Can You Afford The Costs Of Do-It-Yourself Investing?

| About: Vanguard S&P (VFINX)


Do-it-yourself investing has become an increasing popular option.

The DIY approach is rooted in the failure of many advisors/brokers to truly help investors and the rise of online services making it easier to go it alone.

Many DIY investors believe they are saving advisory costs by going it alone, but instead are costing themselves many times a good advisor's fees due to poor decisions.

Do-it-yourself investing is becoming an increasingly popular option for people. The rise of technology and access to online services that allow you to invest on your own has been widely embraced. Many financial advisors have helped to accelerate this trend by alienating investors - putting their own compensation and market efforts ahead of client outcomes.

More specifically, selling high-cost products and claiming to provide services (security selection and market timing) they cannot possibly hope to perform successfully (but that investors want to believe is possible). What's more, investors are becoming increasingly aware of their investment costs, and avoiding the fees that an advisor charges is the easiest way to do this.

But would investors be so inclined to go the do-it-yourself route if they knew how to find a good financial advisor and learned that this approach could possibly save them many multiples of the fees they pay? I'm not so sure they would. What are the ways that financial advisors can add value to their clients beyond a self-directed approach?

Before I get into the details, I want to be careful to make a distinction on financial advisors. Here I am only referring to fee-only (no commission), Registered Investment Advisor (RIA) firms that have a fiduciary responsibility to put their clients' interests first. As we'll see, this isn't the be-all and end-all for finding a good advisor, but it's a good start.


Despite investors trending towards the use of fewer actively-managed approaches (stock picking, market timing, buying actively-managed funds), the vast majority of investment dollars still resides in these failed approaches. Unfortunately, the long-term evidence* finds that active management underperforms a basic index fund by 1% to 2% a year over time.


1984-2015 Annualized Return

Actively-Managed US Stock Funds


S&P 500 Index


By avoiding active management and embracing a more diversified, broad-market approach to investing, an advisor can help you keep 1% to 2% per year more of your returns.


Most do-it-yourself investors go out of their way to avoid losing money in the short run instead of positioning themselves to maximize their long-term portfolio growth, which is essential for attaining sufficient retirement balances or avoiding purchasing power erosion in retirement.

This typically takes the form of excessive amounts of cash and bonds compared to stocks in portfolios. Stocks, the thinking goes, are OK for investors with extremely long time horizons, but for investors who plan to retire or are already in retirement, they are too risky for a serious or permanent commitment. The evidence finds this is completely backwards.


Frequency of Higher-Stock Mix Outperformance

Average Annualized Outperformance

100% S&P 500 vs. 65% S&P 500, 35% 5-YR T-Notes



65% S&P 500, 35% 5-YR T-Notes vs. 35% S&P 500, 65% 5-YR T-Notes



The chart above looks at all 20-year rolling periods from 1926-2015. Investors who are saving for retirement should realize that all-stock portfolios have routinely outperformed allocations with 30% to 40% in bonds (a typical "age-in-bonds" approach), and the average outperformance over 20-year periods is +1.6% per year. Investors who are in retirement might be surprised to learn that stock-oriented asset allocations outperformed portfolios that were more bond heavy almost 99% of the time, by an average of +1.7% per year.

An advisor who helps you look past short-term market movements and focus on a portfolio policy that has historically maximized your long-term wealth within reasonable risk levels can help you achieve 1% to 2% per year higher potential returns.


Using market index funds in your portfolio is obviously superior to trying to pick stocks, timing the market or buying actively-managed funds. But too often, do-it-yourself investors restrict their index choices to the large cap, blue chip stocks that dominate "total" market indexes and forego the potential for higher returns from smaller and more value-oriented stocks.

Some think that adding small/value stocks to their portfolio leads to unnecessary risks. In reality, most of their additional stand-alone risks get washed away in a diversified portfolio, leaving only the higher returns. See the comparison details here, reported in the table below.


1996-2015 Annualized Return

1996-2015 Volatility

All-Stock Index Mix*



All-Stock "Asset Class" Mix*



By diversifying your index-based portfolio more broadly across US and non-US value and small cap asset classes, you've historically been able to achieve 1% to 2% annualized higher-than-market returns without taking significantly greater portfolio risk.


While many do-it-yourself investors feel they can design a reasonable asset allocation using low-cost index funds, many get tripped up by the tax and estate implications of how they implement their plan. In general, you can avoid unnecessary taxes and earn higher long-term returns by placing tax-efficient stock funds in taxable accounts and tax-inefficient bond funds in IRA accounts.

The IRA shields investors from paying yearly taxes on bond interest at ordinary income tax rates, and prevents high-income investors from having to accept lower (pre-tax) returns on municipal bonds held in taxable accounts. Slower-growing IRA accounts (due to lower returns on bonds compared to stocks) also reduce the amount of future required minimum distributions beginning at age 70 1/2 that are also taxed at ordinary income levels.

From an estate/legacy perspective, this approach also helps to maximize the amount of wealth you can pass on to your loved ones or other groups of interest. If required minimum distributions are not needed for income (because of other cash flow sources), the law allows you to make charitable contributions from your IRA that avoids income taxes. By locating more of your stocks in taxable accounts, you position yourself to achieve a higher long-term rate of return and a "step up" in cost basis when you pass away.

This means your heirs will have to use less of their inheritance to pay taxes and will be able to keep more of the wealth you've passed on to them. What's more, with your slower-growing, diminished IRA balance representing a relatively smaller part of your financial legacy, your heirs will owe less ordinary income tax on the continued forced withdrawals from these accounts.

While every situation is unique depending on goals, asset allocation and account structure, it's not hard to see how smart tax and estate planning, in conjunction with a qualified CPA and estate attorney, can net you an additional 1% to 2% per year greater wealth over time.


It's an unfortunate reality that even smart investors who are able to do most of the mechanical aspects of investing well still struggle with the emotional element of managing a portfolio. Investors tend to be overconfident in their decisions, overweight recent events ("recency bias") when managing their portfolios, have an aversion to short-term risks (and ignore the more important long-term ones) and often have an illusion of control.

These heuristics often lead to poor decisions during periods of market uncertainty, and studies have found that investors' returns are 1% to 2% per year less than the investments they own. John Bogle, Vanguard Funds founder and champion of do-it-yourself investing has admitted as much.

In a study covering the period from 1997-2011, he found that investors across US large cap, mid cap and small cap funds as well as international funds achieved returns that were 2.2% per year lower than the funds themselves (page 113 "The Clash of Cultures"). Investors captured only about 60% of the returns available to them after controlling for their own bad behavior!

One thing I should add to this point: no one likes to admit we have fallen victim to these shortcomings. That's because we have a blind spot when it comes to our own abilities or inabilities with investing. While it's relatively easy for us to spot mistakes that other people make, we have a very difficult time seeing them in ourselves. A classic example comes from Cass Sunstein, co-author of a book on behavioral economics.

Though a recognized expert on human behavior, he was still unable to apply his knowledge to his own portfolio situation, bailing out of stocks in late 2011, just before a surprise market recovery that cost him a considerable percentage of his wealth. You can read the full article here, which originally appeared on Bloomberg but has mysteriously been taken down.

No matter who you are, experienced or novice, young or old, there's a good chance that you will make at least one, if not a series of regrettable mistakes when it comes to managing your portfolio - mistakes that an advisor who knows you, your goals and how your investment plan relates to those goals can help you prevent through regular ongoing dialogue, reviews and well-timed infusions of perspective, rationality and confidence. Avoiding these bad decisions can help you earn another 1% to 2% per year compared to what you would achieve on your own.


All told, there are several ways an independent, fee-only advisor can help you achieve better results with your wealth compared to you investing by yourself. If you struggle with just one of these areas, you will wind up costing yourself as much or more than the expense of an ongoing advisory relationship. You won't save yourself the advisory fee; you'll pay far more in explicit costs based on less-than-optimal decisions and implementation.

What's more, think about the time you spend on investing activities and the burden you place on family members or loved ones who would have to take over in your absence. Working with a financial advisor can also provide you the freedom to pursue more rewarding aspects of life than pouring over investment books and online forums, and the peace of mind to know you have a plan and investment portfolio that is well designed for your personal circumstances - a plan that isn't predicated solely on your health or your personal insights for success.

While we can quantify the cost of do-it-yourself investing to be several percentage points more per year than the expense of hiring an experienced, fiduciary-minded financial advisor, the quality of life and consistency that an advisor partnership affords you and your family might be the most important benefit of all.


Source of data: DFA Returns Web

* "Mutual Fund Performance Through a Five-Factor Lens," 2016 DFA Working Paper.

* All Stock Index Mix = 70% Vanguard 500 Index Fund (MUTF:VFINX), 30% Vanguard Total Int'l Stock Index (MUTF:VGTSX), rebalanced annually.

* All Stock "Asset Class" Mix = 21% Vanguard 500 Index Fund, 21% DFA US Large Value Fund (MUTF:DFLVX), 28% DFA US Small Value Fund (MUTF:DFSVX), 18% DFA Int'l Value Fund (MUTF:DFIVX), 12% DFA Int'l Small Value Fund (MUTF:DISVX), rebalanced annually.

Past performance is not a guarantee of future results. Index performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

Disclosure: I am/we are long DFLVX, DFSVX, DFIVX, DISVX.

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

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