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« Free Money Finance March Money Madness, Round 1, Posts 45-48 | Main | Get-Rich-Quick Mentality Leads to Poverty »

February 12, 2011

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Well, "financial planners" have to make money one of two ways. Either they get a flat fee for performing, or they get a commission on sales. If he was an independent, working on a flat fee structure, he might very well recommend ETF index funds to his clients. As he's working for someone else, I imagine he's locked in to selling their funds, if he wants to put food on the table. In many cases, I suspect, he is still doing quite a bit of good for his clients, as lots of folks get locked into much worse product than that by their financial planner.

I agree with your assessment - 1% is too much and it really costs a lot over the long term. If nothing else pick out a target date fund that corresponds to your situation and have someone show you how to buy low cost ETFs to match the fund. Check it every 3 or 4 months or whenever the market makes a run or pay an advisor $150 to spend an hour doing it for you. You'll be able to retire 2 years earlier.

Let's assume that this guy is using a family of funds, for example maybe Powershares that have 130 funds in their family. Sure, you can buy and sell any of those funds yourself for next to nothing in commission but what if he is going to actively manage them for you in a very capable way using ranking and analysis software that you don't have and wouldn't be able to use skilfully even if you did. I would first ask him to show me what his performance has been over the last 12 months and if it was a lot better than you can do on your own then a fee of 1% on your money is a real bargain. Advisors don't work for nothing and if they are good and you are just a passive Buy & Hold investor you might be surprised how much better his perfomance has been than yours.
The key is the potentially large difference between Active and Passive management of money.

Old Limey --

Haven't we established that, on average:

1. Passive investing beats active investing

2. Past performance is no guarantee of future performance

So, now:

1. How am I supposed to evaluate him?

2. And even if his past performance is good, can I bank on that for the future? After all, my increases in expenses are FOR SURE. His potential performance is questionable.

I've seen a number of comments like this recently on this site from FMF and others who say things along the lines of "X is charging Y so he is ripping people off" or "X is getting a return of Y so he is ripping people off" (not exact quotes but in that spirit). There was another post (I think it was a help a reader) where somebody was saying shame on you for having the audacity to earn less than the S&P 500 last year despite the fact that the person had NO IDEA about the person's risk tolerance, financial situation, etc.

I am not a financial planner and I don't use one, but I understand that for the vast majority of people, a financial planner is better than DIY. Obviously, financial planning isn't rocket science to the people on this message board, but to a lot of folks, it is! A financial planner isn't there to just take orders for mutual funds or whatever. He is there to help assess people's true risk tolerance, guide people towards an asset allocation which makes sense, and help people to stay the course when things look bleak (like they did in March 2009).

Think of all of the people who "thought" they knew what they were doing, but got spooked to sell late 2008, early 2009 which of course was the ABOSOLUTE WORST TIME to sell. A _good_ financial planner might have been able to talk them off the ledge. Certainly that sort of service is worth 1% to people who might have otherwise flushed their retirement down the toilet with panic selling.

What I see from a lot of people is they extrapolate their own experiences on others. They figure, well I am smart enough to know to invest in index funds which are low cost, and I have a enough perspective to know that you should stay the course and invest to the long term and not let every little bump in the road spook you. Therefore, everybody should behave the same way. This is human nature to believe this of course, but it is dead wrong. People are all individuals. We have different risk tolerances, we have different attitudes, we have different natures. Some of us are logical and some of us are emotional. Some people have the knowledge, confidence, and stomach to be our own financial planners, and some really could benefit from a person to hold our hands.

Yes, for a financial savvy person like FMF, 1% might be perceived as a ripoff because you don't need that type of help. But there are others in this world for whom 1% is a bargain if it stops them from doing something stupid with their money.

Here is an analogy:

If I am bald, then a haircut at any price is worthless to me. However, are barbers a ripoff? OF COURSE NOT! Just because I myself wouldn't benefit from them, doesn't mean that there isn't somebody who wouldn't benefit from their services. However, somehow people forget this logic when it comes to financial planners.

Rather than say "shame on you" to a person who goes to a financial planner, I say "good for you". At least the person has the self-awareness to know that they need somebody to help them to stay the course.

MBTN,

I think there is an implicit assumption in your reasoning. If an advisor is going to use tactical asset allocation-- move an investor in and out of asset classes to try and time/beat the market-- then they are charging their client higher fees and still run the same risk of jumping in and out at horrible moments, just like an investor with no advisor could. It could be argued that an advisor is actually MORE likely to attempt that strategy than your typical index investor would be. So, extra investor risk for higher cost.

An advisor committed to a stay-the-course buy, hold, and rebalance strategy using low cost index funds is a different story and could be helpful in saving an investor from himself. The problem is how few of those advisors exist, the difficulty finding them, and the lack of awareness of investors that this should be the advisor he seeks. The result is most people hire an expensive advisor who puts them in expensive funds and tries to beat the market, which is the perfect storm of cost and risk.

Many people need a good advisor. Most of these people end up with a bad advisor instead. That is the risk of seeking help, and far too often people end up worse off.

MBTN
You are exactly correct.
ETF funds are multiplying in numbers like crazy.
The proprietary database that I have subscribed to for many years contains 871 ETF funds as of today. It also comes with software that enables its user to rank and compare funds by a great many measures over any time period for which a fund has existed. Total Return over a period is just one parameter, there are many others that compare volatility and risk.

I do not understand how any reasonable person can make the statement that passive investing whereby you pick a handfull of well known ETFs that represent the well known indexes can in any way be superior to a very experienced financial advisor, or a very experienced individual investor that possesses the time and ability to purchase a selection of the funds that suit his objectives the best out of 871 ETFs and futhermore to actively manage his fund selections by using techniques that indicate when it is advisable to switch out of one that is acting poorly and replace it with one that is acting much better.

Obviously none of us have crystal balls so we can't fortell the future but very often when a particular sector starts to act poorly, if you do your homework thoroughly, you can usually determine why it's happening, and it's usually that the "Smart Money" already knows the reason and is starting to unload.

The average DIY investor that's busy at work every day trying to earn a living or run a blog has no idea of the wide variation of ETF funds that are available. They range from almost every country in the world that has a stockmarket to futures on just about every commodity that exists, to funds representing every market sector that exists, almost every currency that exists, as well as all types of bonds from many countries.
If, using the power of your computer, you have the experience and knowledge to sift through all of that data every day, learn to understand it, and act accordingly, it should be obvious that you can outperform the DIY investor that doesn't have the time, tools, knowledge, or experience to do that. It's also why if you find a really good financial advisor that has a great track record it's probably money well spent to have him manage some of your money for you.

BTW I was an engineer for 38 years, and for the last 10 headed large software development programs for a major aerospace company, and have been retired for 18 years, and have only ever managed my own family's money. I became very good at managing our money after I retired and had lots of time to put into it, and now it has grown to the point where I am no longer trying to grow our capital, I am only trying to earn a modest income from it while minimizing the risk, so I don't even use ETFs. I find ETFs to be much more volatile than funds that only trade once/day and for my purposes these days low volatility issues work the best for me.

If you really believed that "we have established" that passive is better than active, then you couldn't also logically believe that this fellow is "honest," FMF. If it is PROVEN that pure passive is better, he is charging 1 percent for NOTHING. That ain't honest.

I personally would go with a low-cost index fund. I think the guy is rationalizing that his 1 percent fee is justified. I agree with you that he is honest (just not capable of seeing the entire truth).

I think the same is true of you (and of me as well, to be sure). We have not ESTABLISHED that pure indexing is best. There are people who think that (I happen to be one of them). But there is no definitive proof. If there were, there would not be honest people doing what this fellow is doing.

The dogmatism (and there is more dogmatism on passive investing than on any other subject on Planet Earth, in my experience) hurts us all. When we become dogmatic, we close our minds and we stop learning.

I share your take in all you say in the blog entry. But it makes me want to pull back when you say that it is ESTABLISHED that pure passive is best. It is my strongly and sincerely held belief that that dogmatism makes all indexing advocates look bad. If it all were so established as some make out, there would be no one on the other side anymore. And there clearly are still a lot who aren't convinced that the indexers were the first group of investors to figure it all out perfectly.

Rob

Must be one of those Rydex funds! 1% for passive funds is outrageous!

MBTN --

My general assumption is that people reading this blog are far more advanced than average and thus do not really need a financial advisor for much, if anything.

Old Limey --

This statement from you surprised me:

"I do not understand how any reasonable person can make the statement that passive investing whereby you pick a handfull of well known ETFs that represent the well known indexes can in any way be superior to a very experienced financial advisor, or a very experienced individual investor that possesses the time and ability to purchase a selection of the funds that suit his objectives the best out of 871 ETFs and futhermore to actively manage his fund selections by using techniques that indicate when it is advisable to switch out of one that is acting poorly and replace it with one that is acting much better."

It's well documented (and basic math) that index funds deliver average returns before expenses. But after expenese and especially over time, they beat the majority of expert stock pickers/financial advisors -- people who have the time, money, training, and ability to pick better stocks, but for some reason can't. And instead you say the opposite? That's perplexing to me.

FYI, you can see more details on my thoughts here: http://www.freemoneyfinance.com/2011/01/the-beauty-of-index-funds.html

Furthermore, you have admitted that your own ability to beat the market was made possible by two things the vast majority of people (90%? 95%? More?) don't have: 1. the time to do it -- you only were successful after you retired and then spent a huge amount of time managing your money - so much so that your wife called an end to it and 2. a once-in-a-lifetime market event -- in your case the dot-com bubble.

Now I'm not saying that no one can beat the market, but I am saying that far more people can not do so then can, and that I have seen no evidence that financial advisors can help them do so. To the contrary, I have seen evidence that financial advisors (like mutual fund manager) can help people perform worse than they could on their own by using an index fund based strategy.

Of course, if someone is totally ignorant of personal finances, it's likely that a financial advisor will be a benefit. But for someone with even a decent level of financial knowledge and a bit for discipline, they are likely better off on their own IMO.

I think people are operating under the misconception that a financial advisor is a "stock picker" for lack of a better word. Some may be just that, but others look at things from a more strategic point of view. You would be surprised how many advocate asset allocation, passive investing, periodic rebalancing. You might wonder, then, what the individual is paying for. It's the determination of risk tolerance; it's the determination of an optimal asset allocation; it's the rebalancing (which many people forget to do). But most importantly, it's the hand holding that is required to stay the course when things look bleak.

RBK:

If you have read my other posts, I am a big proponent of passive investing, so no, I was not assuming that an advisor was there to provide "tactical asset allocation" as you call it. What I am trying to convey is that, for some people, even a passive strategy requires some measure of hand holding to keep them on couse with a passive, periodic rebalancing strategy. If that 1% fee (which is quite low for a financial advisor in my opinion) is going to save an investor from abandoning a plan because of emotions or short term thinking, then it is money well spent.

FMF:

I think your assumption may be somewhat misguided to be perfectly honest. Yes, there are some people who read this blog who are above average in their financial acumen. However, I am guessing that the vast majority are people who know that their financial skills are lacking and are looking to educate themselves. After all, if your readers are primarily advanced, then why do you get so many "help a reader" questions. :-)

MBTN,

All I'm saying is that your average advisor is not going to recommend passive stay-the-course investing, and your average investor needing an advisor will not be seeking that sort of solution because he won't know the difference. So, too often, the investor is much worse off with an advisor than if he just did a little reading and opened some Vanguard accounts.

You're right about people, of course. They are impatient and easily frightened, and this leads to bad decisions. All I'm saying is that advisors are also prone to such habits (and worse ones).

I agree with you FMF. 1% is in my mind too much to pay for expenses on mutual funds. The index funds I use with Vanguard are generally much less.

Interesting discussion.

As a former financial advisor, giving the limited information here, I think that this guy sounds like he is one of the good guys. Now, a 1% fee is not insignificant and as previously mentioned, many people, including most of the readers of this blog can likely do for themselves what this guy offers at a fraction of the price.

However, I believe that most people in the U.S. don't feel entirely qualified to make their own financial decisions - often for good reasons. How much is an advisor like this guy worth to you if he gets you started investing five years earlier than you otherwise would have? How much is he worth to you if he keeps you from putting half your investment account in the hot stock of the day right before it crashes? How much is he worth to you if he keeps you from getting greedy and too aggressive at market highs and getting sacred and bailing at the bottom?

Sure, buying and holding low cost index funds isn't rocket science. But loads of people choose far worse strategies and end up with worse results. This advisor, as described, would probably be a big help to your average American.

If you don't like his 1% fee, I would be curious what you think a fair price for his services should be. A lower fee based on assets? Commissions? An hourly fee? I know that many people think that hourly fees are the way to go, and they do have some advantages. However, one of the big downsides is that they can scare off the young and the less well off which is unfortunate because these groups of people can usually benefit from solid financial advice more than anyone.

FMF
You are quite correct that the dot.com bubble was a once in a lifetime opportunity that I took full advantage of.
However putting that aside, from 3/31/2000 until 11/1/2007 I made 100.68% on my money. Vanguard's VFINX fund made 13.31% during the same period.
Soon after retiring, from the day I started managing my own money at Fidelity - 12/28/1992 to 2/11/2011 - I have made 1938.58%, Vanguard's VFINX has made 323.88%.
From 11/1/2007 to 2/11/2011 when I moved into the slow lane I have made 12.03%, Vanguard's VFINX has lost 5.31%.
Vanguard's VFINX S&P500 fund performance includes the reinvestment of all dividends from the 500 companies it owns.

You are incorrect on one issue. My wife was not disturbed by the amount of time it took me to manage our money because it really doesn't take me that long. What she did complain about was the huge amount of time I was spending 7 days/week writing a very large investment software program that in the beginning I was giving away to users of the funds database I use. I gave it away to about 200 hundred experienced investors during development in order to get feedback and suggestions on how to make it better. However once the program and its 300 page manual was finished and printed I put it on the market, the free copies had a drop-dead date built into them, and I was handsomely rewarded for my two years of very hard work and incredibly long hours.

Thanks for your advice on passive investing but I am going to stay with my active investment style in which I pay very little attention to a fund's management fees but use "Active Fund Selection" to keep everything that I own in an uptrend. It's seldom that I hold anything as long as 6 months but it works for me. It's very seldom that out of the 11,000+ issues in the "funds only" database that I use that you can't find 5 or 6 funds that are in a nice uptrend somewhere in the universe of equity and bond funds. The company also have a "stocks only database" but I have never subscribed to it. It's far too much work if you use use stocks because you need such a good sized number of them in order to obtain sufficient diversification.

Here's one ETF fund that I bet not a single reader of this blog owns.
Its symbol is JO.
It invests in coffee futures.
Since 6/7/2010 it has gone up 84.57% which is an APR of 142.92% - not too shabby.

This topic is quite right - Not All Index Funds Are the Same

Old Limey --

I think the trick is to pick the fund BEFORE it goes up 85%. ;-)

FMF

You don't ever try to get the whole cake. You let others get the first few slices and then if it looks very good you jump in, be happy with a nice chunk, and then jump out as soon as the trend deteriorates or levels out. That works the majority of the time. In the case of JO I wouldn't want to buy it right now, APRs of 142.9% aren't sustainable for very long.

That's why in March 2000 I had my finger on the trigger ready to to launch the Sell orders. Between 10/27/1999 and 3/9/2000 my portfolio had an APR of 499.35% and the Nasdaq 100 had an APR of 452.37%. That's a good indication of how GREED works, it produces rates of increase that are totally unsustainable. It's only the very greediest of people that keep pushing it up and up. The dot.com bubble took 15 months to go up and then 2.5 years to give it all back. At the time, Alan Greenspan coined the right phrase, "Irrational Exuberance".

The Nasdaq 100 peaked at 4309 in March 2000, its last close in February 2011, 11 years later was 2379. At 76 I doubt if I will live long enough to see it ever make a new high the way our economy, budget deficit, national debt, housing and unemployment situation, and the unfunded liabilities of the big entitlement programs are as the big wave of Baby Boomers qualify for SS amd Medicare.

a randomly selected portfolio of stocks in the s&p 500 over the last 10 years outperforms the S&P index. This was not true in the previous 10 years.

A random group of stocks would have likely outperformed a market cap index (snp500) since 2000.

My only point: what worked in the past might not work in the future. Index funds underperformed pure randomness over the last 10 years.

On the 1% fee: If the strategy consistently outperforms 1% is a deal. Fees must be in context.

If I am given $100 and to keep any of the money I have to offer some of the money to you. If you dont accept my offer, we both get zero. If you do accept my offer we both go home with the split. How much should I offer you? We are both better off if I give you 1 cent.

1% fee is only outrageous if your returns are below the benchmark returns after the fee.

Tyler --

Of course. But based on the facts that we do have regarding the performance of "professionals", do you think this is likely -- that his investment advice would be 1% better than a solid strategy?

In addition, the fee is payable whether or not he outperforms -- it's fixed and it's payable in advance, before you know whether or not it worked. So the risk in finding out is all on the investor. If the advisor is so sure he can out-perform the index alone (after expenses), why isn't his fee contingent on him doing so?

I would guess his advice is not worth the fee. I think most people in the industry are morons who dont have a clue- that's my bias here. You're smart enough to know what works for your financial needs, so the fee is even more expensive for you.

The SEC wont allow him to change based on his performance. (I dont expect he would want to do so.) His ability to charge you for his services is highly regulated.

The partnership structure (hedge fund) is really the only way he could charge you based on his performance.

The 1% fee can be a lot for an index fund. The bigger question might be what else do you get for that 1%?

I'm comfortable managing my own money and wouldn't want to pay someone else unless I had vetted them thoroughly and KNEW absolutely they could do much better than the market. I'm not sure how I would find this person and at the moment I also am not interested in spending the time to find an advisor who could get returns for me like Old Limey (sadly, I believe he has commented before that he won't take anybody else on ;-> ).
On the other hand, my mother is NOT comfortable managing her own money. She is willing to pay a percentage of her portfolio to have somebody else handle it. In return she gets someone who promptly answers questions and emails, is willing to drive to her house to meet with her or sign papers a couple times a year (and she is WAY out in the middle of nowhere), who walked her through all the steps she needed to transfer ownership of accounts when Dad died, who helps her calculate RMDs, fill out beneficiary forms, and perform lots of other maintenance tasks that would leave her at a loss. He is also always willing to get on a conference call with both me and my Mom to answer any questions about anything. She trusts him completely and so do I, and it is reassuring to have a second perspective on issues. For all he does, the 1% is well worth it.

Index funds look great from historical perspectives, however, hasn't the game changed? Our government is piling up massive amounts of debt that, at some point, must be paid back. Higher taxes to individuals and companies are pretty much a sure bet along with higher interest costs. As such, to get adequate returns, we may have to focus much heavier outside our borders and invest in economies with a better long term growth story. Will it be possible to do that in index funds? I really don't know. I have handled my finances up to this point, but I am really thinking about getting some professional assistance.

KMI
Your mother has a real bargain getting that kind of service for 1%/annum of her portfolio unless of course she is a multi-millionaire and then it adds up to a lot of money. I manage my three grown children's accounts for nothing but I basically have them in the same mix of positions that I am so it doesn't make any extra work for me. I handle my son's 401K differently because he only has 26 funds to choose from. I currently have him 30% in a small cap stock fund and 70% in a fund of high dividend paying stocks. I took it over in 2000 when it was $7,103, now it's $236,021 and he contributes the maximum every month and has never had a losing year. During the downturn I had him in a total return bond fund all year. I wish he had a pension to look forward to when he retires, but he doesn't unfortunately, but at 47 he still has a lot of working years ahead of him and has a nice income and a very secure job as his company's top sales producer.

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