Behavioral Finance and the Impact of Financial Advice
We wrote our behavioral finance series to raise awareness about the impact our psychological biases have on investment decisions. However, one might reasonably ask, “Why is this important and what is the larger context?”. The reality is that most people are not undone by one catastrophic financial misstep. In fact, they gradually fall behind due to recurring small errors with a few larger mistakes mixed in for good measure. Ernest Hemingway said it best, “How do you go bankrupt? Two ways. Gradually, then suddenly.”
Financial Advice Pays
Is paying for financial advice really worth it? If you can trade for free, and source investment ideas from social media, what is the purpose of engaging with an advisor? It is a fair question and one that should be considered carefully. Throughout our series, we pointed to specific examples where investors made significant mistakes due to their biases. While this anecdotal evidence is interesting, a more quantitative, rigorous analysis is warranted.
In a seminal paper written in 2001 titled, “Advisor’s Alpha,” Vanguard Investments evaluated this question head on. Ultimately, they estimate that the value added by working with a capable financial advisor is approximately 3% per year. It bears mentioning that the 3% delta will not be achieved in a linear fashion. Rather, the benefits of working with an advisor are lumpy and tend to be most pronounced during times of intense volatility (i.e., intense feelings of fear and greed). This uneven distribution of advisor value is why we place such importance on behavioral finance. The most successful advisors who deliver the greatest value to clients are both strong practitioners and excellent behavioral coaches.
Similar research conducted by Aon Hewitt and managed accounts provider, Financial Engines, also supports the value of advice. The initial research was conducted from 2006 to 2008 and compared investors receiving help (online advice, professional advice, target funds) versus those who did not receive advice. During this time those who received help outperformed those who did not by 1.86% per year, net of fees. They subsequently performed a similar analysis of “help vs. no-help” groups during 2009 and 2010. During these particularly volatile years, they found that the outperformance of the group receiving assistance grew to 2.92% annually, net of fees. As rational decision making becomes more challenging, the value of advice only becomes more apparent.
If the results are lumpy but the fees are consistent, one might ask whether an extra 2-3% is worth the risk of overpaying. Those figures may seem insignificant at first. However, the marvel of compounding changes the expected long-term value.
In a 2012 “Value of Advice Report” the Investment Funds Institute of Canada found that investors who receive financial advice are more likely to adhere with their investment plan than those who did not. Because of this commitment, the wealth discrepancies between families that receive advice and those who do not increase over time. For those who receive 4 to 6 years of advice, the multiple is 1.58x. Those receiving 7 to 14 years of advice nearly double up (1.99x) their no-advice peers. Those receiving 15 or more years of advice clocked in at an overwhelming 2.73x multiple. In dollar terms over the long run, that means that the DIY investor has $100,000 versus $273,000 for those with a financial plan.
Quality of Life
While there are quantitative benefits to competent financial advice, there are qualitative aspects, as well. Delegating tasks to a professional frees up time to focus on the activities and people that you value most. Moreover, research suggests that having a plan brings peace of mind. A study by the Financial Planning Standards Council found that 61% of investors paying for advice indicated that they had greater peace of mind. Furthermore, 51% of respondents with a plan felt prepared for retirement against a dismal 18% of those not receiving advice. Ultimately, having a financial plan pays dividends both in terms of outcomes and in terms of a greater sense of well-being.
How do advisors help their clients achieve better long-term results? Vanguard quantifies the added value by many common activities performed by an advisor.
Quantifying advisor value
|Drawdown strategy||0 to .70%|
|Using low-cost products||0 to .45%|
|Asset location strategies||0 to .75%|
|Potential value added||“About 3%”|
Source: Francis M. Kinniry Jr., Colleen M. Jaconetti, Michael A. DiJoseph, and Yan Zibering, 2014. Putting a value on your value: Quantifying Vanguard Advisor's Alpha. Valley Forge, Pa.: The Vanguard Group.
Note: For "Potential value added," we did not sum the values because there can be interactions between the strategies.
From a professional perspective, Vanguard’s findings are unsurprising. Our anecdotal experiences align closely with their conclusion. Ultimately, behavioral coaching is the most meaningful driver of outcomes and is why behavioral finance is such an important topic. Our biases and mental shortcuts can lead us to make suboptimal financial decisions, which are ultimately accretive over time. Professional advice helps clients develop a financial plan, consistently employ strategies linked to better outcomes (rebalancing, asset location, etc.), and provides clients with greater confidence in their overall financial well-being.
The Added Value of Financial Advisors
Read the full Vanguard Advisor's Alpha summary here.
This is not a recommendation and is not intended to be taken as a recommendation. This material was prepared for general distribution and is not directed to a specific individual.
LPWM LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers.