Financial Advice: A Top Ten List

Yesterday, while I was otherwise engaged, Josh Brown threw some fuel on the active v. passive fire:

“Active investors, in the meantime, really can’t say anything. There isn’t a single empirical datapoint backing up the idea that an investor is financially better off paying someone to pick their stocks for them. There are other considerations in favor of active managers – mostly emotional ones involving elbow-rubbing, fancy lunches and alerts – but we’ll leave those aside for now.”

Putting aside the actual substantive argument (my views, including why I advocate some active management, are here and here), advisors routinely tell me that if they used index funds, their clients wouldn’t need their services, consistent with the Dilbert cartoon above.  I disagree vehemently.  Here’s my top ten list of reasons why.

1. Goal Formation. 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.

2. Investment Policy Statement.  An IPS should state one’s investment philosophy, goals, guidelines and constraints to be adhered to with respect to money management.  It also instills structure and discipline.  Every investor should have one but only a competent advisor is likely to be able to make sure the IPS created does what it is supposed to do. A (much broader) financial plan also makes great sense.

3. Asset Allocation. The total return of any portfolio has three components, which may be positive or negative: (a) returns from overall market movement; (b) incremental returns due to asset allocation; and (c) returns due to market timing, security selection, and fees. The best research suggests that, in general, about three-quarters of a typical portfolio’s variation in returns comes from market movement (a), with the remaining portion split roughly evenly between (b) and (c). To the extent that research differs from that stated above, it concludes that asset allocation is more important and the elements that comprise (c) are less important.  The exercise of allocating funds among various investment vehicles and asset classes is at the heart of investment management. Asset classes exhibit different market dynamics, and different interaction effects. Thus the allocation of money among asset classes and among investment vehicles within asset classes will have an enormous effect on the performance of an investment portfolio.  Passive market weighting cannot do anything like that.

4. Persistence-Weighting.  Various studies demonstrate that certain investment characteristics can and do outperform with persistence over time (even though they can and do underperform for significant periods).  These include size (the small-cap premium), value, momentum, low beta and concentration.  Passive market weightings cannot take advantage of these opportunities.  By following competent advice, investors can and should.

5. Risk Management. Passive management (at least as generally construed) looks to “stay the course” through all times and seasons.  Thus it can only manage risk by adjusting one’s asset allocation and, even then, will only do so on account of non-market factors (such as advancing age, a change in goals or a change in circumstances).  Good advice can make such adjustments more effective.  It can also provide other tools for managing risk, including asset/liability matching and tactical adjustments due to long-term factors such as a secular bear market or low expected returns (even though I recognize that the distinction between market-timing and tactical adjustments can seem mighty small indeed).  Good advice can also offer various hedging and insurance strategies.

6. Behavioral Management.  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.  Our behavior typically corresponds to the following chart. A good advisor can mitigate these tendencies. Since we frequently act too fast, a good advisor can also slow us down to allow us to “check our work.”  Losses on account of delay will almost always be out-weighed in the aggregate by more careful and thoughtful analysis keeping us from taking action too hastily and without sufficient reason. A good advisor will help 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.

7. Productive Simplicity. Simplicity is a good thing, but with a careful qualifier. Per Einstein, the goal is to make things as simple as possible but no simpler. A competent advisor will know the difference.

8. Senior Protection. 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.

9. Tax Efficiency.  Experienced money managers routinely argue that you shouldn’t “let the tax tail wag the investment dog.”  And it’s true that a poor investment isn’t often salvaged by good tax treatment.  But tax efficiency still matters a lot and a good advisor providing the best approaches for dealing with taxes offers tremendous value.

10. Financial Planning.  Each item on this list relates to financial planning in one form or another.  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 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.

Ultimately, a good advisor can and will influence and even change your 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, irrespective of any active v. passive investing debate, good advisors are an absolute necessity.