Investors have long wondered whether it’s worth paying someone to mastermind a financial plan. Financial advice comes at a cost, after all, and the catch is that if you pay an advisor, your investments have to do even better to gain real value from the advice. But according to Robyn K. Thompson, a Certified Financial Planner at Castlemark Wealth Management, good financial advice doesn’t just cost, it pays. How much? About 1.82 percent per year, according to research from Morningstar Inc.
If you have an advisor - or are considering working with one - how an advisor generates value is worth considering. So let’s take a look at what financial advice can add to a portfolio, and how you can ensure that when you do pay an advisor, you’re getting your money’s worth (and more).
Financial advice: What is it worth?
In 2012, two major studies emerged that attempted to put a price on financial advice. In September, research from Morningstar Inc. attempted to pin down that added value and came up with a number: 1.82 percent per year. That may not sound like much, but the researchers projected that it could mean an extra 30 percent in income per year for retirees who receive financial advice compared to those who go it alone. Morningstar called that added value “Gamma”.
Another research paper put out by the Centre for Interuniversity Research and Analysis on Organizations (CIRANO) called “Econometric Models on the Value of Advice of a Financial Advisor” found that the presence of a financial advisor meant an increase in a household’s financial assets. When “identical individuals” were compared, those who had a financial advisor for between four and six years were found to have 58 percent more financial assets than their unadvised doppelgangers. Interestingly, the longer respondents worked with a financial advisor, the bigger the benefit it had on their returns.
What’s most interesting about both studies, however, is where this added value actually comes from. Here’s a hint: It’s not from choosing investments.
Do advisors pick better investments?
Where financial advice has run into obstacles over the years is that most studies find that experts don’t, on average, beat market benchmarks. In a nutshell, that means that most advisors and investment managers don’t choose investments that perform much better than an index fund, which has much lower fees. Case in point: A study published in the Journal of Investing in 2012 made the same conclusion as many others before it by determining that active portfolio management failed to add value above the fees it charged to investors. It’s this sort of statistic that makes many investors wonder if they’re better off managing their own investments, or just sticking to an index fund.
But here’s where things get interesting: Both the Morningstar study and the CIRANO report determined that the value of financial advice didn’t come from better asset selection – at least not the most significantly. The “Econometric Models” paper stated that advised savers’ rates of return were only 3 percent higher than those who received no advice, which hardly accounted for the 173 percent difference in assets that mounted between the investors who received advice and those who didn’t over a 15-year period. The question then becomes, if financial advisors aren’t helping investors choose better investments, where is that additional value coming from?
The power of financial advice
Historically, investors have looked to financial advisors or money managers to earn their fees by beating the benchmark returns investors can't get on their own. What Morningstar’s report clearly defines is that it isn’t specific investments that are the make-or-break factor in a portfolio’s long-term returns. In fact, it’s the little things that many investors tend to overlook that made the biggest difference. Morningstar zeroed in on five of these factors:
- Asset allocation
- Withdrawal strategy
- Tax efficiency
- The use of traditional investment products vs. guaranteed-income products
- Investing with a goal of meeting an investor’s specific needs and timeline
The most important factor here was using a withdrawal strategy that was “dynamic,” in which withdrawals were re-assessed on a regular basis to ensure they were sustainable based on market conditions. Translation: Advisors provided value by regularly recalculating investors’ withdrawal rates during retirement to ensure they wouldn’t run out of money.
The second biggest factor was tax efficiency. This refers to the use of investment strategies to help reduce an investor’s tax liability. What’s interesting is that if you asked most investors why they seek financial advice and what their advisor does for them, these probably aren’t the jobs that spring to mind.
An open and shut case ... not really
Whether financial advice boosts returns enough to be worth the cost is a debate that’s likely to continue indefinitely. In truth, advice is hardly a scientific thing, and even when it comes packaged with the best intentions, it’s still subject to human error. Plus, we’d venture to say that there’s significant variability between advisors in terms of the results they produce for their clients – and the fees they charge to produce those results.
Even so, Morningstar’s report does suggest the way in which investors view financial advisors may need to shift. Rather than seeking an advisor to select mutual funds, what we should be looking for is someone who’ll sit down and listen to our specific needs and financial goals; someone who’ll consult with us regularly and ensure that our savings and investment goals are on track; and, most importantly, someone who’ll look out for our long-term interests and ensure that we have not just a portfolio that is filled with good investments, but one that isn’t being drawn down too quickly during retirement, or being eaten away by taxes.
The final piece of the puzzle
For anyone who is working with an advisor, or might want to start, the ways in which professional advice can generate better returns are worth considering. But there’s one caveat: While a good financial advisor can pay, even the best advice is no substitute for taking an active interest in and responsibility for your own financial life. This includes vetting and choosing an advisor carefully, and working to understand his or her recommendations. After all, advice is just advice. What we're really talking about is your money.