What’s an Advisor Worth?

Is it a good idea to have an investment advisor?  The answer usually hinges on intangibles.  For those that answer “no,” often the rationale reflects confidence in their own capabilities, and a tinge of suspicion toward investment professionals.  For those that answer “yes,” often the rationale reflects confidence in an advisor’s ability to beat the market, appreciation for answering questions whenever they come up, or the most nebulous of all, “discipline.”

Are there tangible benefits?  I don’t mean pretty pie charts.  A quarterly report, although real, doesn’t put money in the bank.  Can advisors create value that is as tangible as the money you pay them?

At synthiumcapital.com, we quantified the value of five investment techniques, and concluded that together they can increase returns by up to 26%.  Few investors implement all five techniques, and many advisors don’t either.  Is it realistic for an investor to implement the techniques on his or her own?  That depends on the investor, and on the technique.  But our analysis does build a foundation for quantifying tangible benefits to having an advisor.  Here we go through the five techniques again, assessing whether individual investors can implement each technique their own. 

Technique #1: Optimal asset location

Value: up to .33% per year

Rating: Easy

    

Taxes can be reduced by placing high yield bonds, which produce a lot of income taxed at higher rates, into nontaxable accounts (IRAs, 401(k)s, etc), and placing tax efficient equity investments in taxable accounts.

Do you need an advisor to do this?  Not really.  Just sort your assets according to their tax efficiency.  To the extent you’re able to place assets in nontaxable accounts, the assets you should place there are the less tax efficient ones.  The rest of your assets, which would presumably include the most tax efficient ones, should go in your taxable account. Your overall asset allocation will be the same, but your after-tax returns will be higher.

Technique #2: Overweighting toward small and value

Value: up to .50% per year

Rating: Easy

Many academic studies indicate that small capitalization stocks and value stocks produce greater returns over the long term, albeit at higher risk.  For a long term investor, this can be a boon – assuming the effect persists. 

Tilting your portfolio toward small/value equities is fairly straightforward.  Since the effect is difficult to see at low levels of diversification, most small/value aficionados invest in mutual funds or exchange-traded funds.  You just need to look for funds with acceptable expense ratios that invest in small or value equities, although an advisor familiar with this technique probably already has done that research.

Technique #3: Whole portfolio, tax-sensitive rebalancing

Value: up to .55% per year

Rating: Difficult

To recap, rebalancing a portfolio means maintaining a specified asset allocation over time in order to maintain a consistent level of risk.  Most investors have multiple accounts, both taxable and non-taxable (e.g. IRA, 401(k), etc.). Many investors – and even some advisors – rebalance account by account.  This achieves the desired level of risk, but leads to higher taxes.  Whole portfolio rebalancing considers the tax consequence of the trades — buys and sells — required to get a portfolio back in balance so maximum tax advantage is achieved.  

If you have more than one account, whole portfolio rebalancing gets very complicated.  Some advisors pay thousands of dollars per year for rebalancing software; we sensed an opportunity to do a better job, so we wrote our own.  Only advisors can justify this kind of investment.  Properly doing it by hand, even with the help of a spreadsheet, is a nightmare.

Technique #4: Tax loss harvesting

Value: up to .46% per year

Rating: Moderate 

Tax loss harvesting means selling assets that have incurred a capital loss.  The investor can either use this loss to offset current capital gains, or, if there currently are insufficient gains, ‘carry forward’ (indefinitely) the losses, using them to offset future gains. If there is not an offsetting capital gain, $3,000 can be deducted every year from ordinary income until the loss has been used up.

After selling an asset, investors will frequently purchase a ‘proxy’ asset that is expected to behave in an analogous manner, but is not similar enough to the original asset to trigger the “wash sale” rule, which would nullify the tax loss.

Conceptually speaking, tax loss harvesting is not hard.  But to do it on your own, you had better enjoy putting the “green eye-shade” on.  There’s a lot of record keeping, both to keep track of your cost basis and to avoid accidentally triggering the wash sale rule, especially if you have multiple accounts and proxy assets.  And to minimize your taxes, you should be using specific tax lot accounting, which involves more record keeping.  If you’re comfortable with accounting, you might consider tax loss harvesting easy; if you’re not, you’ll probably consider it difficult.

Technique #5: Enhanced index funds

Value: up to .48% per year

Rating: Difficult

Enhanced index funds use a variety of techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies to achieve better returns than traditional index funds. The pioneer of enhanced indexing is Dimensional Fund Advisors (DFA), but other firms now offer them, including researchaffiliates.com, wisdomtree.com, and revenuesharesetfs.com.

Individual investors must sign up with a DFA-approved advisor in order to invest in DFA funds, which is why we labeled this technique “difficult.”  Individual investors should be able to invest in one or more of the alternatives listed above, but we feel they do not have enough of a track record yet.

Conclusion

Should you sign up with an investment advisor?  For most people, the answer revolves around intangibles, which we think is unfortunate.  Here’s a simple way to focus on tangible benefits.  Tally up the tangible benefits above that, for whatever reason, you can’t or probably won’t have the time to implement.  Assuming the advisor implements those techniques, and the tangible benefits exceed what the advisor charges, then maybe signing up is a good idea.  If they don’t cover what the advisor charges, maybe it isn’t such a good idea.

Finally, since most advisors don’t implement all the techniques, we hope our analysis will lead to some enlightening conversations between clients and advisors.

How to make $600/day the hard way

This Wired magazine article is not about investing, but some might find it as interesting as I did (I heard about it from bogleheads.org).

Mohan Srivastava, a geological statistician, found a statistical flaw in an Ontario lottery program, allowing him to predict winning tickets with 90% accuracy prior to purchasing them.  When he contacted the Ontario Lottery and Gaming Corporation,

he was referred to Rob Zufelt, a member of the lottery corporation’s security team. After failing to make contact for a few days, he began to get frustrated: Why wasn’t Zufelt taking his revelation more seriously?  “I really got the feeling that he was brushing me off,” Srivastava says.  “But then I realized that to him I must sound like a crazy person—like one of those people who claims that he can crack the lotto draw because last night’s number was his birthday spelled backward.  No wonder they didn’t want to talk to me.” Instead of trying to get Zufelt to return his calls, Srivastava decided to send him a package. He bought 20 tic-tac-toe tickets and sorted them, unscratched, into piles of winners and losers.  Then, he couriered the package to Zufelt along with the following note:

In the enclosed envelopes, I have sent you two groups of 10 TicTacToe tickets that I purchased from various outlets around Toronto in the past week… You go ahead and scratch off the cards. Maybe you can give one batch to your lottery ticket specialist. After you’ve scratched them off, you should have a pretty solid sense for whether or not there’s something fishy here.

The package was sent at 10 am. Two hours later, he received a call from Zufelt. Srivastava had correctly predicted 19 out of the 20 tickets. The next day, the tic-tac-toe game was pulled from stores.

The article also includes some troubling statistics.  Households earning less than $12,400 spend an average of 5% of their income on lottery tickets, whose expected value is 53% of the price you pay.  Thirty percent of people lacking a high school education said that playing the lottery is a wealth-building strategy.

Coincidentally, lottery tickets made an appearance in the Dilbert comic strip yesterday.

Ticker Tube Tales

After a Stairmaster workout at my athletic club, I often find several members sitting there in the locker room, fascinated by the CNBC ticker.  I am fascinated, too: not by the ticker, but by their fascination.  These are not day traders.  Why do they find cacophony so interesting?  For me, the ticker obscures more than it illuminates.

That scene underscores something remarkable about investing.  Unlike most disciplines, investing does not have a common cadence.  Cosmologists think in terms of billions of years; geologists, perhaps millions.  For politicians, there’s a natural four-year rhythm.  Musicians produce songs that are roughly five minutes long.  For computer hardware engineers, nanoseconds matter.

But investing has no common cadence, and perhaps it is better that it doesn’t.  It’s analogous to radios.  We’re all surrounded by the exact same electro-magnetic radiation, but by tuning to different wave lengths, we each hear entirely different music. 

What is signal to one person is noise to another; with radio, it’s easy to tell the difference.  With investing: not so easy.  Consider this example.  Say I plan to retire in 20 years, which is to say I don’t need the money for 20 years, and then I do need it.  As with any investment, risk matters, and sooner or later volatility of annual returns is likely to enter the discussion.

Why annual returns?  Gee, I don’t know, but to me, that seems to be the most common basis for volatility calculations; maybe providers of data are trying to split the difference between day traders and Warren Buffett.  If the 20-year investment horizon above is to be taken seriously, volatility of annual returns shouldn’t matter.  The cadence doesn’t match.  What should matter is the volatility of 20-year returns. 

Plenty of investors miss the distinction.  Watching the herky jerky ticker movement is like watching trees swaying in a stiff wind.  In the process of entertaining, it diverts attention away from the long term growth rate of the trees.  Day traders, of course, believe there is money to be made in the storm, whether or not the trees are growing.  They might be entertained by time-lapse photography of a tree growing, but they will learn nothing useful from it.

When the cadence matches, there are even more insidious ways to learn the wrong lesson.  Data breeds confidence; more of the former means more of the latter.  But even a prodigious amount of data reveals little about rarely occurring events.  Decades of video of a tree, for example, whether time-lapsed or otherwise, says a lot about the growth rate of trees, but very little about the risk of a forest fire.  This, in my view, is the main point of Nassim Taleb’s book, The Black Swan.  It is a best selling book; we can only hope it is also best read and best understood.

Truth be told, the locker room TV is just as often tuned to ESPN, where learning the right lesson from the right data can be just as challenging: think Moneyball and Moneygolf.  Whichever channel the TV is set to, the mesmerized look is the same.  Which leads to another theory: CNBC is just another sports channel, meant for entertainment only.  It sure beats breaking a sweat.