My father-in-law was a wise old Yankee from Massachusetts when I met him at the ripe old age of 63. He was 17 years older than my mother-in-law and since he had spent most of his career as a State Department diplomat, I would listen closely to what he had to say since his world and perspective was so alien to the one I knew. He was born in 1915 and like many of his generation his thinking was shaped by the events of the Great Depression and then World War II. His formal education was cut short due to financial hardship but that didn’t mean he stopped learning. He would always say that he went to college at the school of hard knocks. He never gave me any unsolicited advice in all the 27 years I knew him but if asked he would offer an opinion, which I always valued. He had a saying that is particularly relevant to this tale and that I remember often. He would tell me “Common sense is the least common of the senses.” I’ve come to appreciate the wisdom of this phrase as well and use it often. It’s especially true when it comes to investment management.
What my father-in-law meant by the phrase and how it applies to your portfolio is that you shouldn’t over-think or over-intellectualize a problem. Investing is something that if you over-think or over-intellectualize it usually costs you money. Good advisors know that they need to keep things simple in order to not lose their audience or clientele. This tale speaks to a common sense approach to investing and outlines the duties of the advisor.
We’ve learned in other tales to identify several types of advisors as FABs, SADs and HAMs. As a reminder, FABs are fee-based advisors, SADs are sales-driven advisors and HAMs are hired asset managers. What we didn’t learn was anything about their day-to-day duties and responsibilities to us as their clients. So what do advisors do to merit the money they charge you? This tale looks at what SADs and FABs have to offer and why it’s valuable.
From what I’ve learned over the last 20 years of advising clients and assuming that SADs can overcome their inherent conflict of interest, SADs and FABs have two primary duties of equal importance and one secondary duty which has little value in my opinion.
The first of the two primary duties of a SAD or a FAB is to determine the appropriate asset allocation or capital allocation that’s right for you. If you don’t know what asset allocation or capital allocation is I encourage you to read An Asset Allocation Tale before you read any further. Let me repeat and stress the phrase asset allocation that’s right for you. You are not a formula and neither is asset allocation. If you meet with an advisor that is formulaic and says something inane like “Your bond allocation should match your age, you should have 35% of your portfolio in bonds because you are 35 years of age” you should immediately head for the exits. These simplistic asset allocation formulas based on age are flat-out wrong, devalue the importance of the right asset allocation and give people the impression that one size fits all. You are not a cookie so forget the cookie-cutter approach. I consider proper asset allocation critical to my client’s long-term success. Make sure you have the right allocation and stick with it. Call it your plan.
The second of the two primary duties of a SAD or a FAB is to hold your hand by advising you to “follow your plan” when you want to “alter your plan.” People have a tendency to self-destruct. It seems silly but it’s not. There are countless behavioral reasons for people to have this tendency and I find it so important that I have dedicated an entire section of these tales to behavioral issues that set people back. Hand- holding is a critical duty of an advisor. Read A Two Timing Tale to see how important following your plan is to your financial success. People, left to their own devices have difficulty practicing the required detachment, objectivity and discipline that a good advisor brings to your situation. These skills developed over an advisor’s lifetime are important and you should not downplay them. They are essential to your success.
As an example, let’s look at the typical mutual fund investor. Mutual funds are designed as long term investments. They are not designed for people to hold for 6 months or a year. They are designed for people to hold for the long term, which I characterize as more than 10 years. Yet study after study shows that the length of time that individual investors hold mutual funds is getting shorter and shorter. The last study I read said that the average mutual fund holding period has dropped to less than 3 years. What this means is that people are trading mutual funds. This is a recipe for disaster since most people are lousy traders of anything and that includes mutual funds. The results prove to be true. The typical mutual fund trader underperforms the very same fund he is trading by almost 6% per year. A good advisor knows this about mutual funds and prevents the individual from practicing this type of self-destructive behavior.
I recently read a book by one of America’s top institutional investors called
. The author manages the pension plan for Yale University; has a very impressive performance record in the institutional money management business and is highly respected. His name is David Swensen and his book is terrific. I suggest every reader that reads my tales and chooses to manage their own money instead of hiring an advisor read his book and take his advice. Take every word of his advice however because he doesn’t give you a lot of latitude to drift off course. Read it carefully because it’s complicated and written from the perspective of a man that has devoted most of his life to the study of financial markets.
The basic message of the book, other than the knowledge that he imparts, is that you can and should go it alone. You should act as your own advisor. You should manage your own investments. That if you follow his rules you can perform well. I disagree with him because it’s my experience that people can’t follow rules, even simple rules. His facts are correct but his conclusion doesn’t match mine for most people.
He goes through a series of logical progressions that give the impression that advisors aren’t necessary. He says to keep it simple. He’s right. He says to diversify. He’s right. He says to keep costs low and use exchange-traded funds and Index funds. Again he’s right. He says to stick to your asset allocation plan through thick and thin and rebalance when necessary and again he’s right. He says that market timing is an unprofitable pursuit for most individual investors and again he’s right. Then he says that most importantly you must stay disciplined. This is where I think Mr. Swensen fails in his message and the reason a good advisor is worth what you pay them. Mr. Swensen thinks that staying disciplined is easy. It’s not. It’s easy for him but it’s not for others. Underestimating people’s irrational reactions under stress leads him down the wrong path. He concludes that people can follow rules. My empirical observations say the opposite. Most people can’t follow rules, they aren’t disciplined and left to their own devices will self-destruct. Limiting this tendency or perhaps reducing it entirely along with the proper asset allocation is the true value of an advisor. I think he doesn’t appreciate how difficult it is to advise people to stay true to their plan when faced with periods of extended gloom or extended boom. It’s especially true given that people are most fearful and most greedy during these periods and are bombarded with expert advice everywhere they turn. In any event I suggest you read his book and if you can stay disciplined you should take his advice because he’s right and you might save yourself a fee.
An area that Mr. Swenson does not touch upon and perhaps the true motivation behind his go at it alone advice for the individual investor is advisor competency and motive. If every advisor was competent and motivated to serve the client then Mr. Swensen misses the point in my opinion. The reality is that most advisors that individual investors or small investors can hire are either incompetent or self-serving. Perhaps Mr. Swensen has factored this into his equation and the end result is you should invest your own money and not use advisors. He may reason that most advisors have no more discipline than the individual investor. Perhaps he reasons that the SAD will always overweight a person’s portfolio towards stocks because they make more money when their clients are in stocks than in bonds or cash. Perhaps he reasons that a SAD has a financial incentive to move your money out of the market and into safe investments at or near market bottoms or the opposite, to move your money into risky investments at or near market tops. He doesn’t say it in his book but I think he understands the financial landscape well enough to know that if you follow his advice you have as good a chance as dealing with an advisor.
So what is the final and secondary duty that you get when you hire a SAD or a FAB? The answer is investment selection. Mr. Swensen says it’s of limited importance and I agree. Most individual investors think investment selection is the most critical component to investment success but they couldn’t be further from the truth. Today’s FAB or SAD has at their disposal about as much personal finance information as the average investor. Over the last 20 years information has become commoditized and is today a great equalizer in that regard. But beware, where to invest is very different than how to invest. “Where” deals with investment selection while “How” deals with asset allocation and staying true to your plan. A good SAD or FAB knows “How” to invest and stays disciplined. You may too but it’s unlikely.
In my opinion if you know “How to invest” you should manage your own money. Why do I say this? When you consider that the average annual fee that a SAD or FAB charges is between 5% and 25% of the expected return on your portfolio, it’s a stretch to justify this fee on the grounds of investment selection or the “Where” alone. This especially true when you recognize that few FABs or SADs have any idea on “Where to invest.” If they did, they wouldn’t be FABs or SADs. They’d be David Swensen or some other notable investor. In other words, it’s an awful lot to pay for “Where” when there is no “Where” expertise. Again, beware of the difference between “How” and “Where.” You can pay for “How” but not for “Where.”
So in summary, when you hire an advisor you may think that you are paying then for “Where” to invest your money but in fact you are paying for their asset allocation interpretation and most importantly for their discipline. You are paying for their “How.” You shouldn’t expect to achieve the rates of return that someone as talented as Mr. Swensen can achieve but you shouldn’t short-change yourself either by hiring incompetent or self-serving advisors. Let me close this tale by saying that there exist a number of advisors that are capable of earning their fee based not just on the “How” but the “Where” as well. I would not be in this business if I believed that my firm didn’t add investment selection value or what I call “Where” value. However, the chances are that you are not dealing with an advisor or a firm that does and probably the reason why I believe Mr. Swensen says you should take matters into your own hands.