Investment Advisors - Should You Have One?

A reader recently sent me the following question:

I've just discovered your blog and have enjoyed reading through your prior posts.  I'm curious about your thoughts on when to use an investment advisor/portfolio manager and when to go it alone.

That's a good question.  Let's take a look at the types of investment advisors and their potential services below:

(First of all, the discussion below is going to be from my own experience.  Others may have had different experiences - feel free to share them in the comments.)

OK, so you are maybe 6 or seven years out and maybe you have accumulated $200K or so - maybe $100K of it is in your 401K.  The grind of daily practice is weighing on you and you start thinking that if you can kick your rate of return up, then you can retire early - or just have a little more security. 

Let's say that you have already read (and understood and applied!) books like "A Random Walk
Down Wall Street".  You understand about risk-adjusted portfolio management.  You have a portfolio that is primarily weighed toward equities with a significant chunk in the large-cap or SP500 area.  (As would be appropriate based on your age and your assumed risk tolerance.)

However, you are now starting to be able to put aside some additional money and you are looking at maybe going beyond the funds that are included in your firm's 401K.  You are starting to look around at other potential investments and are trying to determine whether they are good for you. 

You have heard about investment advisors and portfolio managers, but they are pretty much a blank slate - and it doesn't seem like there is any easily-accessible resource with which to evaluate them.

Let's think for a minute about what we want the investment advisor to provide.  Do we want: 1) A review by a licensed professional so that we can get their opinion about the risk/reward equation of our portfolio and maybe make some changes based on their recommendations? 2) Do we want hot stock tips - that may or may not work? 3) Do we want to completely abdicate all responsibility for our portfolio and just turn it over to someone else - knowing that it will be costly?  4)  Do we really want to have our cake and eat it too - have gains with no risk?  Let's take the questions in order.

Fee-Based Investment Advisor - If you just want someone to give you their opinion, your best bet is to go with a Fee-Based Investment Advisor.  They will charge you a fee of about $500 and will review the holdings in your portfolio.  They may also ask you questions or give you a survey about risk to help you make a portfolio that you may be more comfortable with.  PRO: They won't be trying to sell you anything.  CON: Most financial planners give very "stock" advice.  Diversify, hold US and foreign, hold large cap and small, use bonds to moderate risk.  Now, there is nothing wrong with that advice, but you can get it in many places for less than $500.  There are many books - such as Random Walk - which can present these principles to you in way that it just about as good and for less money.

Further, many mutual fund companies provide tools that perform this service.  (Vanguard definitely does.)  Additionally, there are several online investment advising services that will also let you enter in your investments and show you your diversification - one of them is Morningstar's X-Ray. 

So, a Fee-Based Financial Planner can be very useful if you are not sure about how to construct your portfolio.  However, they typically don't recommend individual investments and are not going to give you hot stock tips.  As far as slow-and-steady goes, they are pretty good.

Commission-Based Financial Planners - are salesman (and women) only  - you have to realize that up front.  They are there to sell you something so that they can make money.  They really only care about you making money to the extent that it means that you can buy more from them in the future.  Commission-Based Financial Planners come in many flavors such as:

Insurance-Based - wants to sell you annuities or "whole life" or "permanent" insurance or something similar.  These products can be OK if you are absolutely terrified about market risk and are absolutely confident that the insurance company will not fail.  However, you pay a fairly high price for your security - typically about 3-4%/year as compared to the SP500 averaged over the long term.  To put this in perspective, a 4% difference over 30 years for a $100K investment is worth $225K, which is significant.

Fund-Family Based - There are several fund families that are sold through agents wherein the funds are OK, just more costly than competitors.  The American Funds are typical of these.  American Funds are typically sold with a sales charge and also have expense ratios in the 0.7-0.8 range where similar investments at Vanguard and Fidelity would be at about 0.1.  This can really hurt you because year after year 0.6-0.7 of your money is disappearing.  Typically, you will have your 401K investments in a fund family and then the fund family will send people around to try and get you to buy more of their funds outside the 401K

The worst part about most commission-based financial planners is that they are typically ABSOLUTELY TERRIBLE at investing.  This surprises some people - after all, they sell investments, right - so they should be good investors!  Nope.  They are typically good SALESMEN, not good investors. They often don't know the first thing about investing.

I don't recommend that you go with any commission-based financial planners.  I have never gotten anything useful out of them that I could not have gotten elsewhere for cheaper.  They also typically don't really know what they are doing - they are just eager to push the next product that corporate tells them to push.

Brokers - I have worked with full-service brokers both in a large investment house and a small one.  In the large investment house, I came to realize that in order for them to pay real attention to you and your portfolio, you really needed to have about $5MM with them.  Other than that, you were just too small potatoes for them to constantly have your portfolio on their mind.

For example, one would think that if one has $500K with a large brokerage house and lets the broker direct the investments, then the broker would keep track of those investments and would initiate sales when the situation warranted it in order to prevent losses - or take some other kind of loss-prevention activity whatosever.  Nope.  Not at all.  They sell you an initial package and then they don't want to hear from you unless you have a trade (fee commission) for them.  It was up to me to monitor the performance of the portfolio and initiate trades.  It was also surprising how little they really knew about investing as well.  When you ask them about their personal portfolio, they were often very bland. 

Occasionally, a large house will have access to an IPO that you can't get into otherwise.  However, IPOs don't always go up.  This was one time that they would call me - when they wanted me to buy shares of an IPO that they had to "fill" by selling it to their investors.  They would also occasionally call to fill shares in some new deal that they were working on.

Smaller brokerage houses were pretty similar, except they wanted more trading.  Also, when you asked them about their personal portfolios, they did a lot of options and futures investing with the bulk of their assets - and that's a little too risky for me.

As for hot stock tips - for both the small and large houses, they were right about as often as they were wrong.  No gain there.

Percentage of Asset Investment Advisors - This category is pretty broad.  On one end it is similar to Fund-family based financial planners, but these guys typically have their own office and do not market themselves as part of a fund family.  On the other end of the spectrum are hedge funds - which typically take 2%/year and 20% of gain.  (I am assuming that you are an accredited investor).

Regardless of how they operate, one rule is typically true - the bigger they are, the harder it is for them to make money.  Why?  Well, for each trade there has to be someone on the other side.  If there are 100M shares of ABC corp and you want to sell 100 shares, then you will probably get close to the quotes price.  However, if you need to sell 10M shares, then the price is probably going to drop significantly before you can get your selling done.  You can try to hedge this using options, but there are a finite number of options available as well.  Also, hedge funds on average have not outperfomed the market and you can build your own using mutual funds.  Hedge funds were pretty hot in about 2004 when their returns were supercharged in part due to the securitization craze - especially CDOs. Most of them crashed pretty resoundingly back to earth.

Bottom Line
If you don't know what you are doing or want a spot-check, then go to a fee-based financial planner (and start reading and studying up on investing).  Otherwise, there is no "magic bullet" investment advisor/portfolio manager - although there are a lot of salesmen that claim to be.  (Hey, if you find one, let me know!)  As you accumulate resources, you will be very aggressively solicited by these salesmen - but I have not yet found anyone worth what they cost.

I suppose if one was completely lacking in knowledge and just had $1MM in a money market account, then most of these products could increase your return.  However, if you are fairly well invested and are making about what the market (SP500) makes, then it is tough for these services to give you much more in additional return.

One other thing that you may have picked up on - before I invest with someone I ask them what they invest in and how that has performed.  You can tell a lot about how much someone knows about investing by how they respond.  Look for WHY they made the moves that they did rather than the actual moves.

In Part 2 I will discuss some services that have actually enabled me to get above-market returns on at least part of my portfolio.