While improving, there is substantial evidence that Canadians on average tend to have low financial literacy. Many are struggling with creating sufficient wealth for a secure retirement. These struggles lead many to fear their financial outlook and suffer tremendous stress and anxiety in their lives. Financial advisers play an important role with helping individuals make better decisions to improve their financial situation. While the public is fixated on the cost of advice it is up to advisors to justify their fees by demonstrating their value and how they influence investors.
Let’s address a common argument against paying for advice. We have all read headlines such as, “Why pay fees when low cost passive investments outperform?” More than six years into a bull market, it is tempting to discount the value added by an adviser’s ability to help an investor optimize their behavior. Based solely on investment performance against a theoretically unattainable benchmark (how can you get that benchmark investment without incurring costs?) it would appear that having an advisor is unnecessary. However, let’s examine this argument further.
A study by Dalbar demonstrates that there is a wide gap between investment returns – the return of a benchmark index – and the much smaller returns that mutual fund investors actually captured. In 2014, the S&P 500 delivered returns of 13.69% but the average equity mutual fund investor brought home returns of just 5.5%. A study by Morningstar looked at a 10-year period and determined that the average mutual fund investor underperformed the average mutual fund investment by around 2.5% annually. This implies that investors sacrifice a substantial portion of their returns by incorrectly timing when to enter and exit investments.
The potential for self-directed investors to make mistakes due to lack of financial knowledge or behavioral biases is where advisors can really influence their clients. Behavioral bias is the main reason for poor investment decision making and underperformance. Dalbar defined nine of the irrational investment behavior biases as shown below:
Loss Aversion or panic selling -The fear of loss leads to a withdrawal of capital at the worst possible time.
Narrow Framing -Making decisions about a security or an area of the portfolio without considering the effects on the whole. This bias tempts clients to chase performance and take risks that are misaligned with theirobjectives. It is important to be the sort of adviserwho helps them focus on the big picture.
Lack of Diversification -Believing a portfolio is diversified when in fact it is a highly correlated pool of assets. Individuals tend to consider new investment opportunities in isolation, without considering the overall risk of their portfolio.
Anchoring -The process of focusing on previous experiences and not adapting to a changing market.
Mental Accounting -Separating performance of investments mentally to justify success and failure instead of looking at the big picture.
Herding-Following what everyone else is doing triggering a “buy high/sell low” strategy.
Media Response -The media has a bias to attract readership and also to sell products from advertisers. Advisors can protect clients from the fear-based media that is focused on the short-term and day to day movements.
Regret -Not performing a necessary action due to the regret of a previous failure.
Optimism -Overconfidence can lead to harmful decisions and cause excessive trading. Continued success during a bull market may tempt an individual to take too much risk. It only takes one overly risky decision to wipe out all the gains.
Clearly advisors can play a crucial role with helping clients optimize their investment performance. Investors can be their own worst enemies while advisors can be their best friend. While this in itself would be enough to justify fees, the reality is that the value of financial advice extends far beyond a focus on investment returns.
Individuals often mistake financial planning with investment management. Financial planning is much broader. It involves setting goals, taking action, implementing strategies, monitoring conditions and reacting accordingly. It’s comprehensive planning for lifestyle, budgeting, tax management, insurance planning, retirement planning, education funding, estate and legacy planning and more. It also involves crisis prevention and management.
As good as the investments of a do-it-yourself investor may perform, gains from investment management can be undone in a hurry with poor financial planning. An advisor using an Investment Policy Statement as a roadmap outlining their client’s investment philosophy, goals, guidelines and constraints instills structure and discipline for their clients. A good advisor can and will influence and even change their clients’ behavior. They act as financial counselors, coaches and mentors to help educate, motivate, and enable clients to live the lives of their dreams. That is why, irrespective of any active v. passive investing debate, good advisors are an absolute necessity. More than anything, a financial advisor provides peace of mind making the overall lives of individuals much more enjoyable.