What is the Value of Financial Advice?

Vanguard released a new study showing that financial advice provides “meaningful” beneficial changes in behavior, performance and financial outcomes. They had previously published a study citing a 3% “advisor alpha”. I am not gonna lie – I always thought that number was BS and probably way too high. But is there a more reliable way to measure this? Let’s see.

Investing is like being healthy – everyone knows how to do it, but implementing a plan and remaining disciplined is difficult. And financial advisors are a lot like personal trainers. We aren’t going to turn you into Warren Buffett. But we will make sure you’re better off than you otherwise would be. In the world of personal training this is analogous to the fact that most personal trainers won’t turn you into Mr. Olympia, but they will make sure you are in better shape than you otherwise would be. Financial advisors do this primarily by implementing and maintaining a disciplined plan of action and forcing you to stick with it.

The interesting thing about individual investors is that they’re relatively undisciplined. Since 1987 AAII has provided reliable data on individual investor asset allocations. Over that time the allocation has averaged:

• 61% stocks
• 16% bonds
• 23% cash

This data is interesting primarily because it exposes how irrationally fearful of fixed income most investors are. And this fear has cost them a substantial amount of money over time mainly because they’ve left 23% of their portfolio out of the game for 30+ years. It’s an interesting thing I’ve noted through my entire career – while we tend to think of the stock market as the scarier asset class it’s actually bonds that most investors are irrationally scared of. And overcoming these various misleading bond narratives is not an easy thing to cure.¹

In fairness, this might not look like such a bad idea in the era of 0% interest rates where cash and bonds are functionally similar and bonds arguably have much higher principal risks over certain time periods, but historically speaking, investors leave way too much money in cash. And of course, banks love you for this because it creates a risk free arbitrage for them where they can invest cash at the Fed Funds Rate while giving you little to nothing. Most investors don’t realize it but this adds up to what is essentially a very high fee on a portion of your portfolio that is easy to invest if you are a little proactive with it. ²

Now, the data is pretty clear that most investment managers cannot beat the market. But beating the above portfolio is pretty simple. In fact, a plain vanilla 60/40 allocation of US stocks and a total bond portfolio handily beats that portfolio since 1987:

• AAII Average investor: CAGR: 8.17%, standard deviation: 9.23%, Sharpe Ratio: 0.57
• plain vanilla 60/40: 8.79%, standard deviation: 9.23%, Sharpe Ratio: 0.63

So there you have it. The most brain dead financial advisor recommending a 60/40 allocation and making you stick with it helped you beat the average individual investor by a full 0.62% per year. This isn’t a small amount. On $100,000 it amounts to a difference of $250,000 over 30 years. Of course, the kicker here is fees. The advisor who charged you 1% for a cookie cutter 60/40 actually detracted from your relative performance to the tune of 0.38% (assuming the same underlying fund fees). But anyone paying reasonably low fees did better than the average individual investor just by implementing the simplest of portfolios.³

Of course, we’re not even accounting for other potential advice like tax location, tax loss harvesting and other personalized advisory services. But when it comes to portfolio management the data is fairly clear. If you’re like most individual investors you probably hold way too much cash because you are behaviorally biased and fearful of bonds. And paying any fee lower than 0.62% would have generated better returns primarily because financial advisors keep you in the game even when you’re too afraid to remain fully invested.

NB – Vanguard’s original 3% may not be that far off in many cases. After all, if a boring plain vanilla portfolio of 60/40 adds 0.62% in returns then it’s not unreasonable to assume that personal planning, tax location, harvesting, etc would add upwards of 3% in certain cases.

1 – Oh fun! Here’s a section on understanding bonds. 

2 – I always cringe at large bank account balances and “high yield savings accounts” offering rates that are inevitably lower than T-Bills (despite being invested in T-Bills or other safe government assets). Investors who are more “active” with their cash can almost always earn higher returns by simply reinvesting these cash balances in T-Bills. And historically, T-Bills have averaged 3.4% annual returns. One might even argue that the primary benefit of having a financial advisor is having someone force you into managing your cash balances more proactively.

3 – I used 60/40 for two reasons: 1. it’s the gold standard of benchmarks; 2. I’ve reviewed thousands of other advisory portfolios in my career and I’d venture to guess that 90% of them amount to some version of an excessively complex and high fee version of a 60/40 portfolio.