How To Build Long-Term Wealth

by: EB Investor


Too often investors are focused on the wrong variables in seeking to build wealth for the long run.

It is important that investors follow a disciplined approach to asset allocation that seeks to manage risk and produce superior returns over the long run.

Personal financial advisors can be the key element in helping investors succeed over the long run.

Investment Principles

“Someone’s sitting in the shade today because someone planted a tree a long time ago.” - Warren Buffett

Whether you are starting out on a long-term path of investing or you have been doing it for some time, it is important to understand that there are certain time-tested principles that, if you can adhere to them, will lead you to win the game of investing over the long term.

Principle One: Avoid Behavioral Errors - Stay Focused On The Long Run

The first of these is the notion that the trajectory of mankind, and therefore capital allocation, is up. While there are any number of pieces of noise at any one time telling you to get out of the market, the axiom "this too shall pass" is apropos. The market rewards long-term investors, transferring capital from the impatient to the patient.

Benjamin Graham, the father of value investing, famously said, “The investor’s chief problem and even his worst enemy is likely to be himself.” Costly behavioral mistakes are likely to be the greatest stumbling block for most investors. Instead, investors need to keep their focus on their long-term goals and not be affected by the ups and downs of the market in the short run.

Principle Two: Triumph Of The Bullish Optimists

This brings us to the second principle: The only way for an individual to meet their long-term investment goals is through a diversified portfolio of equity securities. Holding fixed income securities or cash might make you feel good in the moment, but will most certainly rob you of your ability to build wealth over the long term. This is all the more true in our current low interest rate environment where much of the fixed income around the world is trading at negative or near zero yields.

This is a difficult concept for most investors to grasp but over the long run, the standard deviation of returns, commonly known as short-term volatility, smooths out and the long-term investor has turned a seed today into a beautiful tree tomorrow. Your investing life should be lived by principle and not swayed by the winds or the rain. This time is not different.

Principle Three: Keep Costs Within Reason

Principle three is to keep your costs within reason. Be sure to analyze an investor's total cost, and do not fixate on the expense ratio alone. Using low cost active management, with firms that have stood the test of time, and continue to hold large stakes in their own funds, provides you with a winning approach to asset management. Additionally, seeking out a qualified financial professional can actually enhance your wealth building over the long run. Be willing to pay for quality advice.

Principle Four: Work With A Qualified Wealth Manager

This brings us to principle four: Working with a qualified wealth manager. Using a qualified wealth manager just may be the key to investment success. Having an advisor who can keep you on a disciplined plan for investment management, and keep you from abandoning that plan at times of euphoria or pessimism, is key to your long-term success.

The myriad of issues most investors face can be overwhelming to even think about, let alone sit down and deal with. Working with a wealth manager can bring not only the expertise to professionally implement a detailed, goals-based financial plan, but also break down the giant issues hovering over your financial life and bring clarity for the future.

Principle Five: Follow The Research

Principle five is to follow the time-tested conclusions of research on what has worked in investing. Academic research has clearly shown a premium for multiple dimensions of stock returns. Overweighting the size, value, and quality factors, in particular, demonstrates robust return patterns over the long run. Including high quality, small cap, and value stocks in a portfolio will increase the likelihood that an investor will achieve above-average rates of return over the long run.

Now that we understand the why of investing, it is important to explore how to build the portfolio for the long run. The solution that has dominated conversations recently is to use low cost index funds. However if we take a long-term perspective of the markets, we will see why this is not the best approach for investors or for capitalism.

Index Funds Have Gone To Extremes

"It may be said, with some approximation to the truth, that investment is grounded on the past whereas speculation looks primarily to the future, but this statement is far from complete. Both investment and speculation must meet the test of the future; they are subject to its vicissitudes and are judged by its verdict. But what we have said about the analyst and the future applies equally well to the concept of investment. For investment, the future is essentially something to be guarded against rather than be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation, on the other hand, may always properly-and often soundly derive its basis and its justification from prospective developments that differ from past performance. – Benjamin Graham, Security Analysis

The trend over the past few decades has been towards lower cost investments. This has become an even more important factor over the past decade, and even more so the past few years. Lower cost mutual funds, and exchange traded funds have seen a migration of cash from higher cost mutual funds to lower cost products across the investment landscape. Research shows that there is nothing wrong with following a low cost investment strategy; in fact, cost is one of the most important factors in determining future investment returns.

However, the trend towards extreme low cost index funds is a bridge too far. They are a speculative instrument that Benjamin Graham has warned us to guard against. Investors may be saving a small amount on fees compared to a low cost active mutual fund, but they are losing the potential to have a great deal more wealth over the long run. A recent study by American Funds demonstrated this and further proves that managing downside capture and following a disciplined process of investment management are far more important than saving a few more basis points on an already low cost mutual fund or investment strategy.

"The individual investor should act consistently as an investor and not as a speculator." - Ben Graham

Recently even Jack Bogle has questioned whether Vanguard has gotten too big, now approaching the management of some $5 trillion in assets. Even worse is when you look across the index universe. The top three index providers are owning more and more of corporate America, giving index funds more power over shareholder proposals. This has real consequences for capitalism that more investors should be concerned about.

"Every new indexed dollar goes to the same places as previous dollars did. This "guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There's no valuation or other parameters around that decision,"… the result will be a "bubble machine"-a winner-take-all system that inflates already large companies, blind to whether they're actually selling more widgets or generating bigger profits. Such effects already exist today, of course, but the market is able to rely on active investors to counteract them. The fewer active investors there are, however, the harder counteraction will be." - New Yorker Is Passive Investment Actively Hurting The Economy?

A 2017 paper looked at the effect the big three - Vanguard, BlackRock, and State Street - have on corporate ownership and the creation of new financial risks for capitalism. The authors from the University of Amsterdam explore the challenges with passive investing being concentrated in a few firms, versus the advantages of competition and the fragmentation of active investing. Because active investing is more fragmented, it results in corporate ownership being spread around to dozens upon dozens of firms. This prevents any one firm from having potential undue influence over corporate management.

The authors state:

"When we talk about the power of large asset managers, we are concerned with their influence over corporate control and as such their capacity to influence the outcomes of corporate decision-making. Shareholders can exert power through three mechanisms. First, they can participate directly in the decision making process through the (proxy) votes attached to their investments. In a situation of dispersed and fragmented ownership, the voting power of each individual shareholder is rather limited. But blockholders with at least five percent of the shares are generally considered highly influential, and shareholders that hold more than 10 percent are already considered “insiders” to the firm under U.S. law. The growing equity positions that passive asset managers hold thus increase this potential power."

"The size of a node in the visualization can be interpreted as the potential shareholder power of the particular owner within the network of control over listed companies in the United States. Thus, when seen together, the Big Three occupy a position of unrivaled potential power over corporate America.

They conclude:

When Vanguard pioneered its index fund concept in the mid-1970s it was attacked as “un-American,” exactly because they held shares in all the firms of an index and did not try to find the companies that would perform best. Therefore, the new tripartite governing board of BlackRock, Vanguard, and State Street is potentially conflicting with the image of America as a very liberal market economy, in which corporations compete vigorously, ownership is generally fragmented, and capital is generally seen as “impatient.” Benjamin Braun has argued that passive investors may, in principle, act as “patient” capital and thus facilitate long-term strategies. Hence, the Big Three have the potential to cause significant change to the political economy of the United States, including through influencing important topics for corporations, such as short-termism versus long-termism, the (in)adequacy of management remuneration, and mergers and acquisitions. We reflected on a number of anti-competitive effects that come with the rise of passive asset management, which could have negative consequences for economic growth and even for economic equality. As well, we signaled how the continuing growth of ETFs and other passive index funds can create new financial risk, including increased investor herding and greater volatility in times of severe financial instabilities." (emphasis mine)

It is this herding concept that I have written about vigorously in my many pieces against indexing. By having investors pour more and more money into passively managed index funds, the herd creates serious challenges for asset pricing, portfolio management, and capitalism.

With asset pricing, the price of the firm no longer reflects the earnings value of the business. Index funds are buying securities simply because more cash is coming in, not because the firm is more valuable, as value is not a consideration of the index investor. This then pushes stock prices higher, which distorts the portfolio management process because investors may be exposed to severely overvalued stocks and be unaware, thus creating unmanaged risks in the index based portfolio model. The effects of capitalism have already been explored.

"Know what you own, and know why you own it." - Peter Lynch

In sum, the massive rush into index funds, is adding to an environment that remains risky as stocks continue to reach all time highs almost daily. As an example, movement of participants out of market indexes during a financial crisis will likely make drawdowns even worse as everyone has to sell the same stocks to fewer and fewer active investors who are willing to buy them.

"If everyone does (indexing), there will be no allocation of capital to the great, high-potential projects that feed right into fixing our country's long-term problems," said Kim Shannon, founder of Toronto-based Sionna Investment Managers at a 2012 National Club debate on the topic. "The inbound capital just follows market cap, and this is counter to what investing is supposed to be about - taking on risk and getting paid for it in the long run." I agree with her sentiment. Index investing is a growing threat to our economic system, because investors and investment managers are abdicating their critical societal role of allocating capital most efficiently." Brandes On Value

Indexing relies on past winners to continue to be winners. It seems to violate the central tenet of indexing itself, that just because an active manager did well in the past there is no guarantee that they will continue to do well in the future. Yet index fund investors are putting their faith in the companies with the highest market cap, assuming that what has done well will continue to do well. An investor's dollar in an index fund is thus allocated most towards the most expensive companies at the top of the index, and less towards the lowest market cap assets at the bottom.

Bill Ackman has discussed the concept of corporate control as well:

"If the index fund trend continues, and it looks likely to do so, what happens when index funds control Corporate America? Courts have often deemed shareholders to be in control of a corporation with as little as 20% of the ownership of a company. At current rates of asset inflows, it will not be long before index funds effectively control Corporate America and the corporations of many foreign countries. The Japanese system of cross corporate ownership, the keiretsu, has been blamed for decades of Japanese corporate underperformance and economic malaise. Large passive ownership of Corporate America by index funds risks a similar outcome without the counterbalancing force of large active investors and improvements in the governance oversight implemented by passive index fund managers."

(For a more detailed exploration of the topic please see my previous piece "The Danger In Index Funds")

I believe that investors are putting their long-term goals at risk by focusing on the wrong variables when engaging in the portfolio construction process. In all the talk about getting costs to bare bones levels, there has been little discussion about managing risk, the value of active management, and how best to invest to fund one's future goals.

I have written several pieces that have been critical of index funds. The response to these pieces is swift, often with the same robotic arguments that have been made by every index fund proponent, both the famous and the practitioner alike, but the reality remains for those willing to do the research and study research methodology that the majority of statistics used to prosecute the active fund community are quite suspect.

Comparing funds as a homogeneous group may make you feel good for confirming your choice to invest in a low-cost index fund, but it really provides very little actionable intelligence for investors who seek to make quality long-term investment decisions.

In response to most of my pieces, my critics are quick to tell me that I should stop advocating for high cost investments, failing of course to notice that I have never done this. In fact, I have advocated that investors follow a low cost approach to investing, but within reason.

The fact that you can gain access to the managers at PRIMECAP, Dodge & Cox, or Capital Group, just to name a few, for as low as 55 bps, is a steal in my book. Most of the funds and organizations I favor, or have written about, have low costs, high manager ownership, high active share, and histories that pre-date the trendy index fund by decades.

Dodge & Cox for example was founded in 1930, Capital Group was founded in 1931, Tweedy Browne & Co. was founded in 1920 and worked with both Warren Buffett and Benjamin Graham, the founder of value investing.

I like my mutual funds like I like my real estate investments. When looking for real estate, I like to buy houses in established neighborhoods with good schools and nice big oak trees. Investing is the same way. I want funds that have been through multiple market cycles, which have a disciplined approach to managing wealth, and which have significant manager ownership in the funds themselves.

One of the best examples of an exemplary fund management company is Capital Group, the parent of The American Funds. Charles Ellis wrote a fantastic book on Capital Group entitled Capital: The Story of Long-Term Investment Excellence, which I highly recommend. When we look at the data at Capital Group we see that the company has a long and distinguished record of not only beating the index, but providing investors with better long term risk-adjusted returns.

Capital Group also offers investors an opportunity to invest with a world class asset manager for low fees. The firm also has achieved outstanding long-term performance, with their equity mutual funds beating their Lipper Average in 98% of 20 year periods. That is far better than the often cited statistic by index fund proponents that index funds beat 95% of active funds. This statistic is so misleading because of the methodology of grouping all funds together. By doing this you compare apples and oranges, which offers investors little in terms of active intelligence.

“Mr. Buffett’s approach at Berkshire Hathaway has many similarities to how we at Capital Group have built the superior track record of the American Funds― through bottom-up investing, rigorously analyzing companies and building durable portfolios.”

― Tim Armour, Chairman and CEO of Capital Group February 2017

Theoretical Foundations of Manager Selection

"Successful investing is about managing risk, not avoiding it.

-Benjamin Graham

A recent paper by the storied investment firm, Dodge & Cox, sought to demonstrate the advantages of active management by compiling the work of academic researchers. In their research paper Understanding the Case for Active Management the team at Dodge & Cox found that:

"While many active equity managers do not outperform the market in any given year, there are a number of skilled active investment managers who have outperformed over long investment horizons. However, in order to benefit from this kind of long-term outperformance, investors must be prepared to take a long-term view and have the discipline to withstand inevitable periods of underperformance. Those who stay the course are more likely to achieve meaningful incremental results that accumulate over time. Academic and industry research has identified six attributes of active managers who have the highest probability of generating above-benchmark long-term results. This research has also confirmed that investors are well advised to take a long-term view, not only because few investors can accurately time the stock market, but also because few can effectively time their decisions to hire and fire investment managers."

They continue:

"An index fund is not risk-managed: It contains all of the issues-and all of the risks-associated with an index, such as the S&P 500. While the index fund manager is obliged to invest in companies presenting a wide range of risks, an actively managed portfolio can seek to avoid the securities that embody the greatest risks. This creates a level of potential downside risk protection that is not provided by a passive investment in an index."

An index fund's lack of price sensitivity when purchasing equities, means investors are buying more and more of a company's stock as the market cap increases. Investors should understand Warren Buffett's mantra of investing: price is what you pay, value is what you get.

Index investors are thus paying high prices, limiting their potential future return, and maximizing their risk. Therefore, an investment in an index fund, is nothing more than a sub-average return (after fees) for maximum risks. I don't think that is what investors, particularly retirement investors, want in their investment strategy. Further reason why investors should rethink the decision to move to index funds.

Dodge & Cox's research that active management's alpha is realized most in long-term performance periods, furthers the risks of making long-term decisions on how to invest based on short term performance of how a fund performed this year, or this quarter. The benefits of active management are many, and are realized most by investors who can commit to a disciplined process of investing for the long run.

The recent outperformance of index strategies, has caused investors to bail on active management at precisely the wrong time in the investment cycle. As opportunities to exploit inefficiencies in markets increase, disciplined active managers and their investors will benefit.

There is a body of research that provides a road map to picking a successful active manager. The first screen is for funds that can produce alpha, the second screen is to ensure that the alpha being produced is the result of skill and not luck. Once you have whittled the fund universe down to this select group of managers, we then go further by screening and analyzing a fund's characteristics.

The research clearly defines four characteristics of successful investment managers, which we will use to screen active managers down even further. Doing this type of extensive research and due diligence is essential to making effective investment decisions concerning the allocation of assets.

1. A Long-Term Focus That Keeps Turnover Low... Very Low

Funds that consistently turn over their portfolios are speculators, rather than investors. True investors depend on deep fundamental research, and value businesses in whole, purchase businesses at an attractive price and hold for the long run. Warren Buffett is probably the greatest example of this very passive approach to active management. Buffett bought Coca-Cola (NYSE:KO) for example in 1987, and has held it for 30 years. Coke has provided Mr. Buffett with a handsome return over that time period.

This explains the problem with active management as it is practiced today, how many funds can you name that are willing to hold a stock for 5 years, let alone 10, 20, or 30? I only know of a few firms that take this approach to active management. Most firms have held stocks for as little as less than a year to nearly 2 years; this is in my view pure speculation.

"Covering more than 20 years, the median holding period among mutual funds ranged as low as 0.9 year in the bubble year of 1999, eventually climbing to 1.7 years...Longer holding periods were “unconditionally” associated with better results, the study found, regardless of active share. Yet the only funds to show statistically significant outperformance combined high active share with long holding periods."

Research by Roger Edelen et. al. "Shedding Light on “Invisible” Costs: Trading Costs and Mutual Fund Performance" shows that the effect of turnover is even worse than we thought on investors' wallets. This is because the turnover figure fails to include market microstructure considerations of trading volume and per unit costs. When we adjust for these variables using their proposed method of position adjusted turnover, we find a more accurate effect of turnover on returns.

"...sorting funds on the basis of their aggregate trading-cost estimate yields a clear monotonic pattern of decreasing risk-adjusted performance as fund trading costs increase. The difference in average annual return for funds in the highest and lowest quintile of aggregate trading cost is –1.78 percentage points."

The authors are clear concerning the negative effect of turnover on the portfolio. Investors should, according to the literature, give preference to funds with the lowest turnover. Some consider turnover below 50% to be low, I do not. Funds with turnover below 30% are preferred, and funds with turnover in the single digits are ideal. When it comes to turnover, the lower the better. I own one active fund that had 1% turnover last year and is routinely in the low-single digits. These funds are the ideal.

2. Aligning The Interests Of The Fund Manager With The Shareholder

Many mutual fund managers take no positions in the funds they manage. I have to ask, what incentive does the manager then have to produce alpha? This further begs the question what is the link between fund manager ownership and fund performance? Ajay Khorana, Henri Servaes, and Lei Wedge explored this link in their 2007 Journal of Financial Economics paper "Portfolio Manager Ownership & Fund Performance" they found:

"For every basis point of managerial ownership, excess performance of the fund improves by about 3-5 basis points.”

Their research delineates a clear linkage between manager ownership and fund performance. For investors considering active management, the research proves funds with significant manager ownership are preferred over those with lower management ownership.

3. Fund Family Focused On True Long-Term Investing

When searching for a fund family for consideration, a strict screen that analyzes qualitative factors is just as important as all of the quantitative analysis. Analyzing a firm for culture, investing philosophy, and most importantly, fund creation strategy, are all integral parts of the decision-making process. Fund families that operate an endless number of funds are likely interested in asset gathering and speculation, rather than true investment management. Funds that instead focus on a specific strategy and have a limited number of product offerings tend to perform better.

In the paper "Why Focus? A Study of Intra-Industry Focus Effects," Nicolaj Siggelkow (Wharton) found that U.S. mutual funds managed by firms with a limited set of strategies had higher returns than funds with similar investment objectives that belong to more asset gathering focused fund providers.

"We find that the performance of a mutual fund improves with overall family focus, and in particular with the fund family's degree of focus on that funds category."

Vikrum Nanda (Michigan), Z. Jay Wang, and Lu Zheng explored this question further in their 2003 paper "Family Values and the Star Phenomenon: Strategies of Mutual Fund Families." They found successful fund families with a small number of funds outperformed fund families with larger quantity of funds by 2.5% per year.

We can see from the research that fund size matters, as does the firm's focus on a specific strategy. Fund families with an intense focus and a historical record of staying focused on a specific strategy are preferred to fund families that attempt to offer everything under the sun in an effort to gather as many assets as possible.

4. High Active Share

The active/passive debate and the entire discussion surrounding active management needs to be reframed. Martijn Cremers (Mendoza) and Antti Petajisto explore the spectrum of active management in their 2009 paper, "How Active is your Fund Manager? A New Measure That Predicts Performance." Active and passive are two ends of a spectrum of asset managers as you can see in the quadrants on the graph below.

They found the following in terms of the importance of having high active share:

"Active management, as measured by Active Share, significantly predicts fund performance relative to the benchmark. Funds with the highest Active Share outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses...We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum."

This study clearly shows the importance of high active share when selecting active managers.

The partnership of Tweedy Browne & Co., who have produced 534.36% alpha for investors since 1993, is a great example of an exemplary manager. A comment in their recent report sums up this section on manager selection and the argument for the art of real investing in its purest form:

"...we have great admiration for people such as Jack Bogle and Warren Buffett, and perhaps would agree that, in terms of “real” returns, active management is a loser’s game for most, it is not a loser’s game for all. In a recent interview with Bloomberg, Larry Fink, the founder and chairman of BlackRock, expressed a similar sentiment:

I do subscribe to the belief that investing is no different from baseball. Let’s say you have a thousand baseball players. The majority hit .250. We’ll have 45 who hit .300 and we’ll have 10 to 15 who can hit consistently over .300. I don’t believe investing is much different…

The records of many pure adherents to Benjamin Graham’s value based approach over the years are proof of this. At the end of the day, we are comfortable with what we own, the risks we are taking, and the long-term returns we have produced for our shareholders, and this has allowed us to stay the course – which is perhaps the most important thing when it comes to building wealth. While there are no guarantees in the investment business, we remain optimistic and are “tied to the mast,” with over a billion dollars of our own money – that of our current and retired managing directors, employees and their families – invested in portfolios combined with or similar to those that our shareholders own, including over $200 million in our Funds." Partners, Tweedy, Browne & Co.

Portfolio Construction: Invest For The Long Run

"The single greatest edge an investor can have is a long-term orientation.” -Seth Klarman

There are few books on my shelf I value more than those by long time financial writer and practitioner, Nick Murray. His most popular work, Simple Wealth, Inevitable Wealth, has come out in multiple editions, but its principles are timeless. Murray urges investors to follow a long-term investment plan, ignoring the ups and downs of the market.

He also talks about the importance of total equity portfolios, and reminds us that equity ownership in businesses is what builds wealth over the long run. Including bonds in that mix is not about building wealth as much as it is a tool used to meet the behavioral anomalies of investors. Holding a slug of your wealth in bonds is likely to make you feel better, but it will do little to grow your nest egg, Murray argues.

“On which end of your investing lifetime do you want your insecurity, so that you can have security at the other end?...The greatest long-term financial risk isn’t losing your money. It’s outliving your money...There is no such thing as no risk. There’s only this choice of what to risk, and when to risk it.”

I believe that investing for the long run means owning a portfolio of equities from around the world made up of three basic types of stocks. The first section are stocks that are generally high quality blue chip dividend payers. Many have paid dividends for decades and have a history of growing their dividends over time. This section of the portfolio will have a high quality, large cap, and value tilt.

The second section are companies that are severely undervalued, or are compounding earnings at a higher rate than their peers. It is important in this section of the portfolio to own companies from the mid, small and even micro-cap sections of the market. Research has shown a premium for small cap stocks, over large cap stocks over long-term measurement periods. While this section of the portfolio can be a mix or growth and value stocks, it can most aptly be described as growth at a reasonable price.

The third section are companies from overseas. The international section of the portfolio should be diversified into both developed and emerging markets, and carry a high quality and small cap tilt. Small cap international stocks, tend to be more centralized in the specific markets they do business. So for example, a French market chain is reliant on French consumers providing direct exposure to the French market. Larger competitors that may compete across countries and regions, will be competing in similar spaces as U.S. companies. This provides far less diversification for the U.S. based investor.

Finally, holding cash to the extent that an investor may need to draw from their funds is important to ensure that investors are not tempted to sell their equity investments in a draw down, or for living expenses in the case of a retiree.

More than cost, more than which funds you use, more than anything, it is important that you manage your emotions over the long run. Ultra high net worth investors tend to think in terms of generations, and thus the ups and downs of the market in the short run are less important. Young investors who are investing for a long-term goal such as retirement should be no different.

A 25 to 35-year-old has potentially 65 to 75 years to invest, being preoccupied with what the market does this week, this month, or even this year is of little consequence to meeting your long-term goals. Make a plan with a qualified wealth manager, and then stick to the plan in good times and bad. Small consistent efforts, month after month, year after year, decade after decade, are how fortunes are built.

The Importance of Financial Advisors In Wealth Building

"Future investment earnings and interest and inflation rates are not known to anybody. However, I can guarantee you one thing.. those who put an investment program in place will have a lot more money when they come to retire than those who never get around to it."
-Noel Whittaker

The great trend these days is going it alone in investing. Investors are convinced that they can merely invest on their own, and have no need for a financial advisor. One couple I know felt this way, and everything was going just fine, until 2008 hit: They tried to stay the course, even adding to their investments initially; then with the market falling 700+ points a day, their resolve weakened, and with no one to guide them they made a fatal mistake, and pulled all their money out of the market, sure that the entire U.S. financial system was going to collapse.

In doing this, they locked in those losses, and even worse, they were so shell shocked by the experience they continue to be out of the market, choosing to hold their money in safe CD's at the local bank. That moment when they needed a coach - someone to hold their hand through the difficult time - they were all alone. That one decision to go it alone, has cost this couple hundreds of thousands of dollars in wealth that would have been created had they just stayed the course.

Most investors would benefit from working with a financial professional who has a deep understanding of the financial planning process, takes an active interest in you and your personal goals for your money, and most of all can help you create a financial plan, and then ensure that you stick to it when Mr. Market turns against you by either becoming too exuberant or too pessimistic.

Research has demonstrated the value of financial advice. A 2016 article in Barron's by Dr. Daniel Crosby entitled "Behavioral Alpha: The True Power of Financial Advice," laid out a persuasive case for the value of a financial advisor and the benefits to investors. It is an excellent piece, and while I have included a large quote from the piece below, I encourage all investors and especially financial advisors to read the piece in full; it is an excellent analysis of the value of using a financial advisor.

"In a seminal paper titled, “Advisor’s Alpha,” the famously fee-sensitive folks at Vanguard estimate that the value added by working with a competent financial advisor is roughly 3% per year. The paper is quick to point out that the 3% delta will not be achieved in a smooth, linear fashion. Rather, the benefits of working with an advisor will be “lumpy” and most concentrated during times of profound fear and greed."

Further evidence of advisor efficacy is added by Morningstar in their whitepaper, “Alpha, Beta, and Now…Gamma.” “Gamma” is Morningstar’s shorthand for “the extra income an investor can earn by making better financial decisions” and they cast improving decision-making as the primary benefit of working with a financial advisor. In their attempt at quantifying Gamma, Morningstar arrived at a figure of 1.82% per year outperformance for those receiving advice aimed at improving their financial choices. Again, it would seem that advisors are more than earning their fee and that improving decision-making is the primary means by which they improve clients’ lives.

Research conducted by Aon Hewitt and managed accounts provider Financial Engines, also supports the idea that help pays big dividends. Their initial research was conducted from 2006 to 2008 and compared those receiving “help” in the form of online advice, guidance through target date funds or managed accounts to those who “did it themselves.” Their finding during this time was that those who received help outperformed those who did not by 1.86% per annum, net of fees.

Seeking to examine the impact of help during times of volatility, they subsequently performed a similar analysis of “help vs. no-help” groups that included the uncertain days of 2009 and 2010. They found that the impact of decision-making assistance was heightened during times of volatility and that the outperformance of the group receiving assistance grew to 2.92% annually, net of fees. Just as was suggested by Vanguard from the outset, the benefits of advice are disproportionately experienced during times when rational decision-making becomes most difficult.

We have now established that financial guidance tends to pay off somewhere in the ballpark of 2 to 3% a year. Although those numbers may seem small at first blush, anyone familiar with the marvel of compounding understands the enormous power of such outperformance. If financial advice really does work, the effect of following good advice over time should be substantial and indeed the research suggests that very thing."


In this piece, I have reviewed the importance of disciplined investing for the long run. I have gone over a set of investment principles to aid investors in creating a financial plan that works for them. I have also explored some of the challenges with index fund investing, and why active management offers long-term investors several benefits that owning an unmanaged index simply cannot provide. I also have explored the central role of a financial advisor in helping investors build wealth over the long run.

I close this piece with a wonderful analogy for long-term investing that Nick Murray uses in his book "Simple Wealth, Inevitable Wealth." Investors would be wise to follow its lessons. Those who commit to a long-term investment program and can stay the course through good times and bad, will be surprised to learn that their long-term investment focus has created a fortune and changed their family tree for generations to come. Focus on the long run, and ignore the short term - it's mostly noise anyway.

“You plant [a tree] in the earth, and a wonderful force of nature causes it to take root, and to grow. You don’t have to do much with it: the air and the water and the nutrients it needs are all around the tree, and it knows how to use them.

You don’t dig it up every 90 days to check on its progress. (Nothing much will have changed in that brief time, and you might harm the tree). You don’t uproot the tree and store it in your garage over the winter, to protect it from what you regard as bad weather. (Though its leaves fall and it stops growing for a season, the tree itself does not die. And even leafless, the tree is still producing oxygen, without which you and I could not live.)

Give the tree enough room, enough light, and enough time. Then leave it pretty much alone. It will give you back air and shade and beauty as it grows – and will go on doing so for your children, after you’re gone.”

-Nick Murray


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.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.