Friday, January 23, 2009

A common but deadly mistake

Sometimes people apply mental mathematics in evaluating professional fees. Do you have a friend like this? “Let’s see,” they’ll muse. “If I can get five percent by myself, and you charge one percent a year, then you’ll have to get six percent or more for me to beat the market and come out ahead. Right?” This common logic is not only counterproductive, it’s dead wrong.

First, performance isn’t the only measure that counts. If performance were all that matters (and money was not an issue, of course), we’d all drive Porsches or Ferraris. Truthfully, we also care about safety, reliability, comfort, and cost. When taking all factors into account, we almost universally choose something different than the highest performance available.

So mentally charging a professional fee against just one variable – performance – is a distortion of what your family really needs, and also of what you should expect from a quality advisor.
Look at it another way. Looking back, two separate portfolios earned eight percent one year. One was invested completely in the common stock of a single local company, the other in a diverse mix of blue chip stocks. As an investor, does it matter which one you owned? From a pure performance standpoint alone, the answer is probably no (that year, anyway). But any solid professional would tell you that the comfort, safety, and reasonable expectations from these two portfolios are dramatically different.

If a professional makes your family situation or portfolio safer, more reliable, more comfortable, and or less expensive, they’ve provided something you didn’t have before. They’ve added value even if they didn’t add “net” performance. Millions of very smart families understand that’s worth paying for.

Sure, it’s an added cost, but those are added benefits, too. And the value of each benefit isn’t directly tied to portfolio performance. So, mentally, it’s a terrible mistake to use performance as the only evaluation criterion.

And there are other points, too. It’s entirely possible that a good advisor will create additional performance. Not by being smarter or by “figuring out” the market (a fool’s game) but by suggesting newer products, lower fees, or ideas beyond your personal experience. They may broaden your portfolio in ways you’ve never even considered. There’s no guarantee, but most observers believe that – over reasonable time horizons – expertise adds performance.

Another important factor is not so obvious. Risk is a key component of investing, and many individual investors don’t have a clue. An advisor brings experience, knowledge, and risk measurement tools to each situation. This expertise may not seem important, but it’s critically important during market turmoil. Again, it’s added value apart from performance.

Last, there are other financial issues. Our general rule is that we help clients understand all issues as part of our total service package. Maybe you need a plan for college expenses, or help allocating your 401(k). It’s unlikely that either of these will pay us a cent, but we’ll usually help anyway. The fee you pay – and the service you get – is, once again, unrelated to performance.

Maybe it would help to consider professional fees apart from the portfolio itself. Is it worth a few dollars per year to hear advice on how to allocate investments? Might an advisor suggest cost-saving strategies or a better approach to taxes? Could they recommend a manager or fund that would mitigate risks in down markets? Depending on the size and complexity of your investments, $1,000 might be a bargain!

It amuses me that some people think they can manage their own portfolio just as well as a full-time, properly trained professional – all in the name of saving money. Millions of successful people gladly pay advisors for assistance. They don’t have money to burn; simply, they perceive value that overrides the fees paid. The smartest families see that value and let professionals improve their situations. If you have a friend who’s fallen into this common mistake in thinking about professional advice, hand them this column and let them know there’s a better way.

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