The benefit of paying for financial advice

Often when clients think about engaging with a financial adviser a stumbling block is whether the cost is worth it. How will you benefit? What will he or she do that will either improve your life or increase your returns.

As I wrote here, How does a financial adviser add value? there are a number of ways financial advisers add value.

To try and illustrate one of the ways we help our clients I thought I would create a scenario where an investor decides to forgo the cost of paying for financial advice and invests an amount of $465 000 on their own, into the ASX300. This investor decides to review their portfolio at the end of each calendar year (unrealistic as they are likely to look at it more frequently but it's easier to model using the annual approach). He is no different to almost every investor in the world and gets nervous when there is a negative return and so decides to switch into a fixed interest investment for the next 12-months "until things clear up". If the markets have recovered at the end of the year, then he switches back into the market. In fact, this investor also switches into fixed interest investments after two years of low returns!

What would the cost have been over the last 20 years if the investor behaved badly? The data below shows that there were four instances where he would have switched out of the market into fixed interest-I've used a 3% return for these years.

So this investor would have missed the market returns only 20% of the time (4 out of 20 years). Surely this won't make a big difference to his capital? Especially since he isn't having to pay fees to an adviser?

Let's assume the investor had realised it would be beneficial to work with a financial adviser. His initial investment was $465 000 and he pays an initial fee of $5 000 to build the financial plan. He also agrees to an ongoing fee of $450 per month, increasing with inflation.

If the adviser is able to keep him focused on his goals and objectives, as well as the long-term plan and expectations, it is likely that he could keep the investor in the market and prevent any unnecessary switches that are likely to erode his wealth. What would the benefit be to the investor over the 20-year period?

In the graph below you will see the three different scenarios. The purple line is the return from the ASX without any switching or adviser-the market return. The blue line is the returns the investor would have received if he simply made 4 poor decisions in 20 years! The green line is the return, after costs, the investor would have received if he had decided to pay for good advice, and had stayed invested.

The difference in capital over the 20 years is almost $790 000 more, or an extra 67%! This is after paying for advice.

The above scenario is obviously an oversimplification of the process, but it is a fair representation of what happens in reality and something I've seen in over 17 years of advising clients. Typically, instead of simply switching into fixed interest, investors want to switch into last years hot performing fund, will have an even more destructive result than simply moving into cash.

When markets are falling and an investor starts to panic, suddenly deciding he wants advice isn't going to help. It's too late to use reason and logic when the market has fallen 20% and he thought markets only go up (because that's been his experience over the last few years). At this stage, most investors emotions will overtake any common sense and he is likely to make a poor decision. Often the advice given from an investment perspective is to do nothing. It sounds easy, but in practice, it is difficult as it goes against our human nature.

Helping investors understand the markets and the biases we as humans are prone to, is crucial in managing their behaviour and setting their expectations. This needs to be reinforced over years of working together and building trust. Financial advice is most valuable when received as an ongoing relationship rather than as a one-off or "transactional" type service. 

There is a cost to receiving good financial advice, however, the benefits investors are likely to receive from a return perspective, let alone all the other areas we provide advice on is well worth the cost. The reality is that there is a high price to be paid in not paying for good advice.