When it comes to investing, we can identify many risks investors assume, either knowingly or not. At Index Fund Advisors, we see it as our core mission to get investors to take the risks that are worth taking (e.g. market, size, value, term and default) and avoid the ones that are not (e.g. concentration risk, manager selection risk, market timing risk). In our opinion, there is one other risk that may overshadow all of them—the risk related to the selection of an advisor, including an investor choosing to be his own advisor. We call it “Advisor Risk” because it is the investor’s advisor who chooses whether or not to engage in the potentially destructive investing strategies of stock picking, market timing, manager picking, and style drifting. Furthermore, it is also the advisor who chooses when and how to engage in the potentially helpful activities of asset allocation, asset location, rebalancing, tax loss harvesting, tax management, withdrawal strategies, and glide path methods. The advisor also ultimately determines the costs borne by the investor such as fund management fees, transaction costs, taxes, and the advisory fees themselves. An advisor who fails to properly assess the risk capacity of his client will eventually face one of two bad situations: The client bails out in a bear market because he was carrying more risk than was appropriate, or the client fails to capture the long-term returns that were available to him because he did not take on the amount of risk that his capacity allowed. So there are many areas where bad advice from an advisor can have a substantial negative impact on a clients returns.
This year, IFA conducted another internal study of the behavior of our clients over two different time periods, the more important of which was the seven-year period ending 12/31/2014 because it includes the global financial crisis of 2008-2009 and the subsequent recovery. As the chart below shows, the average client that did not follow IFA’s advice (i.e. they chose to become their own advisors) only captured 69.40% of their benchmark portfolio return (the index portfolio determined by their initial risk capacity survey).
In our opinion, there were many advisors who were not successful in capturing benchmark returns for their clients over this period. Many other studies document the failure of average investors, including those with various types of advisors, to capture the returns of the markets in which they invest. We have categorized and summarized some of these studies in the bar chart below. Links to the studies can be found in the sources section.
IFA considers it the duty of every investment advisor to demonstrate their knowledge through education and documentation and to provide transparency of fees and the strategy they plan to follow in the future. Following these practices will serve to minimize Advisor Risk to their clients, and advisors who fail to live up to these standards will inherently have more uncertainty associated with their advice in the future. We think of an investor's risk budget as an amount of uncertainty an investor is capable of accepting.
The less investors know about their advisor's knowledge, fees and strategy, the higher they should rate their exposure to Advisor Risk. Since investors have a limited risk budget, a risky advisor means investors should have less investment risk in order to maintain their risk budget. Of course, with lower investment risk comes lower expected returns. Therefore, advisors who have invested less in the demonstration of their understanding of how markets work may have actually lowered the expected return of their clients who should properly allocate a higher portion of their risk budget to Advisor Risk.
For example, lets say an individual investor scores a 70 on IFA's Risk Capacity Survey. That would equate to an investment risk of IFA Index Portfolio 70 (IP70), which has a risk of 11.5% (that is standard deviation of the 50 year return) and has had an annualized return of 10.99% over the last 50 years. According to IFA strategies, this investor's risk budget is 11.5%. Now, lets assume that the investor decides to hire an advisor other than IFA or to invest on their own, both of which had provided less evidence, documentation and data as to their knowledge about how markets work. Just for sake of discussion, lets also say we assign an Advisor Risk of 3% to that riskier advisor. This would mean that the investor may want to reduce their investment risk to an IFA Index Portfolio 50, which has a risk of 8.5% (3% less than IP70) and an annualized expected return of 9.54%. This would reduce the investors expected return by 1.45%, due to the larger allocation of 3% Advisor Risk. Compare that reduction in expected return of 1.45% to the fee paid to a lower risk advisor. This example brings to mind John Ruskin's common law of business:
"It is unwise to pay too much, but it's worse to pay too little.
When you pay too much, you lose a little money...that is all.
When you pay too little, you sometimes lose everything because the thing you bought was incapable of doing the thing that it was bought to do.
The common law of business balance prohibits paying a little and getting a lot...it can't be done.
If you deal with the lowest bidder, it is well to add something for the risk you run, and if you do that you will have enough to pay for something better."
In our humble opinion, IFA has provided vast evidence of our knowledge through our book, website and advisors and therefore, positioned IFA to be a minimum risk advisor. This allows our clients to accept near zero Advisor Risk and an investment risk that is equal to their risk capacity.
About the Author
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.