Wall Street. It is worth asking in such an age, “Is my adviser really earning her fee?” An appeal to the research shows that the answer is a resounding “yes,” albeit not for the reasons you might have supposed.
In a seminal paper titled, “Advisor’s Alpha,” the famously fee-sensitive folks at Vanguard estimate that the value added by working with a competent financial adviser is roughly 3 percent per year. The paper is quick to point out that the 3 percent delta will not be achieved in a smooth, linear fashion. Rather, the benefits of working with an adviser will be “lumpy” and most concentrated during times of profound fear and greed. This uneven distribution of adviser value presages a second truth that we will discuss shortly; that the highest and best use of a financial adviser is as a behavioral coach rather than an asset manager.
Further evidence of adviser efficacy is added by Morningstar in their whitepaper, “Alpha, Beta, and Now… Gamma.” “Gamma” is Morningstar’s shorthand for “the extra income an investor can earn by making better financial decisions” and they cast improving decision-making as the primary benefit of working with a financial adviser. In their attempt at quantifying Gamma, Morningstar arrived at a figure of 1.82 percent per year outperformance for those receiving advice aimed at improving their financial choices. Again, it would seem that advisers are more than earning their fee and that improving decision-making is the primary means by which they improve clients’ investment outcomes.
Research conducted by Aon Hewitt and managed accounts provider Financial Engines also supports the idea that help pays big dividends. Their initial research was conducted from 2006 to 2008 and compared those receiving help in the form of online advice, guidance through target date funds or managed accounts to those who did it themselves. Their finding during this time was that those who received help outperformed those who did not by 1.86 percent per annum, net of fees.
Seeking to examine the impact of help during times of volatility, they subsequently performed a similar analysis of help versus no-help groups that included the uncertain days of 2009 and 2010. They found that the impact of decision-making assistance was heightened during times of volatility and that the outperformance of the group receiving assistance grew to 2.92 percent annually, net of fees. Just as was suggested by Vanguard from the outset, the benefits of advice are disproportionately experienced during times when rational decision-making becomes most difficult.
We have now established that financial guidance tends to pay off somewhere in the ballpark of 2 percent to 3 percent a year. Although those numbers may seem small at first blush, anyone familiar with the marvel of compounding understands the enormous power of such outperformance. If financial advice really does work, the effect of following good advice over time should be substantial. Indeed, the research suggests that very thing.
In their 2012 ‘Value of Advice Report’ the Investment Funds Institute of Canada found that investors who purchase financial advice are more than one and a half times more likely to stick with their long-term investment plan than those who do not. Because of this commitment to a game plan, the wealth discrepancies between families that receive advice and those who do not grow over time. For those who receive four to six years of advice, the multiple attributable to advice is 1.58. Those receiving 7 to 14 years of advice nearly double up (1.99x) their no-advice peers and those receiving 15 or more years of advice clocked in at an overwhelming 2.73x multiple. Good financial advice pays in the short run, but the multiplication of those gains over an investing lifetime is truly staggering.
Hopefully at this point, there is little doubt in your mind that the cumulative effects of receiving sound investment counsel are financially impressive. But as we look beyond dollars and cents, it is worth considering whether there are quality of life benefits to be enjoyed by working with a financial professional.
After all, many people perfectly capable of mowing a lawn, cleaning a home or painting a room hire those jobs out. While you may have lawn mowing skill equal to that of the person you hire, you may still enjoy peace of mind and increased time with loved ones as a result of your delegation. The research suggests that in addition to the financial rewards that may accrue to those working with an adviser, it also provides increases in confidence and security that are no less valuable.
The Canadian ‘Value of Advice Report’ found that those paying for financial advice reported a greater sense of confidence, and more certainty about their ability to retire comfortably and having higher levels of funds for an emergency. A separate study performed by the Financial Planning Standards Council found that 61 percent of those paying for financial advice answered affirmatively to, “I have peace of mind” compared to only 36 percent of their “no plan” peers. The majority (54 percent) of those with a plan felt prepared in the event of an emergency, versus only 22 percent of those without a plan. Finally, 51 percent of respondents with a plan felt prepared for retirement against a frightening 18 percent of those not receiving advice.
Receiving good financial advice pays a dividend that builds both wealth and confidence. The research is unequivocal that a competent financial guide can help you achieve the returns necessary to arrive at your financial destination while simultaneously improving the quality of your journey.
So, do financial advisers add value?
The research strongly supports that they do, both in terms of improving means and quality of life. But they only add value when we know what to look for when selecting the appropriate wealth management partner. Our natural tendencies will be toward excess complexity and flashy marketing, seeking out those who lead with bold claims of esoteric knowledge. What will add much greater richness is a partner who balances deep knowledge with deep rapport. Someone we will listen to when we are scared and who will save us from ourselves; a simple solution to a complex problem.