How Advisors Add Value to Your Net Return

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Question:  Why would I need to pay an advisor to help me manage my investments?

Answer:  Assessing the value that an advisor can add to your wealth is a rather subjective exercise.  However, in a research paper released earlier this year, the mutual fund company Vanguard quantified what they call the “value-add” that an advisor can add to your net return. 

The authors acknowledge that for some investors, the value of working with an advisor is simply peace of mind.  But they also conclude that working with an advisor can add “about 3%” in net returns when following Vanguard’s framework for wealth management.  Here’s what an advisor can do for you: (The percentages after each section heading represent Vanguard’s estimated value-add net return relative to “average” client experience.)

1)  Suitable Asset Allocation Using Broadly Diversified Funds/ETFs: >0%

The paper re-iterates the widely accepted thesis that diversification into various asset classes such as stocks, bonds, and cash investments--according to the investor’s financial situation, risk tolerance, and time horizon--is the most important determinant of the return variability and long-term performance of a broadly diversified portfolio.

2)  Cost-effective implementation: +0.45%

Gross returns minus costs equals net return.  Costs can include mutual fund expense ratios, trading costs, and taxes.  Research shows low costs are associated with better investment performance. 

3)  Rebalancing: +0.35%

Over time, portfolios will drift from their target allocation.  Portfolios that drift with market changes and are not rebalanced experience higher volatility, and thus higher risk.  Advisors rebalance to minimize risk, not maximize return.    

4)  Behavioral Coaching: +1.50%

Vanguard says this is the biggest value-add and makes up 50% of the 3% increase in your net return.  Investors are human and subject to emotion-driven behavior.  When markets tumble, fear can take over and prompt irrational acts.  During the huge market decline in 2008 and early 2009, some investors cashed in their equities, hoping to stop the slide.  Unfortunately, they failed to get back in and missed the rebound. 

Experienced advisors are trained to stay rational, hold a client’s hand during turbulent times, remind them that market swings are normal and to be expected, and keep them on the course they previously set when their emotions were not influencing their decisions.  Conversely, investors can get greedy, and when they see returns going through the roof, they may want to go all-in.  Advisors will remind them to not chase “hot” investments and to not abandon their planned investment strategy.  

5)  Asset location: up to +0.75%

This refers to the allocation of your investments between taxable and non-taxable accounts and mainly affects taxpayers in high tax brackets.  Advisors help manage taxes in taxable accounts. 

6)  Spending strategy: up to +0.70%

Advisors can recommend and implement appropriate withdrawal strategies to both manage taxes and maintain portfolio growth and/or income according to an investor's plan. 

7)  Total-return versus Income Investing: >0%

For many years, retirees were often able to live off the income (interest and dividends) from their investments.  But in recent years, this has been difficult, if not impossible, to do because of all-time low interest rates.  Retirees' choices are to spend less, move to higher-yielding riskier investments, and/or tap into "total return." Total return includes both portfolio income and capital appreciation. 

Higher yielding investments are in a danger zone that retirees should avoid.  Competent advisors can provide a sound strategy to help retirees navigate the complexity of building a portfolio for both growth (capital appreciation) and income.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to ken@montereypw.com