Financial Reference

I’m naturally skeptical that people need financial advisors; especially the ones who go by the monikers financial consultant or broker. There are two main reasons for my skepticism: (1) I often disagree with the advice they give and (2) I think most people are smart and disciplined enough to implement a simple financial plan.

Even assuming that the planner does not have perverse incentives (i.e. receiving legal kickbacks or encouraging trading and market timing), I often don’t agree with most planner’s financial advice. This is due to a number of reasons:

(1) Planners are more concerned with not screwing up than with helping their clients succeed over the long run. Even for very young investors, planners often recommend an allocation to bonds. The explanation for this in financial periodicals is that it smoothes volatility. But, for a young investor, assuming they don’t have to liquidate, all that matters is the long term. But the practical reality is that it’s much easier for a planner to show a series of slight gains than show a high volatility portfolio that outperforms in the long-run. Losses are psychologically hard to take and could cause the investor to do something rash like trade into less risky positions or, even worse, cost the planner a client.

(2) Planners still neglect to look at the client holistically. While planners are getting better at seeing the total financial picture, there is still some work to be done in this arena. For example, an investor can be very confident his planner will suggest he should keep 3-6 months of living expenses in cash in case of emergency. For most people, this makes no sense!

Let’s assume a typical modern investor with a large mortgage and some kind of other debt (a home equity line of credit (HELOC), credit card debt, margin debt, etc.). This investor would be much better off using the cash to pay down the other debt rather than having debt and cash. He would be better off because he would earn a higher return and not incur more risk. He would earn a higher return because the HELOC, credit cards, or margin debt all cost more than what you can earn investing in cash. There would be no more risk because the investor would still have the HELOC, credit cards, or margin capability in case of emergency. Many people balk at taking on debt during an emergency but it’s better than having debt in good AND bad times.

Even if our investor didn’t have any other debt besides his mortgage, it would still be better to pay off more of his mortgage and take a HELOC in case of emergencies. He could reduce his current payments and reduce his debt. While it is true that in the case of emergency the interest rate on his HELOC would be more than the interest rate on his mortgage, the probability of emergency is by definition small and the amount drawn down on the HELOC would hopefully not be the full amount. Some people critique this strategy by saying “what happens when your HELOC runs out?,” but what happens when your cash pile runs out? You are in the same place. If anything, you should be able to save more using this strategy so you should have more margin in times of emergency.

By ignoring alternatives to rote advice, planners can offer sub par advice for many investors. Looking at the client’s whole financial picture can offer better solutions.

(3) Some financial planners fail to listen to their client’s wishes. This is a small percentage of advisors but there is a recent, salient example. In the June 2006 edition of Money magazine, they covered the family who won last year’s Dream Home — a $2.5 million estate in Texas. After living in the huge house for a year, they realized the $36,000 they had left from the prize money wouldn’t cover the tax bill of $672,000. Now they are going to sell the house and move back into their smallish house around Chicago. But after living in such a huge house for a year they want to add on to their current house.

After hearing this, one of the financial planners suggests that if they only net $250,000 from the sale of the home after paying the tax bill, they should sell that house and move into an apartment. Can you imagine a family, especially a family that loves the idea of living in a big house going from a $2.5 million estate to an apartment? I can’t imagine they could imagine it either.

In addition, with $250,000 they could pay off their current mortgage and still have $115,000 left over to invest. So why would they need to sell both houses? My only thought is that this planner believed real estate prices are headed for a decline and wants them to “short” housing. The advice went against their obvious wishes and was speculative in nature.

While the normal mistakes planner’s make are not going to ruin you financially, they can delay your retirement. In the next part of this blog, I will talk about the second point: whether people are smart and disciplined enough to create and implement a plan. Obviously, it depends on the person and so there is some room for planners to add value. In addition, I will talk about other ways planners can add value.