What do you pay your financial advisor for?

Advice.  That is the top answer I get when I ask this question.

OK, but what kind of advice?

My impression is that when you boil it all down investors hire financial ‘advisors’ (I include financial planners, CFPs, money managers, hedge fund managers, mutual funds managers, etc. in this category) for Timing and Selection advice. That is to say, investors rely on their financial guy or gal to find the best stocks that will outperform all others and/or get them in and out of the market at the right times.  Unfortunately, every single piece of research and evidence suggest that this cannot be done. Yet, financial ‘advisors’ perform this Sisyphean task day in and day out.

The other problem I’ve experienced with some financial ‘advisors’ is they enable their clients’ destructive behavior.  But then again, why wouldn’t they? The timing and selection advisors have the duty of mollifying their clients in volatile markets and so if panic-stricken clients call to sell their position, why not agree with them and facilitate the trade? The justification is that this will ‘help the client sleep better at night’ and heck, if it generates a commission for them, it’s a classic ‘win-win’ in their book.

Think about it. Why would any advisor risk losing a client by telling them, “No, I will not allow you to panic-sell here when the Dow is at 7,500.”  Can you imagine the backlash he would get when the Dow drops to 6,600?  That’s because the advisor’s value proposition is Timing and Selection.

In my view, once an appropriate portfolio is selected for the client, financial advisors’ highest and most valuable duty is being there as a fail-safe against emotional selling or buying.  Dalbar, Inc. produces research that shows how individuals investing in equities (with their timing and selection) fare versus the S&P 500 index (no timing, no selection). Each year it’s the same song, different verse. For the 20-year period through 2010, the equity investor averaged 3.83% per year while the S&P 500 index averaged 9.14% per year during the same period.  Translation: research shows that investors, left to their own devices, take ALL of the market risk and get less than half of the return.

The single most validation of the destructive nature of timing and selection can be found upon closer examination of last decade’s most successful fund.  According to Morningstar, the CGM Focus Fund–careful with the pronunciation–delivered a whopping 18.2% a year from 2000 through the end of 2009. (Note that this was done during a period when the S&P 500 index was largely flat.) The same source, however, reveals that the average shareholder in the fund LOST 11% a year! Not only did the Focus Fund investors underperform the market, they underperformed the very fund they were in! How is this possible?

Let me attempt to explain.  In 2007, when the markets reached all-time highs and the CGM Focus Fund delivered an 80% return that year, investors dumped more the $2.6 billion into the fund the following year.  Then in 2008, when the fund dropped 48%, shareholders panicked and pulled out $750 million by the end of November. Succinctly put, they were victims of Timing and Selection. (Technically, investor coaches would call it a combination of fatal investing errors such as hind-sight investing, track record investing, and the flawed notion of Persistence of Performance).

Dalbar’s annual research and this real-life tragedy of last decade’s best performing fund proves that long-term investment performance is very largely determined by investor behavior. Behavioral investment counseling–or investment coaching–then should be the top priority of investment advisors and what you really should be paying them for.

Any questions? Please comment below.

John Choi

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