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 because 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 they need to keep things simple or else they lose the attention of their audience. 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 haven’t learned is 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 past 30 years of advising clients and assuming that SADs can overcome their inherent conflict of interest is the following: SADs and FABs have two primary duties of equal importance and one secondary duty with, in my opinion, little value.
Primary Duties of Advising
The first of the two primary duties is to determine the appropriate asset allocation or capital allocation that’s right for you. They identify and suggest different types of investments for different buckets. The key here is they suggest what is right for you. You are not a formula and neither is asset allocation. If you meet with an advisor who is formulaic and says something inane like “Your bond allocation should match your age, so 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 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 many of my peers classify me as a financial behaviorist. Nevertheless, handholding is a critical duty of an advisor. Following your plan is critical 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. The mutual fund is a long-term investment. My parents have held the same mutual funds for 40+ years. I haven’t asked them to sell them, and I know better. Yet study after study shows that the length of time 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 fewer than three 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 consistently underperforms the very same fund he is trading by 4–5% per year. A good advisor knows this about mutual funds and prevents the individual from practicing this type of self-destructive behavior.
Don't Go It Alone
Many great investors suggest that the average investor can “do it” themselves. They should go it alone. You simply follow their rules, and presto—success. If it were this simple, we would all be rich. The basic message of these great investors/books/sites, other than the knowledge they impart, is that you can and should go it alone. You should act as your own advisor. You should manage your own investments. You can perform well if you follow their rules. I disagree completely. I have seen that people can’t follow rules, even simple rules. Although the guru’s facts are correct, the conclusions don’t match my conclusions for most people.
Many gurus go through a series of logical progressions giving the impression that advisors aren’t necessary. They say to keep it simple. They are right. They say to diversify. They are right. They say to keep costs low and use exchange-traded funds and index funds. Again, they are right. They say to stick to your asset allocation plan through thick and thin and rebalance when necessary, and again they’re right. They say that market timing is an unprofitable pursuit for most individual investors, and again they are right. Please note it is not an unprofitable pursuit for the gurus since they don’t follow their own advice. They are all market timers or else they wouldn’t be gurus, they would be a stock index fund. Finally, they say that most importantly you must stay disciplined. This is where things fall apart and the reason a good advisor is worth what you pay them. Gurus think that staying disciplined is easy. It’s not. It’s easy for them but not for others. Underestimating people’s irrational reactions under stress leads them down the wrong path. They conclude that people can follow rules. My empirical observations say the opposite. Most people can’t follow rules, they are undisciplined 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. Please note that I believe most advisors are just as undisciplined as the average investor. This leads to a blind-leading-the-blind relationship and is why I always say you can only work with those that have a methodology and have been through multiple market cycles. If you can’t, then you must learn to do it yourself.
I don’t think gurus can 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. The media bombards them with “expert advice” everywhere they turn. In any event, I suggest you read guru books. You may just be the type of person that can stay disciplined.
This leaves a real possibility. Are gurus aware of the individual investor’s lack of discipline and yet still recommend they go it alone? Perhaps the true motivation behind a go-at-it-alone advice is advisor competency. Because gurus recognize that most advisors who individual investors or small investors can hire are either incompetent or self-serving, perhaps they have a point. Perhaps they have factored this into their equation and concluded you should invest your own money and not use advisors. They may reason that most advisors have no more discipline than the individual investor. Perhaps they reason that the SAD will always overweight a person’s portfolio toward stocks because they make more money when their clients are in stocks than in bonds or cash. Perhaps they reason 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. They may not say it, but they understand the financial landscape and, all things considered, still think you should go it alone. Either way, it doesn’t matter. The more you learn, the better your result will be.
Final Duty: Investment Selection
So what is the final and secondary duty that you get when you hire a good advisor? The answer is investment selection. In my opinion, it’s of limited importance. 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 advisor, good or bad, has at their disposal about as much personal finance information as the average investor. Information is now a commodity. It is a great equalizer. But, “where” to invest is very different from “how” to invest. “Where” deals with investment selection, while “how” deals with asset allocation and staying true to your plan. A good advisor knows “how” to invest and stays disciplined. They possess knowledge, experience and wisdom. They recognize when you throw these three things into the equation, you get common sense, and “common sense is the least common of the senses.”
So in summary, when you hire an advisor, hopefully an expert one, you may think you are paying them for “where” to invest your money. 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 a guru achieves, but you shouldn’t short-change yourself either by hiring incompetent or self-serving advisors.