Two Key Benefits of Portfolio Diversification
Now that eight years have passed since the S&P 500 bottomed in March of 2009, I thought it would be a good time to revisit portfolio diversification. It’s easy to become complacent toward risk when the stock market keeps generally moving up from year to year. When times are good it is common that the average investor begins to take on more and more risk. In the short-term, markets are completely unpredictable and risk will show up when you least expect it. It has been my experience over the last 20 years while working with high net worth investors that excessive risk taking/lack of diversification is probably one of the greatest common mistakes I see investors making.
One of the golden rules of investing is to diversify your assets, or as you have probably heard, “don’t put all of your eggs in one basket.” Taking on too much risk and not properly diversifying your investments is one of the quickest ways to derail the success of a long-term financial plan. When designing your portfolio, our objective is to create a mix of assets that will provide you with a high enough expected level of return to meet your long-term financial goals while taking the least amount of risk possible to obtain that return. It just so happens the two key benefits of diversification are:
1) increasing your expected return while allowing you to take less risk
2) helping you avoid frequent and large losses
Every investor has a unique personal risk profile. Through the power of diversification we can maximize your possible future return given the specific level of risk you are willing to tolerate. When many investors first start accumulating assets they tend to believe the sole focus of investing is to generate large returns. But to generate large returns, you need to take concentrated risk. Like a coin, there are two sides to risk – the upside and the downside. Many are on a great scavenger hunt looking for the one great investment that will change their financial destiny. Investors that focus solely on the upside of risk (large returns) are many times negatively surprised when the downside of risk shows up. When the markets become extremely volatile, those that have taken excessive risk sometimes panic and liquidate investments at a large loss.
Downside risk and investor behavior
One of the greatest stumbling blocks to many investors’ long-term success is their own emotions. By diversifying, we can control the risk in a portfolio and reduce volatility. If we can manage volatility, an investor can sleep at night and let their portfolio stay on track for the long run.
I have created the chart below to help visually explain why avoiding large losses are so important. The key learning point of the chart is to realize that the larger your loss, the greater your money has to work to rebound back to where you started. As you can see below, a 20% loss requires a 25% gain to grow back to your starting point. However, a 50% loss requires a 100% gain! That’s a difficult hurdle to overcome, which can become impossible if the loss causes an investor to panic and exit out to cash.
|Percentage Loss||Percentage Gain Required to Rebound|
I think we all know someone who took too much risk during the tech bubble and/or the housing debt bubble, only to panic and sell out during the large downturns of each respective crash. It has been my experience that the majority of investors become increasingly uncomfortable as their loss approaches 20% or more. Sadly, taking on too much risk is one of the biggest mistakes an investor can make. Your only chance of gaining your principal back is to ride through a downturn and transition back into the positive as the market eventually recovers.
Diversification as a tool to balance your risk and return profile
One of the most efficient ways to simultaneously avoid frequent and large losses and maximize your portfolio return given your level of risk tolerance is to diversify your portfolio. At Wealth Engineering, we use a global diversification strategy that reflects the global economy. We diversify across the two main asset class categories of stocks and bonds, and then we further diversify within each particular sub asset class. Here is a quick review of the many sub asset classes your portfolio may own:
|U.S. Large Cap (S&P 500)||Short-Term Bonds|
|U.S. Small Cap||Intermediate-Term Bonds|
|International Large||Corporate Bonds|
|International Small||U.S. Treasury Bonds|
|Emerging Markets||International Bonds|
|Real Estate Investment Trusts (REITs)||Inflation Protected Bonds|
|Municipal (tax-free) Bonds|
|Alternatives||High Yield Bonds|
|Commodities, Gold and Energy|
We further diversify the above sub asset classes on the Stock side by equity style and size of companies. Overall, we favor a tilt toward the “value” style and “smaller” size of companies within stock funds. Much of the academic research we follow documents a compelling long-term outperformance by those stock funds with a slight investment tilt toward smaller companies (more aggressive) and the value style of companies (instead of growth). Think of the value style as investing in companies that based on certain metrics (such as price to book), indicate that certain stocks are underpriced relative to their intrinsic value.
Combining non-correlated assets
As you can see in the above chart, we invest in approximately 15 different asset classes. The purpose of so many asset classes is that we are seeking to find asset classes that are “non-correlated.” This is a fancy way of saying we want investments that do not all move in the same direction at the same time. An economist named Harry Markowitz brought forth the idea of combining non-correlated assets via his research at the University of Chicago. He won a Nobel Prize for his development of “Modern Portfolio Theory (MPT).” We find tremendous value in MPT and it is at the cornerstone of how we build portfolios today.
Through the science of MPT we can create a globally diversified portfolio that balances risk and return. Some of the asset classes we use are high octane, high risk and volatile (for example, small cap value and emerging markets). But by combining a wide mix of risky and volatile assets with very conservative and less-volatile assets (for example, high quality bonds), we can smooth out the risk and return profile of a portfolio and maximize your possible return relative to your ability to handle risk.
Asset class charts
If you click on this hotlink it will take you to an asset class chart from JP Morgan – Asset Classes – JP Morgan – 12-31-2016. The chart illustrates annual performance for many of the asset classes we use. Those in the top rows are the highest annual performers and those in the bottom rows the lowest annual performers. This is a great visual replication of the benefits of diversification. The key takeaways from this chart are:
- Asset class performance is completely random. Last year’s winners are many times next year’s losers.
- The more volatile stock asset classes, such as Emerging Markets, consistently swing from having high double digit positive performance to high double digit negative performance.
- JP Morgan outlined a mock “asset allocation” mix on the chart (the solid line connecting the allocation mix dots from year to year). You can see the benefit of the diversification mix as the allocation portfolio tends to consistently perform in the middle of each respective chart, thus avoiding frequent and large losses!
If diversification is so great, what are the downsides?
There are two issues around diversification that I would like to point out. I wouldn’t necessarily call them downsides, but they will cause an investor to take notice occasionally depending on market conditions.
- A diversified portfolio will never be at the top of the “asset class chart” when ranked by performance. This doesn’t mean you can’t have strong overall performance from your globally diversified portfolio. It only means that your portfolio is by nature a mix of the performance of every asset class you are invested in. Thus, mathematically if you average a mix of high performance asset classes and low performance assets classes, the average (your portfolio), is likely to fall somewhere in the middle. But keep in mind, our goal by diversifying is to create a portfolio with more consistent performance, thereby providing you with the highest probability of meeting your long-term financial goals. For a baseball comparison, when pursuing investment returns, we are seeking “singles” and not “home runs.”
- It has been my experience that investors can become restless when they see the S&P 500 outperform their globally diversified portfolio. Our media loves to focus on the performance of the S&P 500. In 2016 the S&P 500 was the third highest performing asset class, while international stocks were one of the lowest performing. Thus, a globally diversified portfolio did not experience anywhere near the same level of performance of the S&P 500. This happens occasionally, but it is my experience that the home country index out performance is usually short-term. The S&P 500 is only one of many assets classes we invest in. It’s also important to know the S&P 500 is 100% in stock, while your portfolio is a combination of stocks and bonds. Although four out of the last five years have been favorable to the S&P 500, it is a great reminder that this media darling also lost 55% during the 2008/2009 housing bubble crash and 43% during the tech bubble collapse in 2000/2002.
Rebalancing your portfolio
When we first start working together, I design a global strategic allocation for your unique portfolio. Each quarter I refer back to that allocation when rebalancing your portfolio to make sure you are still on target for the long run. Some of my clients are in the “accumulation phase” and adding contributions on a regular basis, while many of my clients are retired and in the “distribution phase.” For those in the distribution phase, this means a monthly or quarterly withdrawal from one or more of your investment accounts. By following a disciplined quarterly rebalancing strategy, it ensures that I am constantly maintaining your global diversification posture, while simultaneously maximizing the balance of potential risk and return, regardless of whether you are adding or withdrawing from your portfolio on a systematic basis.
Hopefully all of the above information has given you some additional insight as to why we believe so strongly in global diversification and our disciplined portfolio management process. As we move forward, know that we will continue to pursue additional asset class opportunities if we have a strong conviction it will help us further balance risk and return in your portfolio, minimize frequent and large losses, and most importantly, help us guide you to your long-term financial goals.
About The Author
Dave Fernandez, CFP® is a native of Arizona and has over 20 years of experience in the financial services industry. He started his financial services career in 1995. As a NAPFA Registered Financial Advisor, Dave owns a fee only financial planning and wealth management firm, in Scottsdale, Arizona called “Wealth Engineering, LLC.”
529 College Savings Plans
Many of my clients have children, grandchildren or other loved ones who plan to attend college in the future. However, it is becoming more challenging each year to plan for the cost of college as the costs are increasing at more than double the rate of inflation. This has been a consistent increase over the last 38 years. To put this cost increase in perspective, below is a chart comparing the rates of inflation over the last 38 years (since 1978) for college tuition & fees, medical care, new cars, and the overall consumer price index (CPI):
Chart courtesy of www.dshort.com
Here are some current average “all in” college costs (tuition, fees, room and board) in today’s dollars:
• Public University – In-State – $20,100/year
• Public University – Out-of-State – $35,400/year
• Private University – $45,400/year
• Harvard, Stanford, Yale or similar = approximately $54,500/year
I can understand why many students have turned to student loans to partially or fully pay for college. In fact, today two-thirds of students graduating from American colleges/universities are finishing school with some level of debt. I have read that the average borrower is $29,400 in the red. Also, total student loan debt outstanding recently crossed the $1.2 trillion mark!
The good news is that if you have the means to save for a loved one that wants to attend college, there is an excellent savings vehicle for this purpose called the 529 College Savings Plan.
What is a 529 plan?
A 529 college savings plan is a tax deferred savings plan sponsored by a state to allow families to save funds for future college costs. They share some characteristics similar to IRAs and Roth IRAs. There are two types of 529 plans: prepaid tuition plans and savings plans. Prepaid plans are plans that allow you to prepay tuition at a particular college in advance at today’s prices. The most common type of plan is the 529 savings plan and that will be the focus of this article.
What are the main benefits of 529 savings plan?
One of the greatest benefits of this type of plan is that all contributions and earnings grow tax deferred like an IRA. And as long as the funds are used for qualified education expenses, all distributions from the plan are tax-free like a Roth IRA.
What are qualified educations expenses?
Qualified education expenses include tuition, fees, books, supplies, and equipment (computers) required for study at any accredited college, university or vocational school in the United States and some international schools. This can also include room and board.
How much can I contribute to one of these plans?
Most plans will allow you to make total contributions of up to $200,000 to $300,000 over the life of the plan. Since these contributions are considered gifts to your child, grandchild or other loved one, you will want to ensure any annual gifts stay below the annual gift tax exemption amount of $14,000. For those interested in making a larger lump sum gift, 529 plans specifically allow a gift exemption of 5 years’ worth of annual gifts to be made in one year or $70,000 (5 x $14,000).
These contributions are permanent gifts for estate tax purposes. Thus, for those with large estates, this is another way to gift family assets down the line but still maintain control of the gift if you are also the owner of the 529 plan.
Who is the owner of the 529 plan?
There is always one adult owner and one beneficiary (future college student) per 529 plan. Any adult can be the owner of the account. This is typically a parent or grandparent, but could include any adult family member or friend.
What if I save for college but my child receives a scholarship?
529 plans allow you to change the beneficiary of the account. Thus, if you have another child that needs more financial assistance you could make a change to designate them as the new beneficiary. Or, if the child may pursue a graduate degree, they could use the funds for later educational funding.
What happens if we use the funds for something other than a qualifying college expense?
Contributions and earnings are distributed on a pro-rated basis. You will have to pay taxes on any of the earnings distributed and also pay a 10% withdrawal penalty on the distributed earnings. There is no penalty or taxes on the distribution of original contributions.
You mentioned these are state run plans. Does that mean I need to invest in my home state’s 529 plan and must my child go to college in this same state?
Another great benefit of 529 plans is that you can invest in any state 529 plan and your child can go to any school anywhere in the United States, or certain schools outside the U.S. For example, you may live in Arizona, but you could decide to contribute to a 529 plan in California and your child may decide to go to school in Colorado.
If almost every state has a 529 plan, which one should I choose?
Out of all of the state 529 plans, there are a handful which are consistently ranked near the top each year for being well run plans, with excellent investment choices and reasonable fees. The one I highly recommend is the 529 plan run by the state of Nevada and administered by Vanguard. I personally use this plan for my two kids.
Morningstar recently ranked the best and worst 529 Plans for 2016. You can read the article here: http://www.investopedia.com/articles/personal-finance/111616/best-and-worst-529-plans-2016-morningstar.asp Morningstar has consistently given Vanguard’s 529 plan a top rating every year. Also, as the 529 plan has grown in assets, Vanguard continues to reduce the expense costs of the investment choices. There are other great choices for 529 plans as discussed in the above article if you prefer a different investment custodian.
Another great website resource to research and learn about saving for college and 529 College Savings Plans is at http://www.savingforcollege.com/.
Are there any additional tax benefits besides tax deferred growth and tax-free distributions?
Many states allow you to take a deduction against your state income tax return for any contributions made to a 529 plan each year. In Arizona, they recently increased this deduction to $2,000 for an individual and $4,000 if married and filing taxes jointly. Arizona is also very flexible in that you can make a contribution to any 529 plan in any state and still use the Arizona deduction against your state income taxes.
Below is a link to a chart of all current state tax deductions available by each state. You will want to review this with your financial advisor to help you determine which 529 Plan may be the best option considering your state of residence. http://www.finaid.org/savings/state529deductions.phtml
What are my contributions invested in within the 529 plan?
Most plans have a mix of mutual funds and age-based funds to invest in. Your financial advisor can help you determine the best asset allocation for each child. Note, 529 plans typically limit investment exchanges to twice per year.
The Biggest Challenge To Investing Success
Our Blog Post today is brought to you by fellow fee-only financial advisor, Phillip Christenson of Phillip James Financial. His article is about The Biggest Challenge to Investing Success. Phillip is a CFA, Chartered Financial Analyst, independent financial advisor and portfolio manager. He helps people with comprehensive financial planning, tax planning, and retirement projections. If you’re ever in Minnesota reach out to Phillip for further financial help. Enjoy the article!
The Biggest Challenge To Investing Success Is You
With modern technology, more and more people are taking it upon themselves to manage their own investments and other financial planning decisions. In the past if you wanted to invest your money you would go through a broker. You would either tell them what to buy for you or ask for a recommendation, in which case they would sell you some stocks or mutual funds, earning a commission along the way. Today many people have cut out the middle man and now use various online tools and mobile apps on their smart phones to invest their money themselves. While this gives the individual investor more power and control than ever before, this is not always a good thing. When you have the ability to buy and sell an investment with the click of a button on a mobile device, the potential for overtrading and making mistakes is far greater that it ever was. The fees alone will add up quickly and eat into your return.
Making Knee Jerk Reactions Is A Common Mistake
To give you an idea of how being overactive with your trading is a bad thing take a moment to think about how quickly you can initiate a trade using modern technology. Not only do smart phones enable you to buy and sell stock from anywhere, they also keep you connected to the world and feed you information all the time. So, let’s say you are having lunch with a group of friends and while you have a moment you check your phone. You quickly become dismayed when you find out that one of the companies you are invested in has taken a decent sized hit with its stock dropping several points.
You quickly react and sell off your stock at a significant loss figuring that it is better to lose some money than to risk losing even more. Not long after you sell the stock it rebounds. If you had only waited before acting, you could have avoided losing a good portion of your investment. This is just one example of how modern technology can prove to be a detriment to you when it comes to your investments. If you hadn’t checked your phone you never would have noticed the temporary dip in the stock. Even if you had somehow found out about the stock dropping, without the ability to execute an online trade you would have had to contact your broker to initiate a sale. Your broker then may have advised you to wait before selling in case the stock rebounded. Or at the very least maybe it was enough time for you to digest the news and make a more rational decision about the future prospect of your stock. In other words, there were a series of buffers that would have prevented you from making the snap judgement that you made, which ultimately ended up costing you money.
How Can You Avoid Making Errors With Your Financial Planning?
One way that individual investors can help to ensure their long term financial health is to commit to an investment strategy that focuses on the long-term rather than short-term trading. Stocks go up and down on a regular basis, if you remain fixated on these daily changes you are going to stress yourself out trying to manage your money on top of your job and other responsibilities. Instead you need to focus on the big picture and realize that as long as you think the stocks you own will be higher over a long period of time, then any short-term fluctuations are inconsequential.
As an investor, you need to keep in mind that you are trying to plan for the future by investing your money today. That means your goals should be to watch your money grow over long periods of time. If you speak with any reputable financial planner, they will tell you the same thing. Unfortunately, since most people don’t consult a financial planner, they continue to make mistakes that limit the growth of their investments.
Try to Limit The Number Of Transactions That You Make
If you want to increase your chances for growing your wealth you need to limit the number of transactions make. This goes back to the concept of having a long-term time horizon. A lot of investors who take charge of their own money don’t stop to think about how quickly the fees they are paying per transaction can add up. But not only will costs eat into your return, any gains you have will be taxed at short-term capital gains, usually much higher than long-term capital gains.
Taking Charge Of Your Own Financial Planning Can Work If You Make Smart Choices
It’s human nature to panic when faced with a crisis. Be it a personal crisis, an accident, or a financial one where you see that a stock you are invested in has started to drop suddenly. No matter what type of situation you find yourself in panicking will generally make things worse. That’s the lesson that people who manage their own money and engage in online trading need to understand. The market fluctuates and stocks go up and down all the time. Just because one of your stocks go down doesn’t mean that it will continue to do so. By empowering yourself to manage your own money you are accepting responsibility for your long term financial health. This can be a good thing if you make smart decisions. Always keep the big picture in mind when investing, don’t make snap decisions, and try to limit the number of trades and other transactions you make. If you can do this then you have a better chance at managing your own investments.
If you have questions or want help with your investments, then maybe it’s time to talk to an fee-only financial advisor today. They’ll be able to create a financial plan that is customized to your situation and goals and make sure you’re invested the right way.
Markets Are Efficient
I would like to thank Greg Phelps for today’s article about Efficient Markets. Greg Phelps, CFP®, CLU®, AIF®, AAMS® is a 20+ year industry veteran. His firm Redrock Wealth Management provides fee only fiduciary financial advice and retirement planning to clients in the Las Vegas area.
In 1965 Eugene Francis “Gene” Fama, (CEO of Dimensional Fund Advisors and Nobel laureate in Economics), proposed the core concepts of market efficiency. This concept can reduce your investment risk and help ensure you achieve the performance your financial plan requires.
Gene was the first to introduce the efficient market hypothesis. The concept is so simple it doesn’t take a financial genius to understand it. I’m actually shocked most investors – and Wall Street – doesn’t understand it.
I suppose there’s probably a good reason Wall Street doesn’t “get it”. Wall Street want’s you think they own the “secret sauce” to investing. If investing was easy (as EMH makes it) you wouldn’t need Wall Street’s overpaid analysts telling you what to invest in. They’d lose revenue, so Wall Street needs you to need them!
EMH doesn’t make headlines, and it’s not fun or sexy. In fact, EMH is just plain boring. But boring is good sometimes, boring is effective.
There are two types of investing “styles”, active investing and passive investing. If you believe in the efficient market hypothesis, you’re a “passive investor”. If you believe markets are inefficient, and you can outpace other investors by good security selection and/or market timing, you’re an “active investor”.
In my own words, here is the efficient market hypothesis:
A security is worth the highest price a buyer will pay and the lowest price a seller will accept at all times. Since information is available to the masses at the speed of the internet, current prices and future expectations are judged by all investors equally. Therefore you cannot buy an “undervalued” asset or sell an “overvalued” asset; hence you cannot “beat the market” consistently or predictably by trading individual securities.Source: Eugene F. Fama, Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics, Vol. 49, Issue 3, September 1998, pages 283 – 306.
Simply put, there is no secret sauce to investing. A security is worth what it’s trading for at any given moment.
If securities are always fairly valued, is it possible to beat the market? Is it possible to know which one will outperform the next?
No, it’s not. Not according to EMH anyway. Of course, statistically speaking some managers and traders will always beat the benchmark indexes. By default, some must beat the index or no one would invest in anything but the indexes.
That being said, beating the benchmark index isn’t much more than luck. Throw enough darts at a dartboard, and eventually you’ll hit a bullseye!
The best price is the current price
When my boys were young, my wife and I spent an awful lot of time at local parks. Every once in a while the boys would want to go running after the ice cream truck.
Let’s say a milkshake was about $2.00, and a Creamsicle® maybe $1.25. Ice cream cones were the cheapest at $1.00, and a snow cone about $1.50.
Market forces set those prices. We trust market forces set efficient prices everyday. The price is always the most a buyer will pay, and the least a seller will sell for.
If milkshake sales struggle, you’ll likely see a drop in the price. If the ice cream truck driver keeps running out of ice cream cones, you’ll likely see the price of ice cream cones rise to maintain inventory and increase profits.
Prices are determined by supply and demand, i.e. market forces. Stocks, bonds, and every other investment are no different. Your house isn’t any different either, it’s only worth what a buyer with cash in hand will pay on any give day.
The collective wisdom of the masses
Millions of investors and managers are constantly analyzing and trading securities around the clock. They each have their own opinions on what direction a security is headed. Up, down, sideways? They all “think” they know.
For every buyer who thinks a stock or bond is going up, there’s a seller on the other side of the trade who thinks it’s going down. Who’s right… you or him?
For every overpaid highly educated analyst at your brokerage firm, there’s an equally overpaid highly educated analyst at your neighbor’s brokerage firm. Whose analyst is right… yours or his?
Have you ever been to a fair where they ask you to guess the number of marbles (or beans or pennies) in a jar? If you’re the closest to the correct number you win a prize.
As it turns out it’s not the smartest guesser that’s usually closest; it’s the average of all guesses that’s closest. This is called swarm intelligence 2, and it simply states that masses of average intelligence are better than any individual’s intelligence.
Many studies have been done on swarm intelligence. In 2008 researchers did a study at the Max Liebermann Haus of the Stiftung Brandenburger Tor (in Berlin, Germany). They had a jar with 569 marbles in it and participants were asked to guess how many marbles were in the jar. Out of 2,057 guesses the average guess was 554. It’s pretty amazing how close the masses were to the correct number of marbles.
Swarm intelligence shows that in a large group, the average of all guesses is most accurate, not the “smartest” guy’s guess. So I ask you, if there are masses of investors pricing stocks, bonds, and ice cream every second – what makes you think you’re right and they’re wrong? 2011 The Association for the Study of Animal Behaviour; Swarm intelligence in humans: diversity can trump ability; Stefan Krause, Richard James, Jolyon J. Faria, Graeme D. Ruxton, Jens Krause.
The upcoming election is no different
Recently, I’ve had many many investors saying “the markets will tank if Trump is elected”. The funny part is for every investor making that claim, the next client comes in and says “the markets will tank if Hillary is elected”.
So who’s right? Client A or Client B? The stock and bond markets are where they are right now based on all available information. Securities are priced fairly at all times based on knowledge and expectations for the future.
What’s even more curious is the Brexit vote. Masses of investors expected it to fail. Very few thought it would pass. Polling showed it would not pass as well.
When Brexit passed, the markets tanked – for a minute! It’s the old “buy on rumors, sell on news” theory. Investors bid up a stock in anticipation of upcoming earnings reports. Typically, no matter how good the news it the stock will sell off after reporting.
I suspect like Brexit, the stock market will drop no matter who is elected President. I also suspect it will be a short term blip on it’s permanent march towards higher long term prices.
Is there a secret sauce to investing?
You’re not smarter than the markets. I’m not smarter. Fortunately, no one else is either! Statistically however, some do get lucky. You must understand that “luck” is not “skill”.
Of course you don’t know what corporate insiders know. You don’t have inside information that would make buying a stock cheap – or selling a stock high – possible. If you did and acted on it you’d be on a fast-track to jail!
Aside from inside information, a stock is always worth what it’s trading for. The same goes for bonds, or your house, and every other investment. They’re worth what someone will pay and what the counterparty will accept based on all available information on any given day – not a penny more or less.
To reiterate, you cannot “beat the market”. I realize you’ve been told for years through slick ads and entertaining TV shows that you, or your advisor/manager, could pick the best stocks, or buy the best bonds. This is the great lie of the financial media.
And what exactly are the best stocks or bonds anyway? Do they beat the market? Do they have the highest return or the lowest risk? Maybe the highest dividend or interest rate?
The fact is the best stocks or bonds are all the stocks or bonds in an asset class because asset classes outperform the best and brightest investment managers far more often than not. Just take a quick look at the SPIVA Scorecards. They clearly show that the majority of indexes beat active managers. Over long periods of time, the percentage of managers losing to the index increases.
Since all information is available worldwide at internet speed, every security is fairly valued and markets are efficient. Since markets are efficient, you cannot beat the market consistently or predictably, therefore there’s no point in taking the risk of trading individual securities.
So what does this mean to you and your financial planning?
When it comes to your finances, the most important thing you need to do first is have a plan! Planning trumps all investment opportunities, because failing to plan is planning to fail (Benjamin Franklin).
Aside from quality financial planning, like my colleague Dave Fernandez at Wealth Engineering does, investing should be looked at as a tool to execute your plan. While the tool is important, the plan is critical.
Since all the stats show index investing beats active investing, become and index minded investor first. Thereafter, you can search for ways to tilt and tweak indexes to improve returns. Mutual funds by Dimensional Fund Advisors are a good place to start!
Emotional Bias in Investing
This article was written by a special guest author and colleague, Stephen Reh. Stephen Reh CFA, MBA, CFP® is the founder of Reh Weath Advisors LLC and https://investwithsteve.com/, a financial advisor in Southern California. Stephen is a member of the National Association of Personal Financial Advisors like David J. Fernandez, CFP® and specializes in financial planning and investment advice.
In the investment world, the human element impacts many of our financial decisions. Let’s look at common biases that can affect investment decisions. One set of biases in behavior finance is Emotional Bias. Emotional Bias is caused by individual predispositions that can affect how someone makes a decision. Emotional Bias is how an individual will frame information and make decisions. An important key is that emotional bias is not deliberate but is a spontaneous reaction. Even as an advisor with training on making optimal financial decisions, I still remain vigilant that these biases are not affecting my decision making process.
Loss Aversion -
This bias is one where someone will focus on gains and losses relative to risk rather than returns relative to risk. Meaning that a 10% loss has a greater impact than a 10% gain in your decision making process. You will commonly see this with investors who are holding on to stocks that have lost money in hopes of gaining it back so they will not have to sell the stock at a loss.
What can you do? First step, recognize there might be a loss aversion. Generally, when people recognize they are having a hard time recognizing the loss, the mere knowledge of it helps them to evaluate other alternatives that may be superior to holding on to the loser.
Overconfidence (Illusions of Knowledge) –
Someone can become confident because they feel they have better information or that they are processing information better than others. This exhibits itself in underestimating risk and setting odds of good outcomes too high vs poor outcomes. Sometimes this bias exhibits itself in excess trading or holding very concentrated risky portfolios.
What can you do? You can keep a record of your decisions including motivation and expectations of the investment. Even on winners, did they make a profit for the reasons you thought or was there another reason? On the losers, did they lose more than you anticipated?
Status Quo Bias –
An individual with a Status Quo bias would be slow to change or react even when it makes sense. For example, an investor that has always been aggressive investors may not want to change their asset allocation to be more conservative even if they recognize that they have become more risk averse.
What can you do? Recognize there might be a Status Quo bias. Develop asset allocation models and other tools and plans that you can implement to mitigate the Status Quo bias.
Endowment Bias –
Individuals place a greater value on investments they own rather than potential future investments. Endowment bias and Status Quo biases are often exhibited together. With this bias, you often see assets that are bought that the investor is familiar and comfortable with.
What can you do? Generally, the endowment bias will show up in the asset allocation. Make sure the asset allocation is appropriate. Recognize there might be an endowment bias and try to look at new alternatives with an open mind.
In general, having decisions making process and plan will help mitigate these biases. If you have any questions about these biases and how they have affect your decisions, give Dave Fernandez CFP® a call. Dave can help make sure your portfolio and financial decisions do not suffer from emotional biases.
401(k) Options When You Leave Your Employer
Regardless if you are retiring or moving to a new employer, once you leave your current job you will need to decide what to do with your 401(k). You have a handful of choices. I have outlined the benefits and disadvantages of each option below. Your personal circumstances may favor one option over the other. I highly recommend you discuss your options with your fee only financial advisor whenever you transition employment so he/she can help you determine which pathway provides the best choice for your unique financial situation.
1) If you have a balance of $5,000 or greater you can likely leave it in your current plan as most 401(k)’s provide a deferral option.
a) This is the easiest decision and likely no action is required on your part. Although, I am always amazed how many investors choose this default option when there are better choices as described below.
a) Every 401(k) plan has its own unique set of investment options. Your current plan may have a limited choice of investment options such as being overly U.S. centric. We live in a global economy and I believe portfolios should provide a decent amount of international options on both the stock and bond side of investment choices.
b) Many 401(k)’s have incredibly high internal expenses. It is not uncommon to see mutual fund choices with expense ratios north of 1.5%. It is very important to keep an eye on your overall investment expense exposure. The more you can lower your investment expenses, the higher probability you can keep returns compounding for your long-term financial benefit.
Be aware that if your balance is less than $5,000, you will want to take action on one of the below choices as your employer may have the option to automatically cash your 401(k) account out or transfer you to an IRA. Cashing your 401(k) account out can have large tax consequences as outlined later in this article.
2) Rollover your balance to your new employer’s 401(k) plan.
a) This is a good way to consolidate financial assets, especially if you have more than one 401(k) from past employment. I always favor consolidation and simplification where possible.
b) This could be a great choice if you have an excellent set of diversified investment options that are low cost.
a) It is not uncommon for your benefits department at work to occasionally choose a new custodian or a new set of investment options in your 401(k) every few years. You have less control in this situation as you are forced to invest in whatever options are provided. What may look great today could easily change unexpectedly.
b) Your new 401(k) may have poor investment choices, and/or investment options with high expenses.
Most 401(k) rollovers are initiated from the 401(k) you are leaving. Your human resources department or benefits office may require that you fill out a termination/rollover packet of paperwork. Some 401(k) custodians may take direction over the phone. Collectively you and your financial planner can determine what is the next step to move forward and he/she can help with completing any necessary paperwork.
3) Rollover your 401(k) to an IRA
a) This is typically my favored option. Once you set up an IRA you have the whole investment universe of options to invest in. This could be mutual funds, ETFs or stocks. It is easy to build a well-diversified portfolio when you have such a wide array of investment options to choose from.
b) You have control over your money. You can always move your IRA to another investment custodian if you prefer a change of investment options.
c) You will have control over investment expenses. There are a number of low cost investment options available via no-load mutual funds and ETFs at a number of investment custodians.
a) If you are still working, you may end up with one extra investment account in a separate IRA. This is a minor disadvantage. The benefits of investment selection and cost control provided with rolling your 401(k) to an IRA easily outweigh the disadvantage.
4) Cash out your 401(k)
a) None, other than liquidity if you are in a situation desperate for cash.
a) This is typically the worst decision you can make as any balance withdrawn is a taxable withdrawal. Your 401(k) custodian is required to withhold 20% in federal taxes, but your tax exposure could be higher depending on your marginal tax bracket.
b) You will owe state income taxes on the withdrawal if you live in a state that taxes income.
c) If you are under age 59 ½ you would also be subject to a 10% early withdrawal penalty.
d) If you have an outstanding 401(k) loan balance, the loan would also become a taxable event and be subject to the taxes and penalties described above.
e) You will miss out on any future tax-deferred compounded growth by cashing out your 401(k) today.
There are a couple of other scenarios to be aware of before deciding on one of the above choices:
1) What if you have a loan balance against your 401(k)?
a. You typically have 60 days to pay back a 401(k) loan after leaving employment. After 60 days, your loan balance will likely be considered a taxable distribution and you will be subject to taxes and possibly a 10% early withdrawal penalty if you are under 59 ½ years old.
2) What if you have greatly appreciated employer stock in your 401(k)?
a. You may have a tax preference option called Net Unrealized Appreciation or NUA which allows you to transfer the stock out of the 401(k) and pay ordinary income taxes on the cost basis and capital gains taxes on the gains. You will want to review this option in detail with your financial advisor and CPA prior to making any decisions.
In closing, I highly recommend you notify your financial advisor of any employment changes which could impact your 401(k) options. Once he/she is aware of your options, they can help you determine what the best course of action is for your personal financial situation. Your financial planner can also join in a conference call with your benefits department and/or 401(k) custodian to make sure you both understand all of your options and what steps are required to move forward.
5 Common 401k Problems Investors Make
This article was written by a special guest author and colleague, Stephen Reh. Stephen Reh CFA, MBA, CFP® is the founder of Reh Weath Advisors LLC and https://investwithsteve.com/, a fee only financial advisor in Southern California. Stephen is a member of the National Association of Personal Financial Advisors like David J. Fernandez, CFP® and specializes in financial planning and investment advice.
First, I wanted to thank David J. Fernandez, CFP®, your Fee Only Advisor in Scottsdale, for giving me the opportunity to discuss common things I see when looking at investor’s 401k accounts. Similar to David, I help individuals and families with retirement and financial planning needs. One of the areas we commonly see is 401k retirement accounts. Below are some common issues, we run into.
Turning Down Free Money
You would be surprised how many employees say, “no thank you Mr. Employer, I don’t want your free money.” If your employer offers to match your contributions and you elect not to contribute, you literally are giving away free money. Even with 401k’s that have inferior investment menus or high costs, the benefit of the company match will almost always outweigh any negatives the plan might have.
Solution – At least contribute enough money to maximize your employer match. We can help you craft a plan that maximizes your employer match and how it fits into your overall investment plan.
Naïve Diversification / Kitchen Sink / Just Pick Everything
A participant is sometimes knowledgeable enough to know they want diversification and they don’t want all their eggs in one basket. What do they do? They pick everything on their 401k menu. The problem arises in that the person really doesn’t know how much risk they are taking or what they are invested in. If there were a lot of high yield bond funds on the menu, a participant may have way too much risk with high yield bonds. You can also have times where the plan has significantly more stock choices than bonds choices which may result in a portfolio that is not appropriate for the investor.
Solution – Do your research and develop an investment plant that includes sound asset allocation and diversification. Need help creating that plan, contact a fee only advisor and they can help save you time and build an appropriate model for you.
Picking the Winners and Selling the Losers
This one sounds good on the surface but what this means is that you are likely late on buying the funds that have done well and late selling the funds that have done poorly. You also run the risk of having a very concentrated position at the wrong time. If you invested in the top funds in the late 1990s, you likely were overexposed to technology. Prior to the financial crash, if you picked the top funds, you were likely overexposed to commodities and financials.
Solution – Do your research and develop an investment plant that includes sound asset allocation and diversification. Need help creating that plan, contact a fee only advisor and they can help save you time and build an appropriate model for you.
Assuming that Target Date Fund Matches Your Risk Tolerance
The Target Date funds start out aggressive and will get more conservative over time. However, there is absolutely nothing that matches a participant with the risk level they are comfortable with. The match is entirely dependent on either your age or the age you want to retire. If you are conservative and young, your target date fund is likely too aggressive for you and you might panic in a downturn. If you are older and have a high tolerance for risk, you might be disappointed that your target date fund did not perform better. Another common issue I see is a young investor picking a target date fund with a slightly “older” age. The problem here is most of the funds are fairly aggressive until you near retirement. So by picking what you thought was a conservative portfolio, it did not make a difference until decades later.
Solution: Build a portfolio that matches your risk. A fee only advisor like David can help build a portfolio that matches your needs and risk.
Forgetting to Rebalance / Ignoring Your Plan
Some people have not rebalanced for years. By not rebalancing, the portfolio might no longer be diversified and you could be taking excess risk or potentially not enough.
Solution: Check your plan at least annually to verify if it meets your needs. Not sure it meets your needs? Contact a fee only financial advisor such as David to help keep your 401k on track.
David and I help investors every day to build portfolios that will meet their needs and goals. If you would like help making sure your investment plan is on track to meet your needs at a risk level that’s appropriate, give David a call.
Sports fans love to compare the sports heroes of their childhood era to current athletes and make a claim on who was the best ever. In many sports this claim on who was the best athlete of a particular time period can be subjective at best. However, baseball is one sport that allows for such a comparison because there are so many years of statistics for past and present athletes. But, what if the statistics were flawed because the data had been manipulated? Wouldn’t this ruin the fun in attempting to determine the “best ever?” As you will see in this article, unlike the baseball figures which are real, the statistics in the mutual fund world have been massaged to make “active” management of mutual funds appear to be better than the actual results.
In the sport of Major League Baseball the current batting averages for most professionals are between .260 to .275. Anyone who hits .300 or better is considered an excellent baseball player. A hitter below .250 would be considered poor and below .200 would be considered unacceptable. A hitting average of .400 or better is truly elite status. Hitting .400 or better is such a difficult accomplishment that the last time it occurred was 1941. Ted Williams playing for the Boston Red Sox ended his season in 1941 with a batting average of .406 – a phenomenal accomplishment.
We recognize how amazing Ted Williams’ achievement was because we can compare his batting average or statistics against his peers, past and present. But, what if baseball did not include all of the batting averages over the last 145 years? Wouldn’t this greatly affect the mean batting average? What if they only included the averages above .275? How would you really know who was a great player if you could not compare them against every player that has ever stepped foot on the field? If baseball did exclude many players’ batting averages you would conclude that all players hit above .275.
Certainly this may not take away a lot of esteem from Mr. Williams, since he has had the highest batting average over the last 75 years. However, there would be a lot of current players that would look like very poor performers, when compared to the long-term averages. In reality, players would not be poor performers, but when compared against an average that had been manipulated, they would appear to be.
Fortunately the sport of baseball does not alter the data. Unfortunately, the game of mutual fund investing does. In fact, many players, i.e. mutual fund managers, are not included at all. It leaves the individual investor to believe that there is nothing but a bunch of .275 plus hitters in the investing league, when in reality, there are numerous hitters below the .275 mark. They just exclude their records.
This flaw in the mutual fund data is known as “survivorship bias.” If one were not aware of this missing data, one could mistakenly believe active managed mutual funds are generally superior to index funds, when in fact, the opposite is generally true. In addition, actively managed funds generally cost 3 to 10 times as much compared to low cost index and passively managed fund options. Thus you could end up greatly over paying for an investment product that has a higher probability of underperforming over the long run.
This “bias” effect has a huge impact on the long term performance records of actively managed equity mutual funds. Mutual funds that have poor performance are made to disappear, most often by the mutual fund company merging a poor performing fund into a better performing one. Unfortunately for investors, only the performance reporting disappears, not the poor returns.
Dimensional Funds (DFA) recently conducted a study over the last 15 years with a sample of 4,500 stock and bond mutual funds, representing approximately $6.6 trillion of wealth. The chart below shows the percentage of equity funds that have survived over the last 3, 5, 10 and 15 year time periods. It is amazing to see the amount of funds that disappeared over the last 15 years, most of them due to poor performance. For example, if you look at the bottom right square, representing the 15 year time period, you can see that only 43% of the mutual funds over that time period survived. That means 57% disappeared!
Why Survivorship Bias Is So Important
So why is “survivorship bias” so important? It illustrates how competitive and difficult it is to outperform a benchmark consistently and repetitively over a long period of time. Those funds that are not competitive are quietly set aside and closed down. It is also a good reminder that trying to pick a winning mutual fund manager can be a futile effort. In baseball, a hitter with a solid batting average tends to repeat their performance in the future. That is not often the case for mutual fund managers. As you can see below, using the same data reporting period from DFAs study, only about 1/3 of high performing equity mutual fund managers were able to repeat their above average performance with any consistency. Note, this chart needs to be read carefully as that is approximately 1/3 of the “winning” portion of the mutual fund sample, which equates to less than 10% of each sample size. This “winning” performance continues to decrease with each additional length of time measurement as it is incredibly difficult to outperform the market on a consistent basis from year to year. This is further evidence that the probability of a mutual fund manager outperforming their benchmark is highly unlikely the longer time goes on.
The Impact of Costs
One of the greatest benefits of index funds and exchange traded funds (ETFs) are their low costs. Keeping costs low allows more return to remain in the investor’s portfolio versus going to the mutual fund company. Ironically, the “all in” cost to run an actively managed mutual fund, including the sales and marketing overhead required to promote and distribute the fund, many times becomes one of the greatest hurdles subtracting from performance. That extra 1%+ in expenses eats away at returns and has a cumulative effect the longer time goes on.
Below is another chart from DFA’s study showing the great impact a higher cost structure via the expense ratio of a fund has on long-term performance. The general trend is that the quartile of the lowest cost funds tended to have the highest long-term relative performance when compared to the more expensive quartile’s of funds over 5, 10 and 15 years.
The Impact of Turnover
Index funds by nature have low turnover. An index fund manager’s goal is to track a particular index, for example the S&P 500. Thus he or she is not actively trading in and out of various stocks because their goal is to replicate a benchmark at a low cost rather than attempting to outperform it. The benefit to this strategy is that stock turnover in the fund is low. Lower stock turnover generally correlates to lower overall costs as there are less brokerage costs and less exposure to bid-ask spreads. Below is a chart from DFA’s study outlining the impact of high trading costs. Similar to the previous chart of high expense ratios, the quartile of funds with high trading (turnover) costs tend to underperform the longer the time period of measurement.
Certainly we have seen some great “investment heroes” in our time – Peter Lynch, Bill Gross, Bill Miller, Jeffrey Gundlach and Warren Buffett for instance. But how many others have failed trying to follow in their footsteps? Survivorship bias tells us that the number is quite large. Even if you found an active manager who demonstrated above average past performance, how do you know it will consistently continue? As well regarded as Bill Gross and Bill Miller are, they both have had their share of challenges since 2008 for example.
In addition, what if something happens to the investment manager? What if they decide to walk away from the game while they are ahead – just as Peter Lynch did after an outstanding performance record managing the Magellan Fund at Fidelity. What if their investment style goes “out of style?” Or, what if they start making the wrong stock picks or overweighting/underweighting the wrong sectors?
As you can see, being able to predict who will be the next Ted Williams of the investment world is next to impossible to determine. The chances of underperforming an index benchmark such as the S&P 500 only grows greater with time. That is why Wealth Engineering continues to recommend index funds, ETFs and passively managed mutual funds from firms such as DFA or Vanguard, as the core holdings of our portfolios. We can’t predict which mutual fund manager will be the next hero, but we can enhance the probability of our clients being able to meet their financial life goals by constructing globally diversified portfolios using index funds, which provide great diversification and high tax efficiency at a low cost.
Why Your Investments May Not Be Working For You
This article was written by a special guest author and colleague, Greg Geiger. Greg is a Principal of Financial Fiduciaries which is a fee-only investment advisory firm, registered with the National Association of Personal Financial Advisors (NAPFA), offering planning and investment services to individuals and institutions throughout Wisconsin. Our knowledgeable, experienced professionals serve as your advocate, helping you achieve customized solutions to your financial challenges by researching all your options and assessing the alternatives for you.
Dealing with investments and insurance products can be complicated and difficult to navigate, which is why many seek out the services of financial advisors, financial planners, or estate planners. But beware: Most financial “advisors” or “planners” are trying to get you to buy what they are selling, meaning that your best interests are in conflict with theirs. The license held by your advisor will determine the type of compensation structure that you will pay for their services.
An investment professional that holds a brokerage license has a license to sell. A broker receives payments through commissions or compensation from the investments that are made. Because broker compensation is directly related to the investments purchased, brokers have an incentive to recommend investment vehicles that provide the highest compensation for them rather than the highest return for you. Besides this obvious conflict of interest, there are several other things you should be aware of when working with a broker.
Brokered financial services:
- Often limit the number of portfolios or investment vehicles available.
- Often mean higher long-term costs than necessary.
- May include excessive transaction costs.
- Often include compensation for mutual funds that pay a percentage of your return to the broker.
- May recommend investments that offer rewards as incentives for the brokers.
- Can include investments with hidden fees.
- Set up an inevitable conflict of interest between the client and advisor.
Fee-Based (also called Dual-Registered or Hybrids)
Dual-registered investment professionals are licensed to sell AND advise. Their compensation is often a hybrid of brokerage compensation together with a fee payment structure. Dual-registered investment professionals often refer to their services as fee-based.
While fee-based services may sound the same as fee-only services – because a fee is charged – they are not the same service. Dual-registered “advisors” typically charge a fee based on assets under management (AUM), but then also receive other forms of compensation from the sale of investment products to you. In fact, many fee-based “advisors” went to a fee-type model for their business as a way to increase their compensation. Although investment professionals that work on a fee-based basis frequently charge lower fees for their work than a fee-only advisor, don’t be deceived: Their total compensation is often much more than that of a fee-only advisor due to other compensation they receive from selling investments to you.
Fee-based financial services:
- Charge you an “advisory” fee.
- Provide additional compensation to the “advisor” from product sales.
- Usually limit the investments to what is available through their broker/dealer.
- Often result in you paying higher than necessary long-term costs to accomplish your goals.
- Often include investments with hidden fees.
- Set up a conflict of interest between the client and “advisor”.
According to PBS’s documentary, The Retirement Gamble, 85% of individuals calling themselves financial “advisors” are partially or completely compensated by the investments which they are able to convince you to purchase. They are more like salespeople peddling their wares rather than financial “advisors”.
Fee-only fiduciaries are financial professionals who do not possess a license to sell investment products to you. A fee-only fiduciary is compensated only by a professional fee for their professional advice and/or financial management of client investments. The fees a client may pay, depending upon the business model of the fee-only fiduciary, include hourly fees, financial planning fees and/or assets under management (AUM) fees. All compensation is paid directly by the client and is clearly and plainly disclosed as the advisor’s fee on the client’s statement.
Fee-only financial services:
- Ensure that investment selection is motivated only by YOUR best interest.
- Allow you to benefit from the entire universe of investment alternatives; i.e., investments that do not require a broker at all, as well as the offerings of many different brokers.
- Permit the advisor the opportunity to “shop” for the best investments to meet your goals and to acquire them at the best price possible for you.
- Do not include compensation to the advisor from investment products selected for you.
- Do not produce an incentive for the advisor to use one product over another.
- Do not provide incentive to include additional products or services that you may not need.
Fee-only advisors have the freedom to structure your portfolio with your best interest in mind. They have no personal interest in making one investment choice over another. The type of compensation structure your financial professional uses can have an impact on the performance of your investment. It’s important to determine the real cost.
Type of Advisor
Standard of Care
How they are Paid
Required to put Client’s Interest First?
|Fee-Only Advisors or Fiduciaries||Fiduciary||Fee based on Assets Under Management(AUM), hourly or retainer||Yes|
|Brokers, Insurance Agents, and Bank Financial Advisors||Suitability||Commissions/compensation from investments chosen||No|
|Fee-Based Advisors, Bank Financial Advisors, and many “Wealth Management” Advisors||Combination with Disclosures||Commissions/compensation from investments chosen and Fees for service||Yes/No with Disclosures|
At Financial Fiduciaries, we compare investments for our clients to find the best fit for their goals. We do not receive commissions or rewards from investment or insurance companies. We provide all of our clients with a clear performance summary measured against an index, which makes it easy to review the return-on-investment.
We can review your portfolio to see if it is meeting your goals, is within your risk tolerance levels and is serving you and not your advisor. Contact us at 1-800-590-8110 ext. 310 or email email@example.com.
Principal, Financial Fiduciaries
What is the Difference Between “Fee-Only” and “Fee-Based?”
Do you know how your financial advisor is compensated? Two common forms of financial advisor compensation are called ”fee-only” and “fee-based.” They sound very similar, but they have vastly different meanings. Whether your advisor is “Fee-Only” or “Fee-Based” can have a huge impact on the type of advice you are provided and the types of investment products which are recommended to you.
Let me provide a made up example related to the medical industry to help differentiate the two fee compensation terms. Not everyone has worked with a financial advisor, but we all have visited a doctor.
Let’s assume you decide to visit your doctor because you have a health issue. Upon the visit, your doctor analyzes your health problem, provides you with a recommendation, possibly sends you to a specialist for further diagnoses, or gives you a prescription to take to your local pharmacy. In return for the doctor’s time and expertise, you likely paid him/her an out of pocket co-pay and/or your health insurance pays them a fee for your visit and any particular procedures or testing done. This scenario would be considered fee-only. You received a recommendation and the doctor received a fee.
Now let’s assume you visit your same doctor for the same health issue. But we further assume that the doctor’s compensation comes from two sources: 1) a fee for an initial assessment of your health issue and 2) the doctor also receives a commission for any particular health recommendation, procedure, referral to a specialist or pharmaceutical prescription sold. What if we take this one step further and also assume that not only does your doctor receive a commission for his/her recommendations, but that their commission based revenue can only come from a select group of products or procedures chosen by the health organization they are affiliated with? Do you see any potential conflicts of interest in this scenario? Would this cause you to question if you were receiving the best medical recommendation, or, if what your doctor recommended was potentially based on what paid your doctor the highest commission? This would be considered a “fee-based” compensation arrangement. The doctor receives a fee for the initial visit but also receives commissions for specific recommendations, procedures, referrals or prescriptions sold.
Consumers are fortunate the fee-based arrangement does not actually exist in the medical industry. However, it is common in financial services.
The two examples above can be directly substituted into the financial advice industry. Fee-Only means the only source of compensation your financial advisor receives is from fees paid directly to the advisor from clients. This could be in the form of an hourly fee, a retainer fee or a fee based on a percentage of the assets under investment management. Regardless of the type of fee, the point is that the client pays only a fee and no other type of compensation is charged. No commissions are received. No financial products are sold such as load mutual funds, commissioned based fixed and variable annuities, equity indexed annuities, whole life insurance or universal life insurance. The advice and compensation is totally independent of the financial products recommended.
Fee-Based is a term the brokerage and insurance community developed to counteract the success of the Fee-Only classification. The terms certainly sound similar and consumers are confused, so their strategy seems to be working. I can’t tell you how many times I have received a phone call from a consumer looking for a new financial advisor and one of the first things they say is that they are looking for a fee-based advisor. I always enjoy having that conversation and explaining the terminology differences as most consumers are greatly surprised.
Where Fee-Based can be confusing and potentially misleading is that not only does an advisor receive fees, but they can also accept commissions from financial products recommended such as load based mutual funds, or annuities and insurance. This system creates the potential for a huge conflict of interest. If an advisor, like the doctor above, has the opportunity to recommend a particular financial product that pays him/her a commission versus a financial product that does not pay a commission, do you think they could be incentivized and influenced to recommend the commissioned based product? Or, what if their product inventory only allows the choice between a select group of commissioned products based on the affiliation of their broker dealer? Would this raise a question – are the financial products offered to me what is best for my financial situation, and, do they make use of the best potential options considering the whole universe of financial products available?
No compensation system is perfect and free from all conflicts of interest. And certainly there are some great fee-based advisors doing amazing work for their clients. But we strongly believe the fee-only compensation method most closely aligns the interest of consumers with their financial advisor. We are proud and fortunate to belong to a great organization called www.NAPFA.org (National Association of Personal Financial Advisors), which represents a like-minded group of fee-only, fiduciary based financial advisors throughout the United States.
So when deciding which advisor you would like to hire, we would suggest that you ask how the advisor is compensated, request that they disclose their compensation in writing and look for someone who is paid as a “Fee-Only” advisor to eliminate as many conflicts of interest as possible.
Or, if you decide to work with a fee-based, commissioned advisor, at least look for one that is licensed under a fiduciary regulation. The fiduciary law requires that all compensation is disclosed in writing. Thus if you are going to pay commissions for advice and financial products, you will at least know what you are paying for. You can learn more about being a fiduciary by reading my article titled “What is a fiduciary and why does it matter?”