Cost of hand- holding
Do- it- yourself or pay an advisor to handle your investments?
If you have a financial planner, chances are the first time you sat down they asked you a bunch of questions, fed a few numbers into a computer and — poof — came up with a financial profile and investment portfolio supposedly geared for your needs.
It can all look like smoke and mirrors, and while the average person likely sleeps better at night thinking that someone out there has a second pair of eyes on their retirement nest egg, investors are increasingly questioning whether they really need to pay for that hand- holding.
Thomas Robinson, managing director of the education division with the Chartered Financial Analyst ( CFA) Institute, an international body that runs financial education programs and administers the CFA designation, said it is true that on average, few active managers manage to outperform markets.
“On average, all managers will under perform the index by their fees and expenses,” the former wealth manager said. “It doesn’t mean there aren’t investors and managers who do outperform.”
Research based on past performance has consistently shown that the most important factor in variations in returns is market movement. Strategic asset allocation, or long- term portfolio building through specific proportions of classes of investments, is next on the list, Mr. Robinson said. That’s where a planner can earn their keep, through optimal allocations that can best a passive index investment.
Everything after that, as they say, is gravy: a combination of luck, risk and how much you’re willing to pay for a professional to help you pick stocks.
“Most of the bang for your buck comes from asset allocation and just being in the markets. Additional investing will come at a cost,” he said. “You’re really taking on additional fees for the possibility of outperforming.”
So how do financial planners do it, and is it truly beyond the abilities of us mere mortals?
There is, as always, a lot of math involved, but basically planners will map out various asset classes ( large- and small- cap stocks, long- and short- term bonds, cash, etc.) based on expected return, standard deviations ( a number representing upside and downside risks) and correlation with other asset classes ( a positive correlation means both assets move up together). The first two are plotted on a graph to create the “efficient frontier”: a line that denotes the maximum return possible for a given portfolio at a given level of risk.
The planner figures out the maximum level of risk based on the initial interview, and includes correlation as a factor in determining asset allocation. Thus, a portfolio is born. Strategic allocation tends to capture a five to 10- year time frame, and planners are responsible for annual adjustments as needed.
Given enough time, research and patience, it is possible for an investor to do this themselves. But it is an inexact science that makes several assumptions, both on the part of markets and on investor behaviour.
First off, planners themselves generally base their assumptions ( and they are assumptions, albeit educated ones) on “normal” models of market behaviour. But a look at past data shows the market rarely, if ever, behaves normally.
Based on more than 20,000 daily returns from the Dow Jones Industrial Average since 1928, a normal model forecasts 56 “black swan” extreme market events. Instead, there have been 364 such events — 6 1/ 2 times more than expected. Most of them are clustered around specific dates, and most are negative.
The other side is the idea of a “rational” investor, or someone who never acts out of fear or greed — something else that doesn’t really exist.
“Planners are there to protect you from yourself,” he said. “You know, return isn’t everything. The advice, the hand holding, taking those phone calls on Sunday nights from worried clients.”
Mr. Robinson acknowledges investors are more wary of paying unnecessary fees for mutual funds and active management in the face of proliferating exchange- traded funds. Fees are a constant, real drag on returns.
But investors have to keep in mind that it is impossible to invest without paying for the infrastructure in some way, he said: ETFS have fees too, there are processing fees for individual stocks, and planners will take their cut.
“Hiring someone is a trade- off: higher fees for better advice,” he said. “It’s just like going to a restaurant. You’re paying more than if you cook it yourself, but you’re paying for expertise.”