The Trouble With Investors And Investment Advisors

by: SA Gil Weinreich

Summary

Investors have abysmal track records, damaging themselves by neglecting their own best interests.

They must ask whether their behavior is calculated to achieve long-term safety and long-term returns while addressing immediate needs and opportunities.

The method of accomplishing this is called financial planning, and only a segment of the advisor population maintain this financial planning focus.

Many investors and many investment advisors seem to share one very bad trait in common: They don't always have the investor's best interests at heart.

That would have to be this author's biggest takeaway after six months of curating the Financial Advisor's Daily Digest.

Noting that Seeking Alpha's 5 million-plus user base contained a significant cohort of financial advisors (some 162,000), we initiated this forum for advisors to talk amongst themselves about the various concerns of their profession - client service, portfolio management, financial planning, practice management, compensation and more.

As it evolved, the daily digest came to attract many non-professional investors as well - both advised and unadvised. The combination has sharpened debate in the ensuing discussions focused heavily on the need for and value of an advisor.

From the perspective of many investors, financial advisors serve merely to diminish their clients' rate of return since they offer no secrets that will enable their clients to reliably beat the market. Numerous commenters have indicated it is the goal of their research on Seeking Alpha to maximize returns, but if they were not so engaged, they'd rather buy an index fund and get the market return rather than something less than the market return via an advisor.

Financial advisors tend to have the opposite perspective, noting that investors usually end up with rates of return far below those of the market because they bow impulsively to fear and greed, thus selling low in panics and buying high in a rising market.

So who's right? My own long experience covering the industry suggests that both are (which is to say that both are wrong). Dalbar's annual investor surveys have repeatedly shown that equity mutual fund investors capture some unwholesome fraction of the return of the most common industry benchmark, the S&P 500. So while that index eked out a return of 1.38% last year, the average equity mutual fund investor lost 2.28%, a gap of 3.66%.

The 20-year gap was about the same, 3.52%, with the benchmark returning 8.19% compared to investors' 4.67%. Other studies, though designed differently, exhibit the same general conclusions. Depending on the starting investment amount and time horizon, investors' final retirement portfolio is likely to be substantially lower than it might otherwise be as a result of investor misbehavior.

Meanwhile, financial advisors have not always covered themselves with glory either. Wall Street is in the business of making money, and they enlist the people they hire as financial advisors to distribute their products to the investing public. Many of those products - from ordinary mutual funds to exotic ETFs - perform poorly because of high fees, high risk or both.

But it's not just mediocre products but sometimes defective ones (like conflicted research or auction-rate securities which took center stage in financial crises past) which advisors have peddled to unsuspecting clients. And it has not infrequently been the case that the firms have misled their own advisors as much as they have the general public.

So what are investors to do if both they and advisors have performed sub-optimally? (Though I have heard from a source I believe to be reliable - without having verified the claim - that investors with mediocre advisors still come out ahead of DIY investors.)

The answer, I believe, is for investors to take their own best interests to heart. If they did so, they could assure themselves of more satisfying outcomes - through their own efforts or with the help of a good advisor.

The way to do this, I would argue, is to take a long-term approach to planning one's life by seeking long-term safety and long-term returns all while addressing immediate needs and opportunities. The method of accomplishing this is financial planning, and the professionals who can genuinely help with all this are called financial planners.

One of the problems with the investment industry is that it is heavily geared to products that investment representatives can sell. So advisors will sell stocks to achieve returns and bonds to achieve safety. But I would argue that owning a home is a more fundamental item on the safety checklist that should precede stocks or bonds.

When the home is eventually paid off, its owner will not have to pay rent, and up until that time, the homeowner has the ability to stabilize his "rent" through a fixed mortgage payment and property taxes. What's more, homes are tax-favored vs. bonds, which are mostly taxed at the highest, ordinary income-tax rate.

Homes offer a certain measure of safety, but for a lower level of return. To achieve high returns, investors need to take high risk. Stocks are one way to do this. A good financial planner will understand, and include in the planning equation, that an entrepreneurial client's business might also entail high risk and high return.

The third arrow in the investor's quiver is liquidity, which is needed to take care of emergencies (so as not to have to sell an asset under pressure), and for opportunities (to buy stocks, businesses, land or whatever) when others might be selling under pressure at favorable prices. Since, as we've discussed, most investors don't think long term, most lack this kind of financial planning preparation, leaving a minority to prosper from the majority's improvidence.

Wise investors, or their wise planners, will recognize the need to balance the investor's needs for safety, returns and liquidity. That means for example that if an investor is presented with a unique high-return investment opportunity - a hot IPO or an established stock selling at a fire-sale price - one must act with restraint, keeping each of the three categories intact. "Don't bet the farm," as the saying goes. You need that farm - your productive assets, whatever they may be - to earn your living (and to fund your ongoing investments).

Wise investors, or their wise planners, will similarly recognize a distinction between expenditures for durable and disposable items, keeping a lid on the latter. Saving for vocational training or a car needed for transportation, for example, should take precedence over non-essential entertainment or extras.

An investor who enjoys thinking through these issues can certainly do so unaided by an advisor. An investor who stumbles in these areas and who could benefit from an outsider's discipline and perspective should recognize the value in having regular access to this kind advice since there will always be new challenges and opportunities to discuss. In that scenario, paying for such a valuable service is no different from someone who is not mechanically inclined bringing his car into an auto shop.

Put another way - since a car is seen as a necessity while financial advice is seen as a luxury - how many parents will pay for parenting advice? Sure, they could (must) do it themselves, as it were, or read books. But usually a parent will come to see that in certain difficult situations, it helps to get an objective perspective.

After exhausting the free advice of friends, relatives, teachers and neighbors, in some circumstances paying to consult with certain kinds of experts may prove to be the best investment parents can make for their child.

Investors blessed with a long-term focus, discipline and a good track record will likely continue to prosper. Those who lack these qualities would do well to put their due diligence not into picking stocks but into picking an advisor with a financial planning focus, integrity and compatibility.

And advisors need to ask themselves whether their approach genuinely leads to the long-term betterment of their client and consider whether they need to make an investment of their own - in their clients, careers and in the knowledge needed to see both of those thrive.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.