Wealth advisors often talk about biases and investment habits of investors that lead to poor investment performance. They talk about cognitive biases such as hindsight bias and mental accounting, and emotional biases such as overconfidence and regret aversion, leading to bad investment habits such as trading too much and not diversifying sufficiently. Research by Vanguard (the bastion of passive investing no less) among others shows that these biases and habits significantly reduce portfolio performance over time.
Advisors, through financial planning, behavioral coaching and guidance, can consistently provide value to their clients. Research by Vanguard and others quantify the value added by advisors to be on average up to 3% per year, net of all fees. Over time, that can add up to a very sizable difference to an investor’s portfolio.
Are Wealth Advisors Immune to Bias and Emotion?
But what makes wealth advisors immune to these biases and habits? Listening to them talk, you would think they are like Mr. Spock from the planet Vulcan in Star Trek, living by logic and reason with little interference from emotions.
In reality, advisors suffer from the same biases and habits they advise their clients against. Some suffer the consequences in their personal portfolios (hopefully not in their client’s portfolio). What can and does prevent them from making the same mistakes in their client’s portfolio is having a time-tested process and sticking to it. (For related reading, see: How to Avoid Emotional Investing.)
In all the discussion about beating benchmarks and passive versus active investments, what is lost is what investors do as opposed to what they should do with their investments. What investors do with their investments in aggregate hurts their performance and by a wide margin. You just have to look at the difference between fund returns and investor returns of mutual funds on Morningstar to see by how much.1 A wealth advisor who follows a well-thought-out process can prevent this from happening. Further, advisors who provide financial planning services can add additional value to their clients.
It is no surprise then that understanding an investment advisor’s process, and his commitment to it, is one of the most important steps investors should take when hiring an advisor. One of the ways that commitment can be judged is to inquire if he uses the same process for managing his wealth. Ideally, an advisor should manage most of his assets in the same way he manages his clients' assets.
(For more from this author, see: The Foundation of a Good Financial Plan.)
1. According to Morningstar research the average annualized difference between investor returns and fund returns for 10-year periods ended 2012 to 2015: is -1.13%. Research by Dalbar puts the underperformance much higher.