You are the benchmark

Mutual funds and ETFs have made accessible and inexpensive various robust strategies with excellent risk-adjusted returns. An individual investor can pick a handful of value and momentum funds that together will all but ensure long-term performance rivaling that of the top tier of hedge-funds. That and with instant liquidity, no performance fees, and management fees near 1%.

In reality, only a minority of professional investors are aware of empirically-tested strategies with a high Sortino ratio, let alone incentivized to use them. Individual investors would be highly exceptional to discover such an approach, let alone have the conviction to stick with it. The vast majority of capital is still managed on a discretionary basis, that is to say, by the amygdala and without discretion.

Quant allows decisions to be made at leisure by the prefrontal cortex, informed by widely-reviewed research and a wealth of historical data. All possible decisions are coded in advance, so that the emotions experienced in the stampede of the market do not result in irrational trades. This is extremely valuable, and for an individual the value should be assessed not against an index, but against the worse performance that would in reality be obtained by an emotionally-driven, ad-hoc series of decisions.

You are the benchmark

The value of an advisor lies in keeping clients from making dumb mistakes, overtrading and attempted market timing being paramount. On their own, most people do not have the knowledge or discipline to obtain even index-level results. An oft-relayed story from Fidelity is that the mutual fund accounts with the best performance belong to people who have died or forgotten they are invested.

A common baby boomer experience illustrates the importance of discipline. Many in that generation credit the bulk of their nest egg to real estate gains. The asset class has performed well in the last forty years, but not nearly as well as a total return stock index. After insurance, upkeep, and local taxes are factored in, typical returns have been well under 5%, compared to 10% for equities. This works out to 10 times more money over forty years. In reality, few boomers have had the conviction to stick with stocks as faithfully as they paid their mortgages.

Advisors are shepherds

Competent advisors rescue investors from the wilderness of nonsensical headlines, theories, and pitches, and dramatically reduce the odds of chronic underperformance or devastating loss. This is their most important role, easily worth a 1% management fee. However, there is a disconnect in the market, as many investors with the knowledge and discipline to use a good advisor know that they could buy and hold SPY on their own and pay 0.1%. Thus an advisor is hard put to ask much more than 1-2%. Of course, an advisor can help structure plans around clients’ unique situations, but in most cases actual advice is viewed just as a perk.

There is huge marginal value in the rescue. Studies of investor behavior show that in comparison to do-it-yourself management, the premium of indexing, let alone factor-based investing, may be as high as 7%. The ongoing QAIB study reveals that the typical investor is lucky to keep up with inflation. Many are so predisposed to lose money that they are best advised to avoid the markets entirely.

Investing badly or not investing results in a dramatically-lower net worth over many years. In fact, I would argue that basic investing skills are at least as valuable as a college education. What is the net present value of a 100-fold increase in the odds of building a 7-figure retirement account? Also consider the value of insurance against a devastating loss of savings through reckless investing.

Market incentives mean most investors stay lost

The disconnect is that the dominant business model does not reward the shepherd in proportion to the value he brings the client, because once enlightened the client becomes fee-sensitive. An advisor’s referral fee, if there even is one, comes out of the meager management fee. Thus the vast majority of investors trail far behind the S&P and experience undue volatility and anguish.

The population of lost sheep represents an opportunity for advisors who can reach them cost-effectively. For an advisor with strong connections to wealthy investors, travel and one-to-one efforts are worth it. Not so if the average new account is $50k. There are small investors out there who are open to good products, and to reach them best approach is to provide quality content that shows competence and integrity. Tweeting, blogging, podcasting and public appearances reach those who are ready to be helped, who are the only ones worth reaching.

In sum, advisors need to write, and investors need to read.

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