Chapter 23
Why I don’t like investment
advisors
Managing other people’s money is a very big business, and for those who engage in it, a very lucrative one.
Since investing and managing money is highly intimidating for many folks, there is also an apparent need. This financial stuff just all seems so complex, it is not surprising that many people welcome the idea of turning it over to a professional who will, hopefully, get better results.
Unfortunately most advisors don’t get better results. Investing only seems complex because the financial industry goes to great lengths to make it seem complex. Indeed, many investments are complex. But as you now already understand, not only are simple index investments easier, they are more effective.
Advisors are expensive at best and will rob you at worst. Google Bernie Madoff. If you choose to seek advice, seek it cautiously and never give up control. It’s your money and no one will care for it better than you. But many will try hard to make it theirs. Don’t let it happen.
When I say investment advisors, I am also referring to money managers, investment managers, brokers, insurance salespeople (who often masquerade as financial planners) and the like. Any and all who make their money managing yours.
Now, I’m sure there are many honest, diligent, hard-working advisors who selflessly put their clients’ needs ahead of their own. Actually, I am not at all sure about that. But just in case, I put it out there in fairness to the few.
Here’s the problem:
By design, structurally an advisor’s interests and that of their clients are in opposition. There is far more money to be made selling complex fee-laden investments than there is in simple low-cost efficient ones. To do what’s best for the client requires the advisor to do what is not best for himself. It takes a rare and saintly person to behave this way. Money management seems not the calling of the rare and saintly.
Well-intentioned but bad advice is endemic in this field. Advisors who put their clients’ interests ahead of their own are, to steal a phrase from Joe Landsdale in his novel Edge of Dark Water, “rarer than baptized rattlesnakes.” And then you’ve got to find one who is actually any good.
Advisors are drawn not to the best investments, but to those that pay the highest commissions and management fees. Indeed, often they are compelled by their firms to sell these types of investments. Such investments are, by definition, expensive to buy and own. And investments that are expensive to buy and own are, by definition, poor investments.
Not surprisingly, a field that provides access to people’s life savings is a magnet for con men, thieves and grifters.
Let’s take a look at how investment advisors earn their money, and how each method works against you. Remember now, here we are talking about those who are legitimate, rather than the outright crooks. Generally there are three ways:
1. Commissions
The advisor is paid each time you buy or sell an investment. These commissions in the investment world are called “loads.”
It’s not hard to see the potential for abuse here, and the conflict of interest is stark. There is no “load” (commission) charged to buy a Vanguard Fund. But American Funds, among others, charge a princely load.
Typically it is around 5.75% and it goes directly into the pocket of the advisor. This means that if you have $10,000 to invest, only $9,425 actually goes to work for you. The other $575 is his. Mmmm. Wonder which he’ll recommend?
Some funds offer a 1% recurring management fee to the advisors who sell them. That means you get to pay a commission not only once, but every year for as long as you hold the fund. No surprise advisors favor these too.
Often this fee and a load are found in the same investment.
Further, since these funds are most often actively managed, they carry a high expense ratio and are mostly doomed to underperform the simple low- cost index funds we can so easily buy on our own.
Consider how all this can add up. Take a 5.75% load, combined with a 1% management fee, along with an expense ratio of, say, 1.5% and you’ve given up 8.25% of your capital right from the start. That’s money you not only lose forever, you also lose all the money it could have earned for you over the decades. Compare that with the 0.05% expense ratio of VTSAX.
Holy Crap!
Insurance investments are some of the highest commission payers. This makes them perhaps the most aggressively recommended products advisors offer and certainly among the most costly to you. Annuities and whole/universal life insurance carry commissions as high as 10%. Worse, these commissions are buried in the investment so you never see them. How such fraud is legal I can’t say. But it is.
Hedge funds and private investments all make their salespeople wealthy, along with the operators. Investors? Maybe. Sometimes. Nah, not so much.
Remember Bernie Madoff? People literally begged him to take their money. His credentials were impeccable. His track record too. Only the “best” investment advisors could get you in. Mr. Madoff paid them handsomely to do so. As did their clients. Oops.
If all this weren’t enough, if you’re not paying attention, there is more money to be mined at your expense by “churning” your account. Churning refers to the frequent buying and selling of investments to generate commissions. It is illegal. But it is also easily disguised, principally as “adjusting your asset allocation.”
2. The AUM (Assets Under Management) Model
With the rampant abuse of the commission model, in recent years charging flat management fees has grown in popularity. These fees are typically 1- 2% of the client’s total assets and this approach is presented as being more objective and “professional.” But there are snakes in this grass as well.
First, 1-2% annually is a HUGE drag on the growth of your wealth and on your income once you are living off it. Investment returns are precious and under this model your advisor is skimming the absolute cream.
Suppose you have a nest egg of $100,000. That’s about the minimum needed to interest an advisor. Let’s further suppose you invest it for 20 years and earn 11.9% per year which as we’ve seen is the average annual 1return of the past 40 years (January 1975 - January 2015). You end up with 3 $947,549.Not bad. Now suppose you give up 2% of these annual gains to
a management fee. Your net return is now 9.9% and after 20 years that 3 yields $660,623.That’s a whopping $286,926 less. Yikes! You not only
give up the 2% each year, you give up all the money that money would have earned compounding for you over the 20 year period. Let me hammer this point home—it’s a very big deal.
Second, we still have the problem of a conflict of interest. With the AUM model it is not as pervasive as with the commission model, but it’s still there. Maybe you are considering paying off your $100,000 mortgage.
Or perhaps you’re thinking about whether to contribute $100,000 to your kid’s college education so they can avoid going into debt. Often advisors will advise against either of these courses. For you, depending on your situation, that may be good or bad advice. For your advisor, it is the only advice that preserves the $1,000 to $2,000 in annual fees that $100,000 puts in their pocket.
Third, the vast, vast majority of advisors are destined to cost you still more money as they underperform the market. The actively managed funds they tend to choose woefully underperform the index. You won’t know for 20 years or so if you got lucky enough to pick one of the exceedingly rare ones that don’t.
3. Hourly fees
Many advisors tend to dislike this model, pointing out that it often limits the time a client is willing to spend with them. That’s true as far as it goes, but it is also true that it takes a lot of hours to equal the money that can be made in commissions and annual fees.
They also point out that clients are less likely to object to commissions and fees because they tend not to notice these being skimmed off the top.
Paying an hourly rate—even when it is more cost effective—requires writing out the check and actually seeing the money leave your hands.
That’s uncomfortable for the clients and that means less money for the advisor. Not such a bad thing for the clients, seems to me.
That said, if you really need advice, this is the most straightforward way to pay for it. But pay for it you will. Rates of $200-$300+ per hour are not uncommon. You are less likely to be cheated, but you still have the challenge of knowing if the advice itself is going to be good or bad for your financial health.
4. Some combination of 1, 2 & 3 from above
This is our last option. If your advisor is using it, likely the reason is not for your benefit.
So what’s my advice on picking a good advisor? Beats me. Doing so is probably even more difficult than picking winning stocks or actively managed mutual funds.
Advisors are only as good as the investments they recommend. Since those are mostly actively managed funds—as opposed to the index funds this book suggests—how often do those outperform?
As we saw in Chapter 8, very rarely. You’ll recall the research shows ~20% outperform in any given year and looking at a 30-year period that drops to less than 1%. Statistically speaking that’s a rounding error; just so much noise.
This is what your highly paid advisor is selling you.
If you are a novice investor you have a two choices:
You can learn to pick an advisor.
You can learn to pick your investments.
Both require effort and time. But the second not only provides better results, it is the easier and less expensive path. Hopefully this book is showing where it lies.
The great irony of successful investing is that simple is cheaper and more profitable. Complicated investments only benefit the people and companies that sell them.
Remember that nobody will care for your money better than you. With less effort than choosing an advisor, you can learn to manage your money yourself, with far less cost and better results.