Many investors compare their financial advisor's performance to the performance of common indices, such as the S&P 500 or the DOW. If their portfolio has outperformed the index, they may feel a sense of confidence. They have "beaten the market." Why does this benchmark mentality exist and at what does it cost the investor?
Expectations and Benchmarks:
A financial advisor is often expected to perform a wide variety of tasks: investment advisor, retirement planner, real estate confidante, tax counselor, etc. Benchmarking their performance primarily on “beating the S&P” yearly is not accurate, fair, or even safe.
Let's get a few things straight. A financial advisor is not the same as an investment advisor. They should not be judged the same. As Josh Brown, financial planner and author of "Backstage Wall Street" stated, "If you're focused primarily on performance," he said, "you're asking the wrong questions."
A plumber is successful if he fixes your broken faucet and it doesn't leak. A financial advisor's success is never as black and white. Worse, the investor and advisor rarely define the benchmarks by which success will be measured ahead of time. Is the advisor successful if he beats the S&P by 2%? What if he charges 1% of your portfolio value and invests in high-priced mutual funds? Is he successful if he lowers your tax basis from the prior year? What if he recommends you to a great attorney? Have you even discussed it?
What if your advisor had your portfolio allocated into 60% small caps and 40% penny stocks? Sure, he beat the S&P, but was the risk profile of your portfolio only 2% more risky? Was your advisor successful? If you answer "yes," then it's time to ask "compared to what?"
Self-Directed Investments Outperform:
Success vs. risk doesn’t have an independent index for comparison. That index resides within you and your common sense.
In an often cited 2012 survey, a university study found that when investors used a financial planner or advisor, they achieved noticeably lower returns. The study concluded that the average individual investor was more effective than the financial planner at maximizing return.
Professors Andreas Hackethal and Michael Haliassos of Frankfurt, Germany found overall lower performance from advisor managed accounts. Bottom line, the study showed using financial advisors had 5% lower annual returns after fees than accounts that were self-managed.
How meaningful is 5%? Start with a typical $100,000 portfolio. Compounded over 30 years, a 7% return versus 12% yields a difference of $2.2 million. That means having only $660,000 in the bank instead of almost $3 million.
To Ditch, or Not to Ditch:
That said, should you abandon your financial advisor? Probably not, primarily because an advisor’s value should be measured in many more ways than just their investment performance.
Just like two heads are usually better than one, having diversified investment opinions is advantageous. Using the services of a financial advisor to ease you into retirement, provide tax advice, estate planning, and even to bounce investment ideas off of, is a good idea.
However, as Hackethal and Haliassos remind us, doing your own research and generating your own investment ideas is perhaps the most significant driver of success in a diversified portfolio strategy.
Your job is to keep your ears open, fill your investment opportunity funnel with as many ideas as possible, and then schedule regular meetings with Bob to get his feedback. By partnering with your advisor instead of depending on him, you will take your financial success to new heights.
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