I recently had an interesting series of conversations with my parents around investing and the world of financial advice, which encouraged me to outlay some thoughts on the subject. First things first – I am not a financial advisor, and none of this should be taken as specific investment advice. My only aim is to highlight some common mistakes people make when it comes investing. If after reading this you feel you may not be getting the best advice, your next step should be to do your own further research and/or have a more informed conversation with your current financial advisor.
Why You Probably Don’t Need a Financial Advisor
Generally speaking, financial advisors are people who provide a service to investors, helping them build, balance, manage and adjust a portfolio of assets, taking into account the prevailing economic conditions and the expectations and needs of the client. There are a multitude of scenarios where financial advisors and asset managers provide a valuable service to their clients, unfortunately, however, as Matt Yglesias points out, this is almost never for small “retail investors”, like you or me.
If this is the case, why are financial advisors still in such demand when it comes to retail investors? I believe it comes down to four factors:
- Unrealistic expectations on the part of retail investors
- Fear of complexity
- The belief that your financial advisor’s incentives align completely with your own, and/or
- A lack of understanding of compounding.
Adjusting Expectations
Your expectations may seem pretty straightforward – you want to maximize the returns on your assets. But let’s dig a little deeper – what level of returns are you looking for? For most people, the prospect of 5-7% per annum returns seems underwhelming – that’s pretty much the average for the market right? What if I want to beat the market – half the investing world is beating the market average in a given year – surely I can be one of those guys?
Unfortunately, there is no shortage of people who will tell you they can help you do exactly that. From stock pickers in your local newspaper to highly paid active fund managers on Wall St, there is an endless line of people who want to help you discover the secret of obtaining above average returns. More often than not, it is even sold as quite a reasonable thing, an opportunity that others have overlooked for some plausible sounding reason, or something that is only available to a tiny subset of investors that you happen to a part of.
The problem is not the salesmen – salesmen are gonna sell – the problem is we keep buying into the promises of above average returns, despite our own better judgment. The reality is beating the market is extremely difficult to do, particularly over any multi-year period. Even if there are advisors and money managers that have found a way to consistently beat the market, they are running a hedge fund with billions in assets, or providing advice to people and/or companies with a lot more money than you or I. They are almost certainly not working 9 to 5 at your local branch of ABC Bank.
To start thinking like an investor, instead of a gambler, the first step is to readjust your expectations. There are no shortcuts to wealth – average market returns should be your expectation. Once that is your expectation, your view on the best way to invest your money fundamentally changes. Now the question changes from “How big is the return I can get?” to “What is the lowest cost way to match the average market returns?” That is the right question to be asking.
Fear of Complexity
Fear is a tool that has been used by professionals in most fields essentially since the beginning of people doing things for money. From lawyers to auto mechanics to management consultants, they have a vested interest in making any job they do seem more complicated than it is to ensure that a) you don’t learn how to do it yourself; and b) they can charge as much as possible for their services. People working in the financial industry are no different.
That’s not to say there aren’t extremely complicated products and concepts in the financial world, but now that we have adjusted our expectations – all we want is to match average market returns – why do we need to understand these complicated products? Do you have a large exposure to Chinese Yuan that you need to hedge? Have you been creating short positions on European junk bonds that you need to cover? You can probably stop reading this if you do.
If we accept that matching the average market return is in fact a perfectly acceptable result, then there are a range of simple, understandable options available to retail investors that are only a regular brokerage account away.
The Incentive Misalignment
Despite the platitudes, a financial advisor’s primary incentive is to maximize the amount of money they make from you as a client. There is some alignment in incentives in the sense that their fees increase as your assets grow (fees are typically structured as a percentage of total assets), but the difference to your advisor between your assets growing at 5% or 7% is minimal. The real money is in finding additional pools of assets to manage. Because of this, it is much more economical for them to spend their time finding additional clients than it is for them to spend that time trying to squeeze an extra percent or two out of your portfolio. Confused? Similar incentives apply for Real Estate agents (I’m just picking fights with everyone today) as is explained very well in the following short clip.
The above misalignment is actually one of the more innocent ways in which an advisor’s incentives can diverge from your best interests. The more disturbing divergence occurs due to the opaque world of incentives and commissions. This varies widely between countries, states and even the specific type of advisor you have, but these payments can lead an advisor to recommend products and strategies that aren’t actually the best option for you[1]. This could include recommending unnecessarily complex portfolio structures, advising you to take on too little or too much risk, or even recommending funds and/or securities that the advisor actually receives commission for selling. Most people have heard about this happening in the US, but don’t believe it doesn’t happen elsewhere – take this excerpt from the Financial Services Guide for Colonial First State, an Australian Wealth Management Group (emphasis mine):
“You may receive advice in relation to the products we offer from financial advisers who do not work for Colonial First State or may be representatives of other licensees in the Bank. These advisers may receive some benefits from us. The adviser’s remuneration is included in the fees you pay when investing in our products.”
The issue here isn’t that these products are being marketed, but there is a blurring of the lines between advisor and salesman that is particularly bad in the financial industry. Again referring to Matt Yglesias – compare buying securities recommended by your advisor to buying a car: “we understand that the car salesman works for the dealership — he’s not your car advisor.”
The key point is that the only person who really cares about your money is you and you should spend as much time researching how you invest your money as you would on any other major purchase. Fortunately, there has never been a better time for investing novices to learn some of the basic concepts of investing – CNN, ASIC, Yahoo Finance and many others have beginner’s guides to investing. For those looking for something more in depth, Coursera is a fantastic resource of free courses offered by some of the worlds leading Universities. Two excellent beginners’ finance courses are currently being offered by the University of Michigan and Yale.
So instead of spending all your time online looking up Joe Pesci trivia, watching John Stewart clips on racial inequality, or researching the best toothbrush to buy, invest some time building your financial knowledge. Start with important concepts like the risk-return tradeoff and diversification, and move onto the different types of securities. Let your curiosity take you where you want… after you watch the Joe Pesci clip of course.
Underestimating Compounding
One of the big reasons so many of the injustices in the financial markets occur is because people consistently underestimate the effects of compounding. Let’s look at a simple example – the bank provides you with an asset worth $0.01, but it doubles in value every day (i.e. it would be worth $0.02 on day two, $0.04 on day three and so on) for an entire 31-day month. How much would that asset be worth at the end of the month?
If your guess had less than 7 figures, you are way off. By the end of the month, that asset would be worth over $10 million. That is the impact of compounding. Let’s look at a more relevant example for investors. Anecdotally, you will often hear people say something along the lines of the following:
“X was a great investment – it doubled in price over the last 10 years.”
What is the average rate of return that would cause an asset to double in value in 10 years? 7.18% per annum. Consistent 7.18% returns is nothing to sneeze at, but it is a lot less impressive than the returns sought by a lot of investors. It is also lower than the long run average return of the S&P500, which is over 9% (see Chart 1).
Chart 1 – Value of $100 Invested in the S&P500 in 1928
Ok, so leaving relatively small amounts of money invested at low rates results in a lot bigger returns than you might expect. If that is the case, it shouldn’t matter if my advisor is charging me 0.15% or 1.5%, as long as I leave it accumulating for long enough, right? Unfortunately the opposite is true, when it comes to fees, compounding works against you. Those seemingly small fees that financial advisors and intermediaries charge you for their services end up having a much bigger impact than you might expect.
Just as compounding works by exponentially increasing a value by giving us returns on our returns, the money lost through fees grows exponentially by taking away money each year that would be compounded in future years. Chart 2 shows a comparison of two $100,000 investments over 30 years assuming the long run returns of the S&P500 (9%). One investment is made in a low cost market index fund (cost 0.1% of assets) and the other in a high cost managed fund (cost 1.5% of assets).
Chart 2 – $100,000 Investment: High Cost vs. Low Cost Management
Within 5 years, the high cost fund has cost you over $10,000 more in fees and lost returns than the low cost fund – that’s over 10% of the value of your initial investment gone. The cost reaches over $30,000 by the 10-year mark, and over $135,000 by year 20.
The worst part of this, going back to the first point, is there is almost no chance that your high cost fund managed to outperform the market index fund over the course of those 20 years, and a pretty good shot it did significantly worse. At best you probably just paid $135,000 to match the average market returns… on the plus side, maybe they will take you out on their new yacht for your generosity.
What To Do?
If you understand and agree with the points made above, and if you are currently investing or are planning to invest any significant money, then what you should be looking for is something that will allow you to reproduce the market average performance at a very low cost. There is a growing number of ways to do this, but low cost managed funds and ETFs are the most accessible to most investors.
However, do not simply substitute this advice for your old financial advice. Do your own research – there is so much information out there, and the best advice is often free. Understand what the product options are, what the fees and costs are, and what returns are expected and why. Don’t be afraid to ask questions – the only dumb question is the one asked after you have lost a stack of money.
[1] The option recommended might simply be less beneficial than the best option as opposed to an option that is not in your interest at all, which would be a breach of fiduciary obligations.
Disagree with any of the above? Feel free to leave a comment below.
Leave a Reply