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Monday, December 12, 2016

Is a financial adviser really needed?

Yes, unless one has the time, interest and discipline, and doesn’t suffer from optimism bias. BY BARRY RITHOLTZ

MANY investors are not sure whether they need a financial adviser. New changes in law such as the fiduciary standard in the United States and technology such as robo-advisers have added layers of complication to the answer to the question: Do you need a financial adviser?

To know, you must evaluate your financial situation. Let’s work through it together, so you have a better understanding of your circumstances and can decide what sort of financial services you need. Let’s begin with the deceptively simple question: How much help do you need?

It depends on several factors:

First, how complicated are your personal financial circumstances? The simplest financial situation is a young single working person who rents his or her home.

At the other end of the scale is someone like this: A successful entrepreneur who owns a company (or three); is facing large capital gains reflecting the sale of a business; has children and grandchildren to pass wealth to;has multiple sources of income and a fairly involved tax filing to go with it including loss carry forwards; owns multiple real estate properties in the US and abroad.

He works with multiple lawyers, accountants and other business counsellors.

He has maxed out 401(k) pension contributions and defined-benefit plans; owns numerous investment portfolios at different firms;has a fully developed will, trusts and insurance policies; and is involved in major philanthropic endeavours.

Your situation is probably somewhere in between these two extremes. The more complex your circumstances, the more likely you would benefit from some
professional help.

Secondly, what are your long-term financial goals for the next five years or more?

Are you on track for making them?

These are the most common answers from investors:

- Saving to buy a home
- Paying for college for children
- Retirement planning
- Outpacing inflation
- Managing the proceeds from a sale of a business
- Philanthropy
- Tax management
- Generational wealth transfers
- Estate planning

I listed these goals in order of complexity. Saving to buy a home, pay for college or retire are the simplest investing goals. Financial planners have been thinking about these questions for a long time. One of the more useful way they conceptualise this is by breaking down your financial life cycle into three phases: accumulation, preservation and distribution.

These three phases usually track age. Younger people in their 20s and 30s have a
longer time horizon, not a lot of cash flow, and the ability to embrace more risk for potentially greater returns.

Middle-aged people in their 40s and 50s typically have more assets such as a home, portfolios, pension accounts, along with greater financial obligations such as paying for college and saving for retirement. They have a moderate time horizon and should embrace somewhat less risk.

People closer to retirement in their 60s and 70s have less potential time for markets to work in their favour and should be taking even less risk.

The distribution phase is exactly what it sounds like: planning to draw down your assets to live on them in retirement. Reward is a function of risk – and risk brings with it the possibility of failing to yield expected returns.

This is an important concept that many investors fail to understand. Very often, we see younger investors fail to take enough risk; they carry way too much cash and bonds for their multi-decade time horizon.

And the flip side is true – we often see people who should be in a preservation mode but are still aggressively embracing far more risk than they need to. That increases potential volatility and portfolio draw downs. Many successful entrepreneurs and business people – hard-working, competitive, driven – have difficulty making the transition between phases.

They are used to embracing risk and do not enjoy throttling back.

It shows in their portfolios, which are often way more volatile and aggressive than is appropriate.

Assess where you are on these timelines and determine whether you can manage
adapting to each phase of your financial life cycle. It is not terribly difficult, and with some time and thought many people can handle it themselves. Whether you want to or not is a different question.


Thirdly, how disciplined are you? Behaviour is where most people run into problems; it is also where financial advisers deliver the most value, in my opinion.

As I have discussed oh so many times, when it comes to assessing risk in the capital markets, you’re just not built for it. The biggest obstacle to your success is not your stock-picking prowess or ability to time markets but rather the one thing that actually is within your control – your own behaviour.

Whenever I speak to a large group of investors, I like to ask how many of them rank themselves as “above-average drivers”.

Typically, 70 to 80 per cent will raise their hands saying yes. That is, by definition, incorrect.

That is followed by the same question about investing: How many of you are
above-average investors? How many of you expect to beat the market this year?

The same optimism bias appears – about 75 per cent think they are better than average and will beat the markets. That is just the beginning of a cascade of cognitive, emotional and psychological errors that lead the majority of investors to do poorly. The average investor, according to numerous studies, is a terrible investor.

Here are some specific questions for the 70 to 80 per cent of you (heh heh) who are above average:

- Do you have an investment philosophy?
- How do you express that in a portfolio?
- Do you follow specific rules when investing?
- When do you overturn those rules?
- How actively do you trade?
- What is your portfolio turnover? How long do you hold your average investment?
- How much does your strategy depend on news?
- How much financial television do you watch?
- What is the role of economic releases and quarterly earnings in your investing?
- What did you do with your portfolio in 2008-2009? 2000-2003? 1997-1999?

If you answer those questions honestly, you should be able to determine whether you have the temperament and discipline to manage your own money.

If you have the time, interest and discipline, there is no reason you cannot do it yourself. It is relatively easy: Select an asset-allocation model, review it
quarterly, rebalance once a year, wait 30 years, retire. Voila! For the rest of you,
financial advisers are standing by.

The writer is chief investment officer of Ritholtz Wealth
Management and author of Bailout Nation. He runs a finance blog, The Big Picture