A financial advisor will recommend different capital market products like pensions, funds, mortgages, income protection and so on. Today, we’ll focus on the stock market and the wealth management element of their work.
This article is not a critique of these professionals, I just want you to make informed choices about your money.
Therefore, the purpose of the article is to understand what you are being charged for. I believe that a lot of investors may not benefit from advisory services. Others will certainly do so keep reading to find out which side are you on.
What is wealth management
This branch of finance is concerned with high net worth individuals. You may win the lottery and all of a sudden you have 50 million, what are you going to do with it?
If you are thinking about buying a mansion, sports car or something else costing more than 100k you clearly need a wealth manager. Making your money work for you should always come first.
Managing 50 million is a full time job so even if you’re self-directed you’ll still need at least one analyst and a personal assistant. It may be cheaper to go to an institution unless you always dreamed of having a family office.
What’s the purpose of a financial advisor
Financial advisors provide easy access to the capital market for the masses. I’m sure they’ll find you some kind of a product even if you just have 1k to invest.
Because of this mass market element the products are not very sophisticated and deliver average or below average returns. This is a consequence of the fact that people don’t like the thought of losing money. Everyone wants zero risk, myself included.
Unfortunately, this is not an achievable objective so the flow of money goes in diversified portfolios of stocks and bonds. You may have heard something like: you are 30 years old so you have plenty of time to absorb a market crash, therefore, an 80/20 stocks and bonds portfolio is a great way to benefit from capital gains.
Such a product is unlikely to deliver any stellar returns but you’ve got a good chance to preserve the time value of money. You’ll have to pay something for the advice so knock off some money for the fees. In the end you may find out that you’re not earning that much.
There are two types of investors and we’ll start with the one which will benefit from she services of a financial advisor.
Why should I pay a financial advisor
This section is about the people who benefit from the services of a financial advisor.
When you start investing you find out that there are lots of products, account types, investing styles, tax implications and mathematics. It can be a bit confusing and you may not have the time or desire to educate yourself for months if not years.
That’s when you hire a financial advisor who already has access to all the information and can set up the products which suit your needs. I don’t think that you should worry too much about fees because you’re obviously busy.
It is implicit that you have a high paying job so you can focus on that to earn money rather than read thousands of pages of finance literature. If you earn £50 per hour and your financial advisor charges £50 per month you’re probably getting a bargain.
I say this because if you spend 1 hour per week reading finance literature you’re likely to end up nowhere. Your time will be better spent earning from your regular job to increase your pot.
What if I want to be engaged in the market
I think that it becomes questionable whether or not you’ll benefit from the services of a professional. The first thing to consider is how much money you have.
You don’t want to take charge of a 250k pension pot just because you’re interested in the market. It’s always more sensible to start with a small amount of money, like 1k, 5k or 10k, and set a goal. My personal benchmark is a mixture between the FTSE 100 & S&P 500.
I’ve heard people say I’d make a lot if I had a million and I always ask them What’s preventing you from investing 1k or 5k? What makes you think that you’ll make it big with a million if you can’t make any money with 2k?
Sure, it’s easier to earn more with a bigger account but you have to start somewhere. Therefore, if you’re in such a situation start investing in a small account before you ditch your financial advisor.
I just started investing yesterday
Then I think that you’re in a perfect situation to be a self-directed investor. Your account will be small by definition so you’ll have the benefit of growing it over time.
The advantage of this is that you will gather experience and make mistakes with a small amount of capital at risk. Furthermore, you’ll have the opportunity to go up a ladder by going through a 5k account, then 10k, 20k, hopefully all the way to the millions.
You’ll invest under different conditions so you’ll even develop a feel about the market. But before you start let’s see what a financial advisor does.
It must be really complicated
I went to a wealth management course some time ago. It was a bit of an accident as I thought the subject was different but never mind. Anyway, I found it extremely boring.
It was all about educating the clients how their portfolio can show a negative profit and loss at one point or another. Apparently this makes investors very frustrated and they start calling the office every 2 hours.
The rest of the content was about choosing what to invest in.
Investment strategy of a financial advisor
It’s based on your age, the younger you are the longer you have to grow your pot of money. If you started investing in 1995 you have already gone through not one but three financial crashes. You know that you made loads of money along the way.
But what about the future, we don’t know what will happen. That’s what your financial advisor is concerned about, not losing your money.
You may have heard the never lose money expression before and I absolutely agree that it is very important. Therefore, your portfolio is split between stocks, bonds and cash.
It starts with 80% stocks and 20% bonds when you’re young and have the time to go through market crashes. No one wants a 50% drawdown in a pensioner’s account.
Then, once you have a pile of money, you switch to 60% stocks and 40% bonds. After that you reverse it to 40% stock and 60% bonds and finally you end up with 80% bonds and 20% stock in your golden years.
The purpose of this is to smooth out market fluctuations as you get older. It’s a good way to prevent any significant losses but it comes at the cost of lower returns.
When I say lower returns I mean that you can live on 3% of 2 million but you can’t get there if you start with 3% return. You’ll need something higher than that.
What’s in the portfolio
Most of these portfolios are invested in active and passive funds.
It’s fairly easy to do it yourself. I think that the services of a financial adviser are for people who are not interested in the market and don’t have the time or energy to do it themselves.
The shares usually involve UK index funds tracking the FTSE 100, 250, All Share or all three. You may also want to invest a bit abroad. Results will vary depending on the allocation.
The US market has been quite strong so you’ll be missing out if you focus on the UK alone. This will also reduce your exposure to any country specific market risks.
Japan is a developed economy too so chances are an investment may end up being worthwhile. I know that it has been in recession for decades and the population is shrinking but I wouldn’t write it off just yet.
There’s also Germany, France, Italy, Canada or any other developed country you can think of.
Since we’re talking about developed economies we won’t need any feet on the ground to conduct research. This means that we can settle for passive management. Furthermore, index funds have outperformed active ones the past few decades so why pay the fees.
I’m no big fan of active funds but everything is a means to an end. And it’s never a bad idea to invest a bit in emerging market economies.
The problem with these countries is that the institutions are not very developed so it may be difficult to conduct business there. On top of that the stock markets are not as sophisticated as the UK and the US. Therefore, it will be hard to figure out things like fair value, growth prospects, etc.
Finally, we don’t speak the language, we’ve never been there, we haven’t seen the product so how do we know if the stock is any good? That’s why we need feet on the ground, someone local and analysts to dig through any information they can find.
Yes, it will cost more but it is worth it. Thankfully, there are active ETFs which can be purchased hassle free via any broker.
Example of good active management
I haven’t checked if this story is true but it emphasises the point so I’ll go with it.
A North European investment bank was offered some US mortgage backed securities back in 2006. The head of the bank said he’s not sure if he wants them before he can see the houses.
The American bank offered to show him photographs, however, he insisted on going to the US to see the houses with his own eyes. When asked why he replied that he can’t put $700 million in real estate without seeing it first.
He decided not to invest after the trip and the US housing market crash followed soon after. That’s the kind of active management we all want!
There are many bond ETFs so you can just pick the one you want. It seems a good idea to invest in UK bonds because of the currency exposure.
However, there is nothing preventing you from adding a small allocation of foreign bonds.
You can even buy investment grade corporate bonds if you want to. It’s important to consider the increased risk of default though.
How do I make a portfolio like a financial advisor
First you choose your risk level. One thing I don’t like about financial advisor products is that the risk is defined in obscure terms like 5 out of 7 or high. This doesn’t mean anything to me.
Maybe because I gauge it by using standard deviation and volatility. For example, stock A’s volatility of 110% is high risk right? However, stock B’s 360% is also high risk.
Ok, but then the stock can’t lose more than 100% so I assume that the market is pricing the velocity of a potential move to the upside. Furthermore, the acceleration is expected to be much sharper for stock B. That’s unless both get delisted like Hertz, there are no clear answers.
You need to find the standard deviation (sigma) of returns of the main index you want to invest in. This is fairly easy to do in Excel by using the stdev function.
It tells you the expected move of the index with 70% probability. Unfortunately the math doesn’t discriminate between positive and negative return so it can go either way.
Sometimes an index can move more than one standard deviation. The Dow Jones made a famous 10 sigma move on Black Monday 1987. The S&P lost 34% this year but recovered promptly.
These are the kind of events that a pensioner’s portfolio doesn’t want to be exposed to. Hence, it is 80% bonds.
Once you’ve chosen your stock-bond split you need to decide which markets you want to invest in.
A very simple portfolio can look like this: UK index ETF, US index ETF, UK Bond ETF. That’s it!
We can mix things up a bit and add some US bonds, European, Japanese, Chinese and Emerging markets stock.
Types of funds
Before we move on to the portfolios you need to know that there are various types of funds and they have classes too.
There are different ways to split them, for example equity and fixed income or accumulating vs distributing. You also have funds of funds which just hold a basket of other funds.
I think that the main factors are the track record of the provider, the fees and the volume.
I wouldn’t invest in a fund of funds which has a daily volume of 2k, fees of 2% and has been around for a year. We’re talking about life savings so research is very important.
We’ll start with a young individual who has just started investing and then we’ll change the portfolio allocation as he or she gets older. This is only an example for visualisation purposes not a portfolio recommendation:
This portfolio is expected to deliver around 6.45% per year based on the past 5 years, including the coronavirus crash. I think that the worst case scenario will be if you start investing and get into a financial crisis immediately.
Later on in life our imaginary investor may choose to reduce the risk of his or hers pension pot. There’s already enough money in there so we want to smooth out any large fluctuations:
We increased the amount of bonds, therefore, now the hypothetical return is 5.93%. It’s not a massive drop, about £520 less on every 100k. Nevertheless, the risk is lower because stocks and bonds have negative correlation.
The investor is now close to retirement and our primary objective starts to move towards not losing any money. He or she may have another 5-10 years to retirement so we can’t allow a massive drawdown anymore:
Unfortunately the return goes down to 5.65% or £280 less per 100k. We can’t reduce risk without reducing return too.
Now we have a pensioner and we want to give them a decent income without any market performance worries. At the end of the day they’ve put in all the hard work so we want them to enjoy life:
The return drops down to 4.98% which equals £49,800 per year on a £1 million pension pot. I know it sounds a lot but it also means £4,980 from a £100k pot.
What’s the point since the returns of the portfolios aren’t that different
It may seem that a difference of 1.5% is not a lot but remember that we’ll be compounding this over a number of years. Let’s compare 30 year results starting with 80% bonds portfolio:
£1,000 x 1.0498^30 = £4,297.31
Now we’ll go through the usual route: 20% bonds, then 40% and 60% in 10 year increments:
£1,000 x 1.0645^10 = £1,868,34
£1,868.34 x 1.0593^10 = £3,323.89
£3,323.89 x 1.0565^10 = £5,758.92
Our theoretical pension pot and the yearly income from it is 34% more!
Is that all that my financial advisor is doing
Yes, pretty much. The difference between yourself and the adviser is that they have ready made portfolios. Moreover, the financial advisor knows a lot about the market and what the average returns were in the past.
If you want to do it yourself you’d need to engage in research and a small bit of mathematics. That is unless you already have sufficient data to construct a portfolio.
What about the funds they recommend
There aren’t any unique funds. Ok, there are but you’ll need a lot of money to get in and there’s no guarantee that it won’t go bust next year. Someone I know waited for years to get into a high profile fund and lost all of the money within months.
A friend of mine had a meeting with two financial advisors a couple of years ago. They talked about the usual risk of losing money and fees stuff, then gave her a list of funds to choose from. No one told her she was more suitable for an 80% stock portfolio so she went for a 60% one due to risk aversion.
If you have to choose the funds yourself you may start to question what is the purpose of the advice. You can just purchase them on the public market.
I can’t tell you how much you’ll make in the market but I have no doubt you’ll pay fees. They are not high, something like 1%. You may think well that’s not too bad, but it can be.
First we need to find out how much is this going to cost over 30 years:
£1,000 / (1 + 0.01)^30 = £741.92
That’s 26% of the money invested assuming you make 0 return. We’ll have to go back to the previous example and adjust it for fees:
£1,000 x (1.0645 / 1.01)^10 = £1,691.39
£1,691.39 x (1.0593 / 1.01)^10 = £2,724.08
£2,724.08 x (1.0565 / 1.01)^10 = £4,272.68
It’s 25.8% smaller pot than the example in the portfolio section. What do you think will happen if you add an advisory fee of £40 per month on top of that?
How much can I save if I do it myself
Before we jump to conclusions I have to acknowledge that it can’t be free. There will be a fee, however, we live in the 21st century so we have many options.
You can always shop around for a low cost SIPP if you want to do it yourself. There won’t be a zero fee account but even a drop from 1.5% to 1% will go a long way over the course of a career.
Financial advisor conclusion
I hope that I was clear that financial advisors provide a valuable service. However, the truthfulness of this statement is dependent on the client. Some clients benefit a lot, others not as much. You have to decide: which side are you on?
If you’re not interested in the market, you don’t have the time to learn about investing and don’t understand some of the content of the article you are in the first group. You get the quality service you paid for.
Someone else may have read this and thought I already know all that stuff and I have a portfolio which made xyz return against my benchmark. If this is you then think about whether or not you’re getting value from your financial advisor.