The #1 Reason to Hire a Financial Advisor

 Victims of our own behavior

Victims of our own behavior

If you asked 100 people why they would hire a financial advisor, I suspect 99 of them would respond “so they can help me make money.”

I don’t disagree with that statement. But recent research shows it’s a bit more nuanced than that.

It's Not About Investment Picking

In a study titled “Advisor’s Alpha” the folks at the investing giant Vanguard found that the added value of working with a competent financial advisor is about 3%. This means that if the market returns about 6% for the average investor, working with a financial advisor gets that number closer to 9%.

3% may seem small at first, but if you understand the fundamental principle of compound interest, you know that an additional 3% can make a significant impact on one’s financial life. Based on this research, it’s clear that advisors are making their clients better off.

So what are advisors doing specifically, to contribute this? Interestingly, it’s not by helping clients pick winning investments. Expounding on the Vanguard study, behavioral finance scientist Daniel Crosby notes:

“This tendency to seek complexity and ignore simplicity has been alive and well for years in investment circles. For far too long, financial advisors have led with proprietary product pitches or the assertion that they can outperform the market through superior investment acumen. This appeal to complexity has rung true to an investing public overwhelmed by the vagaries of financial markets but is beginning to crumble in the face of popular research that highlights the difficulties in generating investment ‘alpha.’”

The True Value of Financial Advice

If financial advisors have a difficult time choosing stocks which outperform the market (generating alpha), where is their value?

The research points out that the 3% increase doesn’t occur year after year in a smooth line, but rather it is most pronounced during periods of greed or fear in financial markets and our personal financial lives.

Thus, the value added by a competent financial advisor is in preventing improper behavior, especially when you start feeling greedy or fearful.

This can happen in a lot of ways:

  • The stock market suffers a severe decline and you’re tempted to sell until things settle down
  • The stock market does well for several years in a row and you feel you should take on more investment risk as a result
  • A short-term financial setback has you thinking about withdrawing money from retirement account prematurely
  • You are tempted to make a large purchase that runs contrary to long-standing financial goals you and your spouse have established

Carl Richards, owner of The Behavior Gap, illustrates the advisor’s crucial role. Visualize three rectangles standing vertically. The far left rectangle is labeled “client” and the far right is labeled “stupid decisions.” The center rectangle? It’s the financial advisor. This is part of the reason why even some financial advisors hire their own financial advisors. Our emotions tug us every which way, especially when things get difficult or financial markets become uncertain. Financial advisors aren’t immune to these behavioral swings either.

If you ever have an opportunity to talk with a financial advisor or planner, listen carefully to the value of their services they are trying to communicate. If the value-add they’re defining is to help you make smarter decisions -- to behave better -- you’re on the right track.