Author: Taylor Schulte
The shortcomings of active management are well-documented, with mounds of evidence that should leave you drawing the conclusion that active investment managers aren’t the secret to financial success.
Seriously. Just pick your source:
- From Financial Times, read how 99 percent of active managers fail to outperform.
- Prefer CNBC? Here’s an article that explains how almost no active manager has beaten the market in the last 15 years.
- Or take this report from Fortune, which points out that the S&P 500, one of your basic index funds, outperformed more than 92% of actively-managed large-cap funds over the last 15 years.
Or skip the news and go straight to mutual fund companies themselves. This report from Vanguard shows that only 18% of the funds that have been around for the last 15 years outperformed their benchmark.
The question may not be so much about whether active managers can outperform the market. The data answers that with a resounding no.
But you still might wonder why this is the case. The answer depends from firm to firm, but by and large active managers go wrong by thinking they know something the rest of the market doesn’t.
Why Active Management So Often Fails
Thinking you have secret or special information that no one else knows about flies in the face of the Efficient Market Hypothesis. That’s the theory that financial markets are efficient ones in which securities are almost always priced correctly according to their value.
That doesn’t mean prices can’t be wrong. It just means that they reflect how the market currently values those securities.
Any time a new piece of information enters the market, prices (on things like stocks and bonds) change to reflect that bit of data. And information flies into the market constantly.
Not only that, but there are millions of market participants just like you out there. There are even some who are much more sophisticated than you are. Don’t take that personally! In this case, it just means that they are professional traders who do this all day long.
They use complicated tech and algorithms to seek out information about the market. When you multiply this by the number of people participating in financial markets, the result is that it’s almost impossible for a single, random individual to know more than the wisdom of the crowds.
Understanding the Wisdom of the Crowds
In fact, there are a few experiments that demonstrate just how powerful our collective, average knowledge is.
One was done by NPR with Penelope the cow (yes, you read that right). Planet Money team members had people guess the weight of a cow at a state fair. Even though there were some outliers in the guesses, with some people guessing really far under the cow’s weight and others guessing incredibly far over…
The average guess, out of over 17,000 people submitting their best estimate, was 1,287 pounds. Penelope’s actual weight was 1,355. That’s just 68 pounds of the exact right answer.
This experiment has been repeated over and over again with jars of jelly beans — and you can do this yourself if you’re curious. Grab a bowl, fill it with tiny candy pieces, and then ask everyone in your office to guess how many candies are in the bowl.
You’ll find that while there are some extreme answers at either end, the average will likely come in very close to the actual number of candies in the jar.
That’s the wisdom of the crowds. It works with cows, it works with jellybeans — and it works with assets in a financial market.
Millions of market participants are all “guessing” the “correct” price of a stock. The stock’s price represents an average of all those assertions, and as it turns out, the average is almost always incredibly close to being spot on.
This is what active managers are up against. They base their actions on the (often incorrect) idea that they know more than the market and all its participants do. This is why a passive investment strategy probably makes far more sense for you and your financial life.
The Advantage of Passive Investment Philosophies
Passive investing is simple and it’s something I regularly preach on my rapidly growing retirement podcast called Stay Wealthy.
Where active managers try to find mispriced securities, passive investment managers build out well-diversified portfolios that represent broad segments of the market.
Passive investment managers don’t believe they have special information that allows them to beat every other market participant to the punch. That means they don’t pick individual stocks nor do they think they know when the next big market fluctuation is going to happen.
The truth is that no one knows when the next big market downturn will happen. We don’t know when the market will hit its peak. People can make predictions and forecasts all they want, but it doesn’t change the fact that no one knows with certainty when these things will happen.
Passive managers don’t try to forecast or guess. They invest for the long term, knowing that historically, the market has always gone up over decades of time (although past performance is never an indicator of future results, no matter what you invest in).
They also know that selling out of the market when things get volatile often leads to worse results than simply riding out the month to month fluctuations and continuing to buy in with dollar cost averaging.
What Does Your Financial Advisor Believe?
One of the questions you need to ask a financial advisor before you work with them is, “what’s your investment philosophy?”
If you run into someone who thinks they know more than the market, you may want to keep looking. Not only are they highly unlikely to underperform, which costs you in potential returns, but they’ll likely charge you a premium for doing so!
Active managers may charge 1 to 2 percent of the assets you have under their management as their fee. That’s on top of the fees and expenses included in the funds they invest your money within, which can bring your total fees up to 2 to 4 percent.
And if they’re not a fiduciary and sell you into investment products loaded with commissions, you could be paying even more.
That’s another advantage of financial advisors who help their clients with investments through passive strategies. Not only do they provide a better return for their clients, but they charge less for their service.
Thanks to innovations in technology — and the fact that index funds are much lower-cost than actively managed mutual funds — a passive investment manager can provide an investment management service for a much lower fee.
That’s critical because even small differences in fees can add up to hundreds of thousands of dollars you don’t get in your net return over your investing lifetime.
Before you hire any financial advisor, make sure they are willing to work as your fiduciary 100 percent of the time. They should also be fee-only, meaning they don’t receive any kind of commissions or kickbacks.
You are the only person who pays your advisor, which eliminates conflicts of interest that would exist if they also got paid by mutual fund companies for investing their clients in certain products.
Finally, an advisor should be able to explain their investment philosophy to you. If you don’t feel comfortable with their approach, keep looking.
Hiring a qualified financial advisor is one of the smartest moves any busy professional can make. By letting a professional advisor guide you toward smart investment choices, you can benefit from their expertise and focus your time on things you enjoy.
6 Red Flags to Watch Out for When Hiring a Financial Advisor
But, what happens if you hire the wrong financial advisor? Unfortunately, all the benefits go out the window. Keep in mind that thousands of “investment salespeople” masquerade as financial advisors in droves, leaving millions in damage and lost earnings in their wake.
This is part of the reason all the drama surrounding the fiduciary rule took place. Without any rules governing the actions of these professionals, many so-called “financial advisors” are happy to line their pockets at your expense.
To avoid hiring a financial advisor who will leave you worse off, you need to know what to look for. Here are six red flags that should leave you running for the door:
#1: They don’t want to tell you how they get paid.
Most financial advisors are either fee-only or fee-based. Unfortunately, these designations aren’t even close to the same thing. Where fee-only advisors get paid a flat fee for their advice, fee-based financial planners can work for a flat-fee or for commission on a product they sell.
If you want to work with a financial advisor who will always work in your best interest, make sure you choose a fee-only financial planner. That way, you’ll never be pushed toward a specific financial product because it pays your financial planner a huge commission.
It’s not that fee-based planners are all bad; it’s that they can’t possibly look out for you when their income depends on how you invest.
If you ask a financial planner how they get paid and they offer a wishy-washy answer, run toward the nearest exit and don’t look back. If their pay is so complicated they can’t really explain it, that’s never a good sign.
#2: They aren’t a CFP® (CERTIFIED FINANCIAL PLANNER™) Professional.
When hiring a financial planner, you should want the best. So, why not hire someone who has gone through the most comprehensive training possible?
While there are more than 300,000 financial planners in the United States, not all of them have a college degree. Further, only 25 percent of financial advisors have gone the extra mile to earn their CFP® designation (Source: cfp.net).
Where fee-based financial advisors are mostly taught to sell investment products, CFP® professionals are taught to take a more comprehensive approach to wealth management. And since earning the CFP® designation requires more education and higher standards overall, most CFP® professionals are at the top of their game.
#3: They focus most of their “practice” on selling insurance.
As mentioned already, thousands of insurance salespeople run around calling themselves financial advisors. If your “advisor” comes from a firm that is known for its life insurance offerings, you should start looking for a new one stat.
Many “advisors” who work for life insurance firms are barely qualified to offer investing advice, let alone help you create a comprehensive financial plan. There are certainly exceptions, but I dare you to ask your life insurance advisor how they get paid or if they’re a CFP® professional. I can almost guarantee you won’t like the answer you hear.
#4: They sell first and ask questions later.
A good financial advisor needs to ask a ton of questions before they begin offering advice. They’ll need to know how much you earn, your short-term and long-term goals, your appetite for risk, and a number of other details to even know where to start.
If your financial advisor starts selling before they ask any questions, this is a red flag of epic proportions. After all, how can they know what you need when they have no idea where you’re coming from?
#5: They insist they will help you “beat the market.”
Some financial advisors make crazy promises, including the one where they say they say they’ll “beat the market.” First off, it’s almost impossible for anyone to consistently outperform the broad stock market indexes. Second, most actively-managed funds that strive to outperform the market offer outsized investment fees that will eat away at your returns.
Your financial advisor’s goal should be helping you achieve the greatest return with the lowest fees possible. They should also be helping you with things in your financial life that you actually have control over. Hint: the direction of the stock market is not something you, or anyone, has control over.
If they focus only on the investment return without any mention of fees, that’s a huge red flag. And, if they make crazy promises that don’t apply to real life? That’s never a good sign, either.
#6: They aren’t a fiduciary 100 percent of the time.
A fiduciary is legally obligated to work in your best interests. Unfortunately, not all financial advisors operate under the fiduciary standard 100 percent of the time.
Some financial advisors work as fiduciaries when it pleases them, but take off their “fiduciary hat” and operate under the “suitability standard” when they could potentially earn more.
Where the fiduciary standard requires your advisor to offer advice that is in your best interest, suitability means they only need to prove a product is suitable for your risk profile. In other words, they don’t need to take into consideration fees, quality, or performance.
By choosing a fee-only advisor that is a fiduciary 100 percent of the time, you’ll never have to worry whether your financial advisor is offering you the best advice – or just selling you something.
And if you want to know whether your financial advisor is a fiduciary all the time, just ask. If this question makes them wriggle in their seat, you know what to do.