Wednesday, February 23, 2011

Why Financial Advisors Are Like Weight Watchers

Recently Free Money Finance had an article that was very anti-financial planner.  Specifically I am referring to this post regarding a financial advisor who, in the opinion of author, is charging too high a fee:

He's an investment advisor, so it was natural for me to ask him about what his firm does. Here's what he said (paraphrasing as I remember it):


"We educate investors about the stock market..."

Like that!

"...and let them know how index funds represent a better way to invest..."

Love that!

"...because they have lower fees..."

Oh yeah...

"...and offer superior returns over the long term."

Yes!!!

He and I were tracking 100% on the same path. I then asked about specifics -- what index funds he used, what the costs were, and how he got paid (I was thinking of potentially having him manage some of my money). It was then when I found out that he was using a proprietary set of funds (not his own but run by another company) and that the fees for both his services and the funds were "around 1%."

Uh-oh.

As you can see, the author believes that charging a 1% fee to invest in index funds is outrageous.  After all, you can go to Vanguard and find index funds which cost only 0.2% or less.  Why would you pay 1% for the same product?

The thing that the author is missing is that, yes you can construct a portfolio of index funds yourself, but some people need help.  They may need help deciding what types of index funds to use.  They may need help with their asset allocation.  However, the biggest service that a financial advisor provides isn't investment selection.  It is to give people the willpower to "stay the course" and stick to the plan.

As we have seen, the biggest mistake that people made during the recent financial crisis is bailing out at the market low which, of course, is the worst time to bail out.  A financial advisor helps people avoid this mistake in two ways:

1. Assessment of Risk Tolerance:  Simply put, a financial advisor will talk to his/her client and determine how much risk a person is willing to take and still be able to sleep at night.  This is an area where most people don't do a good job self-assessing.  When markets are booming, we are willing to take on more risk because things look so good.  Consider how many people sunk tons of money in risky real estate ventures during the mid-2000's because things looked so good.  Consider how many people sunk tons of money in risky dotcom start ups during the late 1990's because thingsd looked so good.  When things fell apart and people bailed, they realized that they couldn't stomach all that risk.  Sometimes you need a dispassionate third party to help assess how much risk you can really stomach.

2. Courage to Stick to the Plan:  This recent article on Yahoo! Finance discusses how Baby Boomers are falling short in their retirement savings.  It gives several examples of people who lost a big chunk of their savings during the recent bust.  One common thread is that people saw their investments dropped, moved most of their savings out of stocks, and then missed out on the bull market of the past two years.  A good financial advisor should have been able to talk them off the ledge and encourage them to stick with their plan.  A good financial advisor would be able to use the perspective of history to inform their clients that markets go in cycles, and that even though things look bleak now, a dip in stocks is also an opportunity to get in on the ground floor of something good.  Historically, big dips are often followed by big gains, and those big gains are what grow your wealth. 

A good financial advisor is like Weight Watchers.  You can lose weight on your own.  The formula is not that difficult:  eat less, exercise more.  However, in practice it seems like applying this supposedly simple formula is not that simple.  Witness all of the people who have trouble with losing weight.  That is where Weight Watchers comes in.  Weight Watchers' system is basically this simple formula dressed up with some bells and whistles.  However, the secret sauce of Weight Watchers is the weigh-in.  On a weekly basis, participants attend a weigh-in meeting where they meet with a coach and other dieters, share tips, and generally get the psychological support and positive reinforcement to keep them on track.

Now some people don't need all of the extra support that Weight Watchers provides.  They are perfectly fine going it alone, and they are successful and keeping the weight off.  However, there are a large number of people who need this additional help to keep them on track and stop them from deviating from their plan.  Likewise some people don't need a financial advisor.  They can formulate their own investment plan and execute it successfully.  However, there are a lot of people who need the extra support that a good financial advisor provides.

Yes, that extra 1% in fees may seem excessive to the "go it alone" person.  However, if it prevents somebody from panic selling and missing out on a 100% gain, then it is 1% well spent.

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