What if I told you that using the investment management services of a financial advisor will make you $2.6 million richer? And this number doesn’t include the benefits of financial planning or rely on magical investment returns that trounce the market.
An exaggeration? Unrealistic? It depends on your specific situation. Read on, and I’ll tell you how I arrived at this number below, and you can decide for yourself if it makes sense or not.
If you are in the mood to entertain some of my goofiness, please read this post straight through. If you would like to skip directly to the meat of this post, jump down to the section titled: The Worth of a Financial Advisor Trust me. I won’t be offended if you jump ahead.
The Most Horrifying Phrase a Financial Advisor Will Ever Hear
It was a stormy night, and cold rain pelted my office window. The streets of Pittsburgh were dark and empty. All souls, with any sense, had sought dry, warm cover. I decided, after a long day of work, it was time to brave the storm and make my way home where a roaring fire and two fingers of whiskey awaited.
I grabbed my fedora, trenchcoat, and umbrella from an antique, wooden stand behind my desk. As I turned to leave, there was a loud crack of thunder and a flash of lightning that bathed my office in a bright glow. A serious-looking woman appeared before me with a large briefcase. “I’m in need of comprehensive financial planning,” she said.
“You’ve come to the right place,” I responded, admiring her financial prudence.
She shifted nervously from one leg to the other and hesitantly added, “However, my husband says ‘It’s not worth paying a financial advisor.’” A bolt of lightning struck close by, and the sound of thunder ripped through the office. A flood of light crashed through the window and illuminated my horrified face.
Thanks for sitting through that. I’ve always wanted to write a great-American detective novel. And after looking at a calendar that’s pretty full of financial advisor stuff, I realize it’s not going to happen anytime soon. Now on to the good stuff.
The Worth of a Financial Advisor
Most work a comprehensive financial advisor performs can be assigned to one of two buckets: investment management and financial planning.
This article will cover the first bucket – investment management.
For much of the data in this article, I lean heavily on research performed by Vanguard and published in a whitepaper titled: “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha®. “ Vanguard’s research concludes that a financial advisor can add approximately 3% to net returns for clients, but “…the actual amount of value added may vary significantly, depending on the client’s circumstances.” I dive into the details below.
It’s no secret you can deposit your retirement savings at Vanguard, a firm that offers inexpensive mutual funds and exchange-traded funds (ETFs). If you do it yourself, you can avoid an advisor’s management fee, which is usually about 1%. Score! That’s a significant savings!
Less well known is that Vanguard has done research measuring the value of a financial advisor’s advice. The benefit of using an advisor? Approximately 3% a year! Even after taking into account an advisor’s 1% fee, the difference is significant.
Using a $500,000 portfolio to illustrate, the 3% benefit of using an advisor equals $15,000/year, or $10,000/year if your advisor charges a 1% fee. And this is not a one-time gain. On average, it occurs every year and compounds over time.
I put together an example to illustrate the benefit of using an advisor below. Before I continue, I feel like I need to put on a lawyer hat. No, I am not a lawyer.
The following is an example and not intended to apply directly to your situation. It is simplified to illustrate a valuable point. Please perform your own calculations, which will be specific to your individual situation. You can find a straight-forward investment calculator at omnicalculator.com. Or, better yet, ask a financial advisor to do a personal, detailed analysis. If you’d like to dig into the exact numbers used to calculate the following returns, please see the appendix at the end of this article.
There are many moving parts in this calculation, and I attempted to use fair assumptions. These numbers may be considered aggressive or conservative, depending on individual scenarios. I am also assuming Vanguard’s research is accurate and reliable. So, let’s get on with it!
How valuable is using a financial advisor according to my calculations? A $500,000 portfolio that consists of 60% equity and 40% will be ahead by over $2.6 million over a period of 35 years.
How is this possible? In my example (again, please see the appendix for specifics), I have the financial advisor managed portfolio returning an extra 2% per year. The 3% benefit of using an advisor is reduced to 2% to cover the average advisor’s fee.
We know that Vanguard’s research states that financial advisors help the average investor earn returns, which are approximately 3% higher than if they manage their own investments. But where does this additional return come from?
The most significant benefit of working with a financial advisor is behavioral coaching. Vanguard indicates an advisor adds 1.5% of return by helping clients through the emotional rollercoaster that is the stock and bond market.
When the markets are seemingly up every day, and discount brokerage commercials are screaming at you to put a second mortgage on your home and invest aggressively so that you can live the Yacht Life, your advisor will be there to remind you of your long-term plans.
When the market has dropped 20%, and the financial media is predicting the end of times, it’s difficult to ignore the nausea you feel each time you look at your brokerage statement. When CNBC covers half your TV screen with the bright red emergency of the day, and your instincts are screaming at you to sell, your advisor will be there to remind you of your long-term plans and reduce the panic you’re feeling.
I know what you’re saying to yourself: “This emotional investor is not me!” However, it very likely is, and studies have shown it. It’s easy to look at a financial plan in times of calm and rationalize a 20% drop in your portfolio as perfectly acceptable. It is much harder to stick with your long-term financial plan when the market is down significantly, the economy seems to be worsening, and every investment pundit with access to the media is screaming – “There’s no end in sight!”
You may be thinking: “Saving and investing is the hard part. I think I’m pretty capable of spending without any help.” Surprisingly, a spending strategy can be complicated, and clients who use a financial advisor can generate an extra return of up to 1.1% a year on average.
Clients with a mix of taxable and tax-advantaged accounts, who are in a high tax bracket, have the most to gain. But just because you’re not spending money yet, doesn’t mean an advisor can’t help you with a spending strategy. Setting up both taxable and tax-advantaged accounts in preparation for retirement will give you the flexibility to keep your tax rate level when you start withdrawing funds. It will also help you avoid income spikes that could launch you into one of the top tax brackets.
The type of account you use to hold different investments is important and, if done correctly, can generate an extra 0.75% of return per year. Tax-efficient investments such as passive equity ETFs should be held in taxable accounts. Less efficient investments that aggressively produce income, like most bonds, should often be held in a tax-advantaged account. The expected holding period will also influence the decision of which type of account to use. Again, clients in a high tax bracket with a mix of taxable and tax-advantaged accounts have the most to gain.
Vanguard research measures the potential benefit of moving toward low-cost funds to be 0.34% in return per year. This advisor benefit may be viewed as easily replicable by clients who are investment-savvy and don’t mind taking the time to research investment options. Truthfully, constructing an initial, low-cost portfolio is not difficult if you have the investment knowledge and patience to complete the task.
However, the difficult part is the ongoing monitoring of the initial portfolio once it is established. Existing funds may have a change in strategy, a change in management, or not perform well when compared to their benchmark. Any of these changes may make it necessary to find a replacement fund. Even funds with passive strategies must be monitored to make sure the original investment thesis remains in place.
There have been over a thousand new ETFs created in the last five years. New funds that hit the market may have lower fees or execute a desired strategy better than an existing holding. This ongoing monitoring is time-consuming and can be tedious for people not interested in the nuance of investing.
Vanguard determined that, on average, portfolio rebalancing resulted in a benefit of 0.26% per year. Rebalancing keeps the original asset allocation steady by adding or trimming holdings periodically.
Researchers compared two portfolios that had similar risk characteristics. One was regularly rebalanced, and the other was not. The rebalanced portfolio had higher returns.
Even more importantly, rebalancing is a risk-reduction tool. When one asset class outperforms, it will grow to a larger weighting in the portfolio. Risk can increase beyond the original expectations if left unchecked.
Does an advisor really deliver 2% in additional returns after fees? Possibly, but real life is messy, and every situation is different. The key point is, even if we attribute an increased return of only 0.5% to an advisor, the benefit over a 35-year time frame can be in the hundreds of thousands of dollars. Plus, by handing off the time-consuming task of managing your investment portfolio you’ll have more time to do the things you love, such as spending time with family, traveling, or writing that great-American detective novel.
Here are the numbers I used:
Present Value (of the portfolio): $500,000
Expected Return using an advisor: 7.1%. The average return of a 60% equity / 40% bond portfolio over the last 92 years has been 8.6%. I subtract 1% for advisor fees and .5% for mutual fund/ETF fees.
Expected Return without an advisor: 5.1%. The average return of a 60% equity / 40% bond portfolio over the last 92 years has been 8.6%. I subtract 3% to account for the underperformance calculated by Vanguard research and .5% for mutual fund/ETF fees.
Period: 35 years
Compound Frequency – yearly
The value of $500,000 becomes $5,515,711 at 7.1%.
The value of $500,000 becomes $ 2,851,445 at 5.1%.
*These final portfolio values are not adjusted for inflation.
A 60/40 portfolio will average the same returns in the future as the past 92 years.
The client does not reduce their equity holdings as they approach or move through retirement. A client might want to invest more conservatively as they age.
The advisor fee is a constant 1%, whereas, in reality, most advisors will reduce their fee as assets grow and pass certain thresholds.
For simplicity, taxes are not included.
The benefit of using a financial advisor is illustrated in this example as a smooth 3% per year. In reality, this benefit is choppy, and timing is unpredictable.
Would you like to receive the PathBridge Financial newsletter? You’ll receive about 4 emails a month. My promise, only the best stuff and never any spam.
David Tuzzolino, CFA, CFP®, is the Founder and CEO of PathBridge Financial, a firm that specializes in providing comprehensive financial planning and investment management services for clients that are nearing retirement and love to travel.