On Monday, I asked readers to consider whether even index investors would benefit from the services of a financial advisor. Most of those who left a comment seemed to agree that the right advisor could add value, although committed DIY investors expressed their doubts.

The most interesting response I received came from a financial advisor with a major financial institution. While he has to remain anonymous—compliance departments don’t like their advisors spouting off on blogs—he gave me permission to publish his thoughts.

This advisor advocates using passively managed funds, but feels that his role is about much more than building portfolios:

Dear Dan,

I thought I would poke my head up and enter into this emotionally charged debate about whether an advisor’s fee is worth it. As with all the big questions in finance, there is no black or white answer: it comes down to what colour of grey you can stomach.

Let’s start with the facts, since they pack less of an emotional charge. At first glance, the data do not look good for advisors. In their paper What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?, John Chalmers and Jonathan Reuter looked at participants in the Oregon University System’s Optional Retirement Plan. Some of the investors in this plan used full-service brokers, while others used the default investment options and received no advice. Chalmers and Reuter found that the broker clients underperformed the non-advised investors by approximately 2% per year on a risk-adjusted basis. They also found that the advised clients were just as likely to chase returns when allocating their initial contributions.

So is the debate settled? Maybe not. I would argue that the broker clients in this study were receiving investment guidance, not advice. This may seem like semantics, but I think it’s where most of the confusion and disappointment comes from.

Guidance is not advice

To understand what I mean by investment guidance—and why I agree it’s usually not worth paying for—I’ll quote Brad Steiman, who heads up Dimensional Fund Advisors in Canada: “The vast majority of advisors I encounter tend to act as financial realtors by driving their clients around the capital market neighbourhood and showing them different portfolios. While touring the neighbourhood they may bring up considerations such as cost, tax efficiency, diversification, or concentration, and when all is said and done, their client chooses the portfolio he can live with, often as a matter of personal preference. In the extreme case, the tour is foregone entirely, and the client, or more specifically the ‘customer,’ simply says which portfolio he wants to buy and asks to have the paperwork drawn up.”

Most of your readers seem to be running from this kind investment guidance, and I would side with them. If all your readers need is a properly designed portfolio, they can use one of your Couch Potato models. For the non-advised investors in the Chalmers and Reuter study, the default choice was a similarly well designed mean-variance portfolio that was automatically rebalanced. There is evidence that investors who use these default investment choices in employer retirement plans tend to have enormous inertia, which in this case worked in their favour.

Unfortunately, most people do not invest like that. A study by Werner De Bondt informs us that individual investors display excessive optimism, are overconfident, downplay the importance of diversification, and reject the trade-off between risk and return. All of these traits show up in the dividend debate that was waged on your site and in those who raised their hands at your investment seminar when you asked them if they beat the market.

Bernstein’s DIY checklist

In an earlier post, you mentioned William Bernstein’s conclusion that “only a tiny minority will ever succeed in managing their money even tolerably well.” Bernstein writes that successful investors need at least four qualities: a genuine interest in investing, the horsepower to do the math, a working knowledge of financial theory and history, and “the emotional discipline to execute faithfully, come hell, high water, or Bob Prechter.”

Your readers should ask themselves if they possess all four of these qualities. If not, then paying for financial advice—as opposed to financial guidance from someone who will just drive them around the neighbourhood—may be the wisest choice they ever make.

I believe there will be a peaceful resolution to the debate between the advisory community and individual investors. As your readers are finding out, passive funds and mean-variance portfolios are tools that allow us to defeat a lot of our behavioural biases. If you combine an advisor who knows how to use these tools with a client who understands how powerful they are—well, it’s not perfect, but it’s the best shot any of us has.


The Optimist