Is it worth paying a financial consultant or financial planner to invest your money in the market, or are you better off investing on your own and avoiding the management fee?
THE PSYCHOLOGY OF INVESTING
It won't come as a shock that our financial planning firm strongly recommends hiring a financial planner. This is not about our profits as much as it is about psychology and statistical analysis. A lot of people believe they are capable of doing the research, finding the right funds, and beating the market. But the research shows that individuals going it alone consistently underperform against professional investors. [1]
Utilizing the services of a 3rd party provides a second (and many times third or fourth) set of eyes on your investments. A financial planner or consultant is not emotionally chained to your money. The emotional attachment to money prevents many from seeing clearly or objectively, impacting their ability to make the right decisions with their investments. A third-party manager is free to operate with a more logical compass as he directs your investments based on a specific strategy and timeline.
Still, there is something more critical to the success (or lack thereof) of individual investors, and that is the fact that every investor has a set of behaviors and biases that impact investing. There is no exception. Investors are human; we are not robots, operating under pre-programmed algorithms or formulas. We cannot avoid certain behaviors because it's how we're wired. Our human nature plays a critical role in the investment process and it is important to understand this in order to truly grasp the value of a 3rd-party planner or consultant. Because the statistical fact is that the returns of those who invest on their own consistently underperform compared to the returns of those who use 3rd-parties.
If you read through these first paragraphs and said, “that isn’t me,” or “I’m more disciplined than that,” you fall in the category of people that are most likely to experience this return disparity because you are less likely to ask for help. Those that overestimate their self-control, attribute success to knowledge, and take pride in their ability to learn will normally associate asking for help with weakness. Unfortunately, this view of Self will prevent someone that is incredibly smart from having the success of a person with a more humble view of their abilities. It’s an amazing correlation I’ve noticed over the years. The physicians calling during a market correction with an interest in pulling money out or wishing to add more at market peaks are clients with the most “head knowledge” about investing, planning, and markets. It’s been a fascinating behavioral study to witness, but emotions such as fear and greed typically win when making our own decisions in spite of what we know to be true.
BY THE NUMBERS
Detailed analysis shows that the behavior of individual investors trends toward the erratic and reflexive, which lead to underperformance. According to the Quantitative Assessment of Investor Behavior, the average equity mutual fund investor underperformed the S&P 500 by -4.70% in 2016. While the market made gains of 11.96%, the average equity investor earned 7.26%.
This didn’t just happen last year, it’s a consistent theme. Let’s look at the last 20 years and consider the actual financial impact. If you invested $100,000 on 12/31/1996, the average person managing their own money had an average of 4.79%, which would result in a balance of $254,916 on 12/31/2016. However, the S&P 500 averaged 7.68% during the same 20 year period, which would have turned your $100,000 investment in 1996 into $439,334 on 12/31/2016. A difference of $184,418! The difference for fixed-income assets was similar. The average investor managing their own fixed-income portfolio averaged .48%, while the Barclays U.S. Aggregate Index averaged 5.29%, a difference of $170,137 over the same 20 year period for someone investing $100,000 in 1996. Some may say, well at least I didn’t have to pay a management fee of 1%. The management fee, assuming 1%, would have totaled $43,742 over this 20 year period. As you can see, this is hardly comparable to the losses suffered by those managing their own investments.
The image below illustrates this.
From DALBAR investing study: https://www.americanfunds.com/advisor/pdf/shareholder/ingefl-050_dalbar.pdf
The report's finding can be summed up this way: (From Quantitative Assessment of Investor Behavior 2017 Report):
QAIB 2017 examines real investor returns in equity, fixed income and asset allocation funds. The analysis covers the 30 year period ending December 30, 2016, encompassing the crash of 1987, the drop at the turn of the millennium, the crash of 2008 plus recovery periods of 2009, 2010 and 2012. No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who try to time the market.
INVESTOR BEHAVIOR
The behavior of the investor plays a larger role in fund performance than the market itself. So, what behaviors cause such disparity between individual investors and 3rd-party planners? There are many, but we will take a look at the most common. If you are considering investing on your own, be aware that these traps threaten everyone who venture into these waters.
1. LOSS-AVERSION: Psychologically, the pain of a loss is felt more deeply than the joy of a gain, making it more difficult for a person to leave money in the market if they feel it’s at a peak. Loss-aversion is all about avoiding the pain that comes from a loss of what you know you have now, to the detriment of one's potential investment gains. Selling out of the market and missing out on my money growing by $50,000 feels very different than the possibility of watching the account go down by $10,000. Though both are a cost, one feels very different than the other and many miss the upside because they operate consistently with a fear of the downside. Between 1993 and 2013, a person missing the best 10 days in the S&P 500 lost 3.73% of what the market offered to someone fully invested during that time. A person missing the best 40 days in the S&P 500 actually lost money during this time.
2. HERDING: Herding, or Herd Instinct, is our natural inclination to invest in certain markets or companies solely because everyone else is. When Herd Instinct takes hold, much of our own logic, math, strategy, and planning go out the window because Herding is driven by our innate (and powerful) fear of missing out on what might be of benefit to others. So we reflexively change course and invest in areas we otherwise might not if given thoughtful consideration. In the large context, herding can cause financial bubbles - like the Dot-Com bubble of the 1990's - that eventually pop once the shine wears off.
3. FAMILIARITY BIAS: This behavior occurs when investors limit themselves only to stocks or companies with which they are familiar. This reduces portfolio diversity and increases risk of loss. Familiarity bias might be the most obvious behavior that would benefit from a 3rd-party consultant. Someone with broad market familiarity will have an advantage over someone who only dabbles with investments.
4. ANCHORING: Anchoring, also known as Confirmation Bias, is when investors look - consciously or subconsciously - for information on investments that confirms what they already believe to be true. It is easy to see how this impacts investing: the investor is already set on allocating money to certain funds or stocks and uses even the most obscure information to confirm the decision. Anchoring reduces the critical element of discernment when investing and blinds individuals to the red flags that a 3rd party may catch.
5. SELF-ATTRIBUTION: This trap causes investors to take all the credit for success and deflect blame for losses. It is a form of pride that grows from the belief that we can predict and conquer market trends. When we're successful we tell ourselves that our "system" works, and when we fail we tell ourselves the system still works but we were the victim of outside forces. A 3rd-party consultant looks at our investments logically without the added weight of personal pride blurring judgment.
6. FEAR: This four-letter word is at or near the psychological root of most investment behaviors. When emotion and arrogance steer the ship, it's easy to become spooked and make poor decisions. A 3rd-party consultant or planner usually understands how to navigate the market in all kinds of conditions.
A 3RD PARTY MAKES SENSE
These are the reasons why a 3rd party makes sense. You cannot escape the fact that your emotional attachment to money creates human behaviors that affect how you invest your money. Your view of reality is distorted through the lens of Self. I’ve held onto that saying for many years as I felt it carried applicable wisdom in many situations, but none seems more relevant than this topic.
The average person believes they know better than the average person. But the tendencies above play out regardless of the personality, background, or education of the investor. Investing is hard. A 3rd party is a practical way to avoid falling into these common problems, and increases the likelihood that your investment will return higher results.
[1] Quantitative Assessment of Investor Behavior (https://www.dalbar.com/QAIB/Index)