Why Do Financial Advisors Still Exist?

most financial advisers can't outperform a simple lowcost ETF portfolio that cost a fraction of a percentage point to own in many ways index funds have effectively solved investing yet many people continue to delegate their investment management and financial decision-making to financial advisors why I'm Ben Felix portfolio manager at pwl Capital and I'm going to tell you why people still hire financial advisors despite investing being functionally solved I want to specify what I mean by a financial adviser before I start I'm I'm talking about someone who manages your Investments for you and provides you with ongoing Financial advice this is different from something like a fee only financial planner who might charge you an hourly rate but will not manage your Investments for you financial advisors allow you to delegate the majority of your investing and financial decisionmaking and the related ongoing tasks and they monitor your financial situation Financial advice is a Credence good a good that is hard to Value even after the service has been provided but the fact that many people continue to hire financial advisers does suggest that it's worth something in a study conducted by Morning Star 312 individual responses to the question please list some reasons why you hired your financial adviser were manually analyzed and sorted into various financial and emotional motivations the top motivations were to alleviate discomfort in handling Financial issues and the desire to achieve a specific goal the next most common motivation was behavioral coaching overall non-financial motivations were identified more frequently than financial ones as the reason that people hired their financial adviser this suggests that purely quantitative assessments of financial advice could miss the mark similarly only looking at the cost of fees while ignoring perceived benefits May paint an incomplete picture a similar study from Morning Star analyzed 620 responses to the question please list some reasons why you continue to have a financial adviser in this case discomfort handling finances as a broad category with specific reasons like peace of mind and money makes me nervous was the top overall response followed by the quality of the advice and behavior coaching finally a 2020 study titled the needs and wants in financial advice human versus Robo advising uses a broad survey to elicit investor needs and their satisfaction in the context of financial advice in line with the Morning Star survey analysis the authors find evidence that people hire financial advisers to satisfy needs including purchasing peace of mind having access to the opinions of an expert and delegating financial decisions even for people who use Robo advisors the authors find that the possibility to reach out to and interact with humans is greatly valued they classify investor needs into five categories the need for knowledge trust personal Improvement delegation and investment performance they find that the most important need is trust followed by self-improvement and knowledge while the least important is investment performance this finding aligns with a 2015 paper in the Journal of Finance titled money doctors where the authors suggest that trust in an investment manager reduces an Investor's perception of the riskiness of a given investment they suggest that the central point of trust mediated money management is it enables investors to take risks and earn returns that they might otherwise not obtain the proceeding information suggest that trust based peace of mind is one of the primary services that investors are purchasing when they hire a financial adviser investing in financial decision- making are scary for a lot of people Canadian astronaut Chris Hadfield once told me the greatest antidote for fear is competence if people can gain the necessary skills and knowledge they might not need financial adviser at all that's of course true of any skill but gaining skills comes at a cost this trade-off is addressed in the context of financial advice in a 2016 paper in the Journal of financial economics titled time is money rational life cycle inertia and the delegation of investment management the author showed that the empirically observed investor inertia where investors devote only sparse attention to their finances can be explained by the time costs required for being actively engaged in managing them to address inertia people can either relegate their portfolio management and financial decisions or use their time to gain the necessary skills to manage their own finances the opportunity cost of time is different for everyone which is one of the focuses of this paper the authors build and solve a realistically calibrated life cycle model where the time cost required to manage one's portfolio is traded off with the opportunity to accumulate job specific knowledge and to enjoy Leisure Time investors in the model have the option to delegate their portfolio management for a fee the attractiveness of delegation varies over the life cycle in related research the authors show that consumers are always better off when given access to a financial adviser but these gains decline with age specifically they find that workers can expect a 1.07% Improvement in lifetime welfare when they have an opportunity to delegate their financial decisions to an adviser from the start of their working lives on the other hand when the delegation option is introduced just prior to retirement at age 60 the lifetime welfare gain is Tiny only 0.02% they conclude that it is better for investors to have an early opportunity to hire financial advisers since access to financial delegation early in life can produce important improvements in wealth and well-being it's also worth noting that delegation's ability to improve wealth and well-being is increasingly relevant with increasing complexity a single person saving just enough to max out their tfsa and investing in asset allocation ETFs doesn't have that much learning to do in order to manage their finances but someone with a family taxable Investments maybe even a family trust or a corporation would have much steeper learning curve increasing the benefits of Delegation retired investors May gain less from delegation but another relevant issue is the potential for cognitive decline research has found that older people tend to underestimate their own cognitive decline and that those who have experienced a severe cognitive decline but are unaware of it are more likely to suffer wealth losses compared to those who are aware or did not experience a severe decline the 20124 study are older people aware of their cognitive decline misperception and financial decision- making examines data from the health and retirement study a representative panel of the US population age 50 plus to study the relationships between self ratings of memory changes assessed changes in memory performance and wealth changes across waves of the survey the results suggest a causal role of unawareness of cognitive decline for wealth losses and that wealth losses among unaware respondents mainly reflect a decrease in the value of their riskier assets like their stocks they also find that wealth losses are concentrated in the highest wealth Cor the authors interpret their findings as the effects of overconfidence where people who have experienced cognitive decline but did not realize it end up making poor financial decisions on the topic of hiring a financial adviser the authors do point out that delegation itself is not necessarily the solution since deciding who to delegate to itself requires non-trivial cognitive skills this is an important Point other researchers found that more financially literate people are more likely to seek financial help from professionals and that this effect is more pronounced older and those with more wealth and more complex Financial situations this result implies that financial literacy and financial advisory services are complimentary rather than substitutes for each other and that you should keep watching my videos something that I have observed working at PW capital is that highly capable and financially literate people do often make the decision to Delegate for many reasons a common one is increasing complexity coincident with the peak of a busy career another common reason is to provide continuity for a less financially literate spouse in the event of an Unexpected death or cognitive decline there are also behavioral reasons for hiring a financial adviser some research has suggested that financial advisers act as a commitment device for good financial decisions one study found that German brokerage clients with self-control issues were more likely to delegate their decisions to financial advisers and that over trading for these investors decreased their investment biases were mitigated and their performance was improved another study of German investors found that Financial advice improves savings Behavior particularly for household with low self-control and increases their allocation to stocks it is worth noting that not all financial advisers are the same and many of them do have severe conflict of interest affecting the advice that they give when seeking out a financial adviser it's very important to ask how they are paid in general advice from someone receiving Commissions in exchange for selling you Financial products is at severe risk of being affected by conflict of interest fee based financial advisers who charge a direct fee for their ongoing advice mitigate many of these conflicts it is also worth asking if the advisor is held to a fiduciary standard a fiduciary is required to act in your best interest which seems like it should be table Stakes for something as important as Financial advice but it is not in Canada there is no statutory fiduciary standard for financial advisers but some professionals including those registered as portfolio managers are highly likely to be held to a fiduciary standard by the courts hiring a financial adviser can make sense if delegation is valuable to you this can be the case if you're comfortable with investing in financial decision- making or if you're comfortable but simply do not want to dedicate the time to managing them yourself for many people the choice to delegate is rational due to the opportunity cost of time which could alternatively be dedicated to acquiring job specific skills or Leisure this is increasingly true with Rising income specialized skills and as Financial situations get increasingly complex hiring a financial advisor can also make sense to mitigate the risk of cognitive decline affecting your household's financial decisions as you AG an toact is a commitment device to reduce unwanted Financial behaviors I'd be curious to know from those watching why they do or do not have a financial adviser you can tell me in the comments thanks for watching I'm Ben Felix portfolio manager at pwl Capital if you want to learn more about how pwl helps Canadians delegate their investing and financial decision- making you can book a meeting with us below