By Timothy Baker, CFP®, MBA
Attorneys, physiatrists, tax and financial professionals all have one thing in common: they offer intellectual capital, something intangible that we can’t necessarily feel or touch. Patients and clients are tasked with quantifying the value of it. The question is: How? Numerous studies have been conducted in an attempt to broadly measure the monetary benefits of working with a financial advisor. Here, I’ll walk through a simple critical thinking exercise, purely designed to help investors make informed decisions.
First, it’s important to point out the human element. Based on our experiences, we all have biases when it comes to interpreting value. Most of us possess situational skepticisms due in part to a daily dosage of fly-by-night quick fixes, aimed at lightening our pockets. If you believe that all physiatrists are quacks, all lawyers are ambulance chasers, or all financial services professionals are salespeople, you probably have a preconception which will inevitably factor into how you value their advice.
Personal Due Diligence: A Litmus Test for Seeking Financial Advice
- Do I have the experience to independently handle the complexities of my complete financial situation?
- Do I have the time to research, apply, monitor and adjust my planning and investment portfolio?
- Do I have the desire to do so?
- Do I have the long-term discipline to independently make prudent decisions not based on emotion?
- Finally, do I have confidence that a contingency (someone in place of me) has the experience, time, desire and discipline?
Let’s break those down a bit further.
The question really isn’t whether or not you can do it yourself. The question that’s more applicable is can you do it well? The biggest challenge I commonly see with do-it-yourself investors stems from understanding how and why financial planning and investment management are related. After analyzing thousands of portfolios through the years, here are some of the most common deficiencies in no particular order:
- A lack of relationship between asset allocation and long-term goals.
- A thorough understanding of each position in the portfolio and how it interacts with other holdings.
- True awareness of overall costs including internal expense ratios and trading fees.
- An absence of appropriate levels of diversification needed to alleviate risk.
Markets and investment vehicles are constantly evolving. Therefore, investment portfolios should evolve as well. We’re always learning more about expected return and where it comes from. As we do, investment providers are quick to adapt, offering solutions with incremental improvements. The problem is, there’s lots of them. At last check, there were around 7,000 mutual funds and over 2,000 exchange-traded funds (ETFs) in existence.
This underscores the importance of recognizing that financial planning isn’t a one-time thing but an ongoing event that requires adjustment with life events. Investments, taxation, insurance and estate planning all need to be working in concert. Collectively, this amounts to a lot more time than many realize, which often leads to a lack of attention.
Does the ongoing, in-depth examination of your financial situation interest you or not? If you don’t enjoy working on cars, you’re probably not keen on repairing your own transmission. The concept of hiring professionals in different capacities effectively allows us to spend time doing what we enjoy, or what we do best.
This goes way beyond the idea of having someone there to hold your hand. Yes, psychology plays a role. However, discipline runs deeper than simply resisting reactions to every market movement. We know it applies to investing, but it must also apply to financial planning. Purchasing a home, having a child, changing jobs, marriage, college, retirement etc. are life events that require sound financial adjustments.
When it comes to managing your portfolio, the behavioral impact on investing is well documented. It’s easy enough to say that disciplined investors have historically been rewarded for maintaining that discipline. However, doing so requires not only a steady hand but also a dedicated understanding of capital markets and how a host of different scenarios impacts your unique situation. We've been through around half a dozen bull and bear markets over the last 30 years. Needless to say, long-term investors are likely to experience a bunch of them over a lifetime.
According to the Investment Company Institute, net new cash flow to equity mutual funds is typically related to world equity returns monthly. The history of mutual fund cash flows through the years paints a difficult picture for investor behavior. In 2008, we saw large outflows in equity mutual funds right around the bottom of the market. Subsequently, we saw positive cash flows in the latter part of 2009 and into 2010 long after markets went into recovery mode. Remember the age old adage about being a successful investor: buy low, sell high? Well, the opposite often happens and emotional discipline is frequently the culprit.
Confidence in all of the above isn’t enough to ensure a favorable outcome. Many overlook the capacity of their heirs to make sound decisions in the event that they no longer can. Death, disability, or incapacity impacts everyone. Prudence dictates an analysis of capable contingencies.
Professional Due Diligence
When weighing the value of financial advice, it’s critical to understand the substantial differences between types of financial advisors. Many lack the credentials or even legal authority to qualify what they offer as advice in the first place. Brokers are not advisors, and fee-based is not the same as fee-only. Here, I’ll focus on fee-only fiduciary advice, the industry standard for placing the clients’ interests first 100% of the time.
Aptitude encompasses the combination of experience, education and reputation:
- Experience: In finance, there’s little substitute for the seasoned experience an advisor receives through a variety of different market cycles and with a variety of different types of clients.
- Education: Undergraduate business degrees and MBAs demonstrate a commitment to education. Industry designations such as Certified Financial Planner (CFP) or Chartered Financial Analyst (CFA) further indicate levels of expertise.
- Reputation: Any due diligence should begin with a baseline evaluation of regulatory history (run a background check). Also, look for specific examples of expertise. Many advisors are active contributors to media outlets. Read columns or interviews to get insight into their investment philosophy or planning approach. Start with the firm’s website.
Carefully understanding what is and isn't in service offerings is essential because service offerings are all over the map. Does the advisor provide one-time financial planning services, ongoing investment management services, or the combination of both? How much access do you have to professionals? What types of reports and online access do you receive?
How do you want to interact with an advisor? There’s a cost to doing business. Face-to-face interaction is costlier than email, phone or video. Therefore, it’s reasonable to expect a premium on face-to-face interaction.
After determining what’s included and what isn’t, you can then analyze the market rate for these services. A recent study by Advisory HQ outlines some of these ideas.
Making an Informed Decision
A comprehensive approach to quantifying value helps to diligently explore elements that often get overlooked. Investors should strive to understand themselves, their strengths and limitations before jumping straight into the evaluation of an advisory firm. Starting off with a basic Litmus test helps to solidify the rationale for seeking or not seeking advice. It’s about placing a timeline of personal due diligence in front of professional due diligence with the goal of making informed decisions.
Recent articles by Timothy Baker: Financial Advisor: The Most Misunderstood Title
Disclosure: WealthShape, LLC provides this communication as a matter of general information. No one should assume that any discussion or information contained in this material serves as a receipt of, or as a substitute for, personalized investment, tax or legal advice.
This article was originally published on Investopedia.