MAXIMIZE THE VALUE OF YOUR DECISIONS
Many people struggle with understanding their finances, in part because, as they accumulate wealth, their financial situations become more complex. Adding to the issue, research has shown that it is common for investors to view financial advisors only as investment managers, whose sole job is to manage money on their behalf. This is unfortunate and short-sighted, however, because as financial advisors we believe it is critical to look beyond an individual’s portfolio and offer advice and guidance on items such as taxes, cash flow, retirement planning, insurance, education planning, philanthropy and gifting, and more. (It’s not only what you make, but what you keep!) So how can investors measure the value they receive from broader financial counsel?
GAMMA – ADVISOR’S ALPHA
The potential benefits from smart financial planning decisions are hard to quantify and will vary among investors. However, research from two highly respected sources, Morningstar and Vanguard, estimate the added value as high as 3% annually.
Morningstar calls the measure “Gamma” (i.e. the third letter in the Greek alphabet) and it is defined as “the extra income an investor can earn by making better financial decisions.” Vanguard refers to the value-add in making informed, disciplined financial decisions as “Advisor’s Alpha”. Historically, investors have focused on choosing the “best” money-managers, the ones who claim to have the strategy and resources to consistently outperform. Independent research suggests that active managers consistently underperform comparative index benchmarks.
When it comes to determining an investor’s success, specific investment selections are much less important than holistic portfolio construction and prudent financial decisions. A good advisor should offer much more than helping someone “pick good funds”.
Vanguard’s research suggests that “Advisor Alpha” can be quantified in three general components:
1. Portfolio Construction: With portfolio construction, it is important to create an efficient, diversified portfolio while ensuring the investor does not overpay for investments or associated taxes on investment returns.
- Suitable asset allocation using broadly diversified mutual funds and/or exchange traded funds (ETFs)
- Use of relatively low cost products
- Asset location between taxable and tax-advantaged accounts
- Total return versus income investing
2. Wealth Management: Wealth management is broadly defined as the holistic management and coordinated effort of all financial related decisions. However, within the context of adding quantifiable value, this entails making regular changes to your portfolio to reduce risk, and to optimize cash withdrawal strategies.
- Regular rebalancing
- Spending strategy for drawdowns
3. Behavioral Coaching: Behavioral coaching refers to the ability and the time to evaluate portfolio investments, review long-term objectives, and weather tough financial markets. Per the research, this “handholding” is the single, most important factor in adding significant value over time for most investors.
- Guidance and support to adhere to your financial plan and long-term investment strategy
WILLOW CREEK’S VIEW
The most important take-away from this research is that the “Gamma”, or “Advisor’s Alpha”, can be controlled by the investor or financial planner. Taking advantage of this “value-add” opportunity in one’s decision making process, along with broad financial planning items, will increase the probability of financial success.
- Portfolio asset allocation — It is critical to determine the right amount of risk in a portfolio based on the investor’s financial and emotional ability to assume that risk in the time allocated to meet financial goals.
- Retirement withdrawal strategy — Portfolio withdrawals should be tax optimized, in conjunction with outside income streams, and within the context of the long-term financial plan.
- Tax-efficiency — Investors can exercise some control on tax management, so it is important to continuously monitor the affect taxes and tax law changes have on portfolio returns and distributions.
- Goal driven investing — Investing should be a means to an end for personal and financial goals. Managing a portfolio for short- and long-term goals requires minimizing risks such as inflation and short-term market volatility.
- Informed decision making — Making smart financial choices begins with having relevant, accurate, and the most recent information and data.
- Portfolio rebalancing — Portfolio asset allocation is extremely important, but another proven component of successful investing is the proactive monitoring of the asset allocation over time. A proactive portfolio rebalancing strategy can help control the risk of the initial allocation and enhance the long-term returns of the portfolio.
- Evidence based investing — Not all risks carry a reliable reward. Investors should seek to capture the risk and return benefits of the markets using the science of capital markets and with decades of research guiding the way. The result is a portfolio structured to capture the dimensions of expected returns. These dimensions are pervasive, persistent, and robust and can be pursued in cost-effective portfolios.
Arguably the most difficult form of “Advisor Alpha” to quantify, behavioral coaching has proven to be the most important contributing factor to an investor’s financial success. All the investment research, portfolio strategy, and financial concepts summed up in this paper are of little value unless the investor has the confidence and discipline to stay the course in the face of financial stress and panic. Unfortunately, many feel the need to surrender to fear and abandon their strategy during times of market turbulence – the consequence of an emotional response can be catastrophic. A good financial planner can be an invaluable resource during hard times to provide counsel, listen to concerns, and keep investors on the right path.