Determining the perfect portfolio for the next three decades is an impossible task...
But, given the evidence widely available, we now know what works and more importantly, what doesn't, in investing. These insights have allowed investors to build excellent portfolios at minimal costs, something the late John Bogle, founder of Vanguard, would be pleased to hear.
However, despite low-cost index funds being widely acknowledged as an eminently sensible investment choice for most investors, the need for professional financial advice remains crucial.
Understanding bad financial advice
First, it's important to recognise what constitutes poor financial advice.
In our view, bad financial advice happens because of:
Overlooking the evidence: Decades of academic research consistently demonstrates that trying to outperform the market index is a losing game. In the past, financial advice often focused on selecting investments, which led to subpar outcomes. With the overwhelming evidence against stock picking and favouring index funds, any financial advice that focuses on 'beating the market' or 'chasing what's hot', should be ignored.
Experts' predictive limitations: No one (including 'experts'), can accurately predict the future. While financial professionals may possess expertise in assessing base rates (known probabilities), attempts to predict specific fund managers' or stocks' performance over the long term are fraught with uncertainty (in fact, data tells us that a significant percentage of active fund managers and individual stocks underperform the market). Ignoring this can be catastrophic for your investment journey. Avoid those who sell this kind of information as financial advice.
Emotion: We make cognitive and emotional errors. We trust people who are good at sales and likeable, but don't trust those who tell us uncomfortable truths we don't like to hear. Evolution has wired us with biases that make high quality decision-making around money, extremely difficult.
What is good financial advice?
In our view, expert financial advice can be divided into five key areas. They bring together a technical proficiency in financial planning, but also knowledge of human psychology.
Those areas are (in this order):
- Well-being, goal formation and quantification;
- Asset allocation;
- Insurance needs;
- Financial products; and
- Tax awareness;
1. Well-being, goal formation and quantification
Good advisers know that wealth is only a way station to well-being. Well-being advisers identify clients’ wants and help clients assess those wants, balance them, and avoid cognitive and emotional errors on the way to satisfying them. And those wants are satisfied by the full range of utilitarian, expressive, and emotional benefits.
Well-being in the context of finance usually implies financial well-being. Discussions about enhancing well-being are typically about enhancing financial well-being, such as saving during our working years to sustain us in retirement.
However, well-being is broader than financial well-being, and enhancing well-being involves more than just enhancing the financial element. In addition to finance, the domains of well-being also include family, friends, and communities; work and activities; and health—both physical and mental. Yet financial well-being underlies well-being in all its domains, and well-being in each domain is impossible without financial well-being.
To flourish in life, crucial to understand the reasons behind your investment decisions. Your why.
Setting financial goals has a profound impact on various aspects of our lives. It influences how we allocate our time, choose our relationships, select our careers, save money, spend money, and invest. In other words, our financial goals determine how we allocate all our capital, not just financial.
While this may seem obvious, the challenge lies in our ability to set goals that align with a meaningful and fulfilling life.
Consider the scenario of setting an ambitious financial goal, such as early retirement, and making significant sacrifices or taking excessive risks to achieve it. However, upon reaching that goal in the future, you may discover that it doesn't bring the expected happiness.
Enter the concept of hedonic adaptation.
Hedonic adaptation refers to our ability to quickly adapt to new circumstances, both positive and negative. Research, such as the 1978 study Lottery winners and accident victims: is happiness relative?, has shown that individuals tend to return to their previous levels of happiness or sadness after significant life events. This means that the allure of early retirement, material possessions, or extravagant experiences may not have a long-lasting impact on overall well-being.
This is why goal formation becomes crucial in financial advice, and is part of the first area to address.
Just like investing, there's a significant body of literature on happiness and life satisfaction. Financial advisers should have an understanding of this subject to provide perspective on what constitutes a meaningful life, which is the ultimate goal for every investor (and human).
Setting up a plan in numbers to achieve a financial goal, without scrutinising the goal itself, can lead to misallocation of capital.
It may seem also unconventional to suggest that financial advice requires an understanding of psychology. However, money is intricately tied to our lives, and financial decisions carry significant psychological weight.
Once meaningful goals aligned with a fulfilling life are established, the next step in financial advice is quantifying those goals. Depending on the specific goal and circumstances, this may involve simple or complex calculations. Quantifying goals helps us avoid falling into the hedonic trap of an infinite pursuit of more. Understanding what is "enough" is vital to prevent reaching a point of regret.
The pursuit of enough is much harder to grasp, compared to the pursuit of more. While speculating in the stock market in the pursuit of more may feel gratifying, it takes much more brain power to step back and reflect on what enough truly means. Morgan Housel, in his book "The Psychology of Money," says the hardest financial skill is knowing when to stop moving the goalposts and realising that insatiable desires for more often lead to regret.
So, step one is crucial. Understanding the psychology behind goal-setting and the pursuit of enough can help investors align their financial decisions with a meaningful life, and avoid the pitfalls of perpetual dissatisfaction.
2. Asset allocation
Once you've established and quantified your meaningful goals, the next step is to consider asset allocation. How should you allocate your financial assets based on your goals and their estimated costs? Before even thinking about whether index funds are the right choice, it's important for investors to determine the right mix of stocks, bonds, and other asset classes. Additionally, it's important to take into account any debt you may have when making asset allocation decisions.
It's not enough to make these decisions in isolation; they should also be rooted in meaningful goals and take into consideration your personal circumstances and abilities.
For instance, a tenured professor enjoys a significantly more stable income compared to a commissioned salesperson in a volatile industry. These variations are important when determining the allocation of financial assets.
Asset allocation is also one of the most important determinants of expected investment outcomes.
For example, opting for a more aggressive investment portfolio that promises a greater return on investment could potentially accelerate your progress towards achieving your goals, requiring less additional savings. However, this approach may also introduce a higher level of uncertainty and be more challenging to maintain during periods of market volatility.
Likewise, picking an asset allocation that's too conservative can have a larger implied cost, due to lower expected returns.
So, you have meaningful goals in place and those goals have been quantified. An asset allocation has been determined to meet the goals with further consideration for non-financial assets, like human capital.
But there's still a gap.
3. Insurance needs
Unless you're financially independent now, there's a good chance you rely on your human capital, or the human capital of someone else in your life, to move toward achieving your financial goals.
A premature death or an unexpected illness can easily derail the best laid investment plan. Life and critical illness insurance may be the least fun to think about, but are some of the most important components of a financial plan.
Similar to quantifying a goal, determining insurance needs can be simple or complex, depending on the circumstances. Understanding insurance needs and the cost of covering them is another crucial piece of financial advice.
4. Financial products
Only now, after considering goals, asset allocation and insurance needs, can we start thinking about financial products (like index funds).
Evaluating the best financial products to realise goals, implement an asset allocation and an insurance plan, is an important area of technical competence, but it can't be done properly, without the context found in a broader plan.
In too many cases, financial advice starts with the product. This is bad financial advice. If your meeting with a prospective adviser begins this way, run in the other direction. There's a reason this is number 4 on the list.
5. Tax awareness
Looming over all of these areas are of course, taxes. Being aware of taxes at every step can significantly enhance the expected outcome without adding to the risk factor. This is yet another aspect where both technical expertise and understanding the context are crucial.
Why not go it alone?
In his book, The Geometry of Wealth, Brian Portnoy talks about the process of 'defining your purpose, setting your priorities, and implementing your tactics'. Tactics, like index funds, are the very last step.
This whole system exists as an iterative process. People change and have different seasons of life, meaning that their objectives, preferences and values also change. The process of managing wealth is one of continuous improvement.
The information is out there after all, and often for free.
Unfortunately, as humans, we suffer from biases. Perhaps you suffer from confirmation bias (the human tendency to form a quick belief and then seek out information that confirms it), or maybe you see decisions as binary when they're not. Maybe you let your short-term emotions get in the way of good decisions, or you're often overconfident - feeling you know more than you actually do.
It's true, not everyone needs professional, financial advice.
But the problem is our inability to make rational decisions around money stems from the information directly in front of us, including our own biases.
One of the best ways to overcome this is by reality testing your assumptions with a sage expert, particularly in complex areas like managing wealth.
Making better decisions with an outside view is a pretty good argument for financial advice.
Why do people seek advice?
In her book, Advice That Sticks, neuropsychologist Dr Moira Somers, offers some of the reasons that people seek expert advice. Here are three.
1. Expert advice allows people to quickly assess financial opportunities and compromises. Going through the above steps with an expert results in a relationship where there's a mutual understanding of goals, preferences and values.
This mutual understanding, combined with technical competence and a knowledge of human behaviour, makes decisions around these trade-offs more efficient.
- Should you buy a bigger house with a bigger mortgage?
- Should you take a lower paying job to spend more time with your kids?
- Should you sell the shares that you own in your employer?
Financial trade-offs come up every day.
Expert advice simplifies complexity. With thousands of pages of information available online, it can be hard to determine the relative value of that information for a specific decision. Experts have the ability to quickly assess the credibility and usefulness of information, streamlining the decision-making process by reducing the number of inputs required. Too much information and perceived complexity easily leads to time-consuming and stressful decision paralysis.
2. Expert advice increases confidence in an intended plan of action. People want to make sure that they've not overlooked anything and studies have shown that those who've consulted with a financial planner have increased financial and emotional well-being. They often have increased confidence in their ability to meet their goals, and deal with setbacks without having to make financial sacrifices.
3. Expert advice saves time. This can be through obvious ways, like reducing time spent on upfront research and eliminating the ongoing tasks required to implement a financial plan. But also in less obvious ways, like reducing the time spent in inaction and the time spent dealing with stress related to the task of implementing the plan.
Financial advice is not about which fund managers or stocks to pick. The fact that index funds are the most sensible investment for most people, does not negate the need for financial advice.
Financial advice begins by establishing meaningful goals and then quantifying them. Next, it involves determining the appropriate asset allocation and insurance plan. Only after considering these factors should you consider specific financial products and strategies, all while keeping taxes in mind.
While it's possible to accomplish these tasks with sufficient research, humans often get trapped in their inside view. This can lead to narrow perspectives, confirmation bias, short-term emotions, and overconfidence, which can all badly hinder the decision-making process.
Consulting with an expert can help in overcoming this. An expert is also able to assist in optimising trade-offs, reducing complexity, and saving time, all within the context of your specific goals, preferences and values.
I tell people to invest in index funds every day, but I also tell them to do a lot of other things, using over 40,000 hours of professional experience, along with my knowledge of human psychology.
If you like help assessing trade-offs, simplifying complexity or saving time, let's talk.