For any business relationship to work, the value gained for both parties must exceed the cost. The calculation for a financial advisor is quite simple: The relationship works for the advisor if the compensation received in return for advice and service is enough to cover costs and a reasonable profit. The calculus for clients choosing a personal financial advisor is more nuanced, but broken down to its most basic level would be: Is the value obtained from hiring an advisor greater than what I pay?

Any investor making this important decision should start with the obvious assumption that an excellent advisor is preferable to an average or typical advisor. Unfortunately for most investors, it can be difficult to recognize the differences between a typical and excellent advisor.

Excellent advisors are not born; they are made through long years of education and experience. Unfavorable employment arrangements, conflicts of interest, lack of experience and judgment, and a need to collect short-term revenue can all be impediments to a young advisor becoming an excellent advisor.

In this article I will illustrate what excellent advice looks like, and why it is so critical to your success as an investor. To begin, here is my take on the characteristics of each:

Typical Vs. Excellent Advisors

Characteristic	Typical advisor	Excellent Advisor
Standard of Care	Suitability Standard: Advisor can choose any investments they deem “suitable”	Fiduciary Standard: Advisor is required to choose investments based on clients’ best interests
Scope of Advice	Investments only, with rough tax and goal considerations	Current view including net worth, cash flow and income tax analysis, goal projections, insurance evaluation, estate plan
Financial Planning	Uses software to build plan, not particularly customized or accurate	Conducts detailed calculations and projections customized to each unique situation
Objective and Fee-Only	NO	YES
Expense Ratios, Turnover, Cash Drag, Loads & Costs	HIGH	LOW
Disciplined Rebalancing	NO	YES
Transparent Advisory Fee	NO	YES
Education for Clients	Confusing jargon, often influenced by wholesalers	Understandable concepts, ongoing behavioral coaching
Tax Efficient Asset Location	NO	YES
Order of Withdrawal	Relies on rough guessing using a cookie-cutter approach	Robust calculations which take into account optimal SS claiming strategy, Roth conversions, and present value of taxes paid under different scenarios.
Investment Approach	Predictive	Pragmatic, using academic research
Decision Making	Emotional and possibly influenced by commissions	Rules-based with few conflicts of interest
Team Approach	NO	YES, works with outside Insurance Agents, CPAs, Estate Planning Attorneys and other professionals

Aside from these notable characteristics, an excellent advisor will have strategies built into their plans that give their clients a direct advantage. Here is a breakdown and explanation of some of those strategies.

Expense Ratios: Annual advantage: .24%

Every dollar paid in expense ratios is a dollar less of potential return for investors. If higher expense ratios equated to higher net returns, excellent advisors would use higher cost funds, but in most cases, the exact opposite is true: higher cost funds have lower net returns on average. Therefore, the excellent advisor avoids expensive funds that utilize a predictive approach and carry an average expense ratio of .5% (equity funds) and .42% (fixed income funds). [1]  Instead, an excellent advisor populates accounts with passive and factor funds, with an estimated average expense ratio of .3% (equity funds) and .1% (fixed income funds). When applied to a balanced account with a 60% equity exposure, the blended expense ratio reduction is .24%. It should be mentioned that if the “advisor” is actually a securities salesman, the difference can be even more extreme. Sales loads often add a full percentage point or more to annual costs.

Rebalancing: Annual advantage .31%

The main determinate of risk and expected return in an account is the selected equity exposure percentage. Over time an account will drift away from the selected equity percentage. The goal of a rebalancing strategy is to control risk. An investor who wishes to maximize return without regard for risk would be well served with an account that is 100% invested into stocks; however, such an account will experience extreme volatility and is more likely to be liquidated at a market bottom due to the high level of psychological distress suffered by the investor. A blended account that is never rebalanced will likely eventually see increasing equity exposure and increased risk as well. According to Vanguard’s calculations based upon data from Thompson Reuters DataStream, over the past 53-year timeframe[2], a 60% stock/40% bond portfolio that was not rebalanced returned an annually compounded 9.36% per year with a risk measure of 14.15%.[3] A rebalanced 80% stock/20% bond account returned more: 9.71% with nearly identical risk of 14.19%. Therefore, the rebalanced 80% stock/20% bond account captured the extra .31% without additional risk. The advantage of rebalancing in this instance equates to .31% per year.

Turnover: Annual advantage .18%

Turnover results in costs known as “transactions charges,” which take the form of commissions, ticket charges, spreads, and market push (equities only). Up-front commissions are obvious to clients, as are ticket charges. However, the remaining charges are hidden to all but the most astute investors. For our purposes I will ignore the commissions earned by some “advisors”. I will also ignore transactions costs within bond funds, as much of the turnover in these funds is due to bonds maturing ­– a situation that does not result in costs­ due to spread, which is the main component of transaction charges. The formula for determining transactions costs as a result of turnover is meant to be a rough estimate. John Bogle estimated transactions costs in large-cap equity funds to be 1.2 times the turnover rate.[4] The average turnover rate among domestic equity funds is roughly 30% [5]  The excellent advisor’s passive and factor stock fund’s turnover rate is an exceptionally low 4%. A comparison shows that the average predictive stock fund carries annual transactions costs of .36%, while with pragmatic funds they amount to .05%. The cost advantage here in the stock funds is .31%, and in the 60% stock/40% bond portfolio the advantage is .18%.

Note that this advantage is understated for taxable accounts. High-turnover funds in taxable accounts create short-term capital gains, which are taxed at the higher “ordinary” income tax bracket, and they cause taxes to be paid sooner than otherwise. As this advantage varies by tax bracket, I will ignore it for purposes of measuring the advantage.

Cash Drag: Annual advantage .12%

Cash Drag is an opportunity cost that is valid when comparisons are being made. It refers to the lost return in stock funds due to low returns on cash holdings verses the higher long-run return on equities. Typical advisors and do-it-yourself investors tend to be emotional, and they move money in and out of stock funds based upon short term events and ever-changing market outlooks. Investors become euphoric in bull markets and run for cover in bear markets. This frequent change in sentiment results in deposits and withdrawals from stock funds. The mutual fund manager who is the recipient of deposits is awash in cash until the funds can be invested and must keep cash on-hand to meet withdrawals in bear markets. Often, he or she is forced to sell equities at the worst possible time to meet the demands of shareholders. Excellent advisors hold funds with smaller cash weightings. The average cash weighting in predictive stock mutual funds as of May 2013 was 3.8%.[6] In the index and factor funds, the average cash weighting is .4%. When the difference of 3.4% earns equity returns instead of cash returns, the advantage for a 60% stock/40% bond portfolio is .12%.[7]

Dimensions of return: Annual advantage .5%

An excellent advisor understands that the predictive approach is futile, and that the analysts necessary to implement it are expensive.  However, they also understand that while securities analysis is futile, a portfolio that takes advantage of the dimensions of return has been shown to enhance returns over long periods of time. Among the dimensions, or premiums that enhance returns, two are most notable:  The price premium and the profitability premium. The price premium is the additional return associated with “value” companies, which are companies that are low in price relative to fundamentals such as earnings, dividends, and book value. The premium has been 3.18% per year over the time period between 1928 and 2019. The profitability premium is the additional return associated with companies that have high free cash flow (profitability). The profitability premium has been 3.57% per year from 1964 to 2019.

One might assume that these additional annual returns could be captured by restricting a portfolio strictly to value companies with high free cash flow.  However, a portfolio that invests in that way would not be adequately diversified. A wise advisor invests in the entire market, while “tilting” the holdings so that more is invested in the value and high profitability segments. Further, the premiums are often not apparent over short time periods; it may take ten years or more for them to be realized. Finally, there is no guarantee that the premiums will be as robust in the future as they were in the past.  There is no way to quantify what they will be, but it seems that an annual return advantage of .5% is very conservative indeed.

Behavioral Coaching: Annual advantage 1.49%

Vanguard conducted a ten-year study comparing investor returns (internal rates of return) to fund returns (time-weighted returns). The investors fared far worse than the mutual funds themselves:

	Large Cap Funds	Mid Cap Funds	Small Cap Funds
Mutual fund return	6.93%	8.58%	9.04%
Investor Return	5.54%	6.73%	7.70%
Difference	-1.39%	-1.85%	-1.34%

The differences between the return in the funds themselves and the actual returns earned by investors in those funds can be explained by cash flows, which tend to be attracted by, rather than to precede, higher returns. In other words, on balance investors are buying high and selling low. With a few unhappy exceptions, the clients of an excellent advisor stay fully invested regardless of market movement. As a result, clients on average obtain personal returns that are very close to the returns of the mutual fund in which they invest. The annual advantage varies by size of fund, but the estimate of the advantage is 1.49% per year.[8]

Elimination of capital gains distributions: Annual advantage: small and variable

Equity mutual funds are required by law to make regular capital gains distributions. These are the result of sales within the mutual fund portfolio. ETFs, by contrast, can defer those gains through “like kind exchanges” with external market makers. An excellent advisor will take advantage of this in taxable accounts.

Asset Location: Annual advantage: variable

A well-diversified portfolio contains some securities that are less tax efficient than others. For example, Real Estate Investment Trusts, Precious Metals ETFs, Treasury Inflation Protected Securities, Corporate Bonds and High Yield Bond funds are not tax efficient. They produce income that is taxable at the high “ordinary” income tax rates. In contrast, tax-free municipal bonds, tax-advantaged stock funds, equity ETFs, and some single-issue stocks are tax efficient: some produce little in the way of “ordinary” income; and some can avoid taxable capital gains distributions, which are deferred until the time of sale. Tax-qualified plans such as 401ks and traditional IRAs do not pay tax on income; only withdrawals are taxed. Therefore, an advantage can be gained by locating the tax-inefficient securities within these tax-qualified accounts. This allows an advisor to locate the tax-efficient securities where it matters: within the taxable accounts.

Due to the desired weightings of each security and the size of each account, compromises are often made.[9] Further, some investors do not own both taxable and tax favored accounts. Therefore, the advantages vary widely. Vanguard conducted a study in which it was determined that the annual advantage ranged from 0% to .75%, but for our purposes of measuring the total advantage, I will ignore asset location.

Order of Withdrawal: Annual Advantage: variable

Clients who hold multiple account types such as individual, joint, traditional IRA and Roth IRAs are faced with a decision in retirement regarding the order of withdrawal. Advisors who implement informed withdrawal-order strategies can minimize the total taxes paid over the course of the retirement years, thereby increasing wealth and the longevity of the portfolio. At times it is actually beneficial to increase the current tax, if by so doing a spike in tax brackets in later years can be avoided. Nonetheless, the proper order of withdrawal is usually 1) taxable accounts, 2) tax deferred accounts, 3) tax free accounts. The calculation is muddied by other factors such as the opportunity to convert traditional IRAs to Roth IRAs, the optimal Social Security Retirement claiming strategy based upon life expectancy, the other income such as part-time earned income, tax free municipal bond interest, and other non- earned income such as pensions, and the effect of these various types of income upon “provisional income” and its effect upon Social Security taxation. A calculation which compares the internal rate of return of the optimal spending order to that of the reverse order results in an advantage of up to .70%. Not all retired clients have multiple accounts, nor are all clients in the distribution phase. For those clients, there is no advantage. Therefore, for our purposes of measuring the total advantage I will ignore the benefits of optimal order of withdrawal.

Summary It is not possible to illustrate a precise advantage of retaining an excellent advisor over a typical one, but a rough estimate follows. To avoid overstating the case, I will exclude any advantage that can only be achieved if both tax-qualified and non-qualified accounts exist. Note that a few investors will be skillful or lucky enough to implement some of these strategies without advice. On the other hand, some will do even worse than the average. The rough average advantage within accounts is as follows:

Expense Ratio	.24%
Rebalancing	.31%
Turnover	.18%
Cash Drag	.12%
Dimensions of return	.5%
Behavioral Coaching	1.49%
TOTAL Average Annual Advantage	2.84%

Excellent Advice benefiting clients outside or between accounts

The implementation of advice for actions outside (or between) accounts is the responsibility of the client. Obviously if the advice is not taken, there is no advantage. The advantage of advice that impacts transactions outside of accounts tends to be uneven, with sometimes no advantage over the course of years, with sporadic, often large advantages taking place at various points in time as a result of advice given. I will provide anecdotal examples of this type of advice using reasonable assumptions, and the estimated resulting dollar advantage of each. The supporting calculations are found in the endnotes. Examples:

Advice regarding cash reserves

Assume that an excellent advisor helps a client to establish a cash reserve target of $50,000 to be held in bank accounts to meet emergencies and opportunities, and that the client has $250,000 in liquid bank accounts. If the advice causes the excess $200,000 to be invested over the next fifteen years for retirement in a 60% stock/40% bond account, the hypothetical, terminal before-tax advantage to the client is $312,469. [10]

Advice regarding the payoff of a mortgage

Assume that a client owes $300,000 on a 30-year first mortgage with an interest rate of 4% and wishes to pay it off with $300,000 in funds in a 60% stock/40% bond account. If the advice changes the mind of the client and the mortgage is retained, the hypothetical, terminal advantage to the client is $425,51. [11]

Advice regarding choice of account type

Assume that a couple who is in a 39.6% tax bracket will retire in fifteen years and subsequently will be in a 15% tax bracket through their retirement years.[12] Each spouse plans on contributing $6,500 per year to a 60% stock/40% bond Roth IRA until retirement, and then to liquidate the holdings and withdraw the funds. If the advice given leads the couple to select a traditional IRA instead of a Roth IRA, the total after-tax advantage at retirement is $72,883.

Advice regarding Roth 401k Conversion

Assume that an ambitious 30-year-old business executive has a $45,000 401k and plans on leaving it invested in a 60% stock/40% bond mix until retirement at age 65, at which time the funds will be withdrawn. Assume that the client’s earnings will increase over the years, and that their current 15% tax bracket will increase to a 39.6% bracket and remain at that bracket through their retirement.[13] If the advice causes the client to convert their traditional 401k to the Roth 401k option, the hypothetical after-tax advantage at retirement is $103,669.[14]

Advice concerning company stock

Assume that a client in a 39.6% tax bracket is retiring and owns a $1 million 401k consisting of company stock with a basis of $200,000. If our advice causes him to pay long-term capital gains on the net unrealized appreciation and roll the basis into an IRA, [15] instead of rolling the entire 401k to an IRA, the tax savings are $156,800.[16]

Advice regarding life insurance coverage

Assume that through our insurance evaluation we determine that a 55-year-old client who pays $320 per month for a $1 million ten-year level term life insurance policy is self-insured. If our advice causes him to cancel the policy, the future value of the savings if invested into a 60% stock/40% bond portfolio for ten years is $54,482.[17]

Advice regarding a deferred annuity

Assume that a client owns a $700,000 deferred annuity invested in subaccounts weighted 60% stock/40% bond, a surrender charge of 5%, and total annual costs are 3.5%. If our advice causes the client to pay the penalty by 1035 exchanging the annuity into a fee-only annuity with the same investment mix, but total costs of 1.5%, the twenty-year future value savings is $609,795.

Advice regarding long term care insurance

Assume that a 65 year-old widow owns a long term care policy with an annual premium of $9,000 and a maximum benefit of $500,000.[18] If an analysis shows that the client is self- insured, and could afford the costs of long term care through the sale of assets, and at age 90 she is admitted into a nursing home and over the course of five years the total cost for care is $500,000, the terminal advantage to the client if the policy is cancelled is $37,588.[19]

Advice regarding equity exposure

Assume that a young and inexperienced client will contribute $25,000 per year for thirty years, is fearful of equity investing, and plans on investing strictly into guaranteed bonds.[20] If educational efforts cause the client to invest into a 60% stock/40% bond account, the terminal before-tax advantage to the client is $581,818.

Advice regarding charitable gifts

Assume that a client in a 39.6% tax bracket who owns $200,000 of stock with a basis of $40,000 gives $10,000 per year in cash to a charity for 20 years, then sells the stock. If advice causes the client to gift $10,000 per year in stock instead of the cash, the capital gains tax savings is $32,000. [21]

Advice regarding estate tax

Assume that a wealthy elderly couple resides in Washington State without credit bypass trusts and have a combined taxable estate of $12 million. If advice causes the couple to have an attorney include credit bypass trusts in their wills or draft a portability election return, the tentative estate tax savings are $2,748,576.

Advice regarding the ownership of life insurance

Assume that a wealthy Washington State widow with a $40 million estate plans to provide for her grandchildren by purchasing a $10 million Variable Universal Life policy, with herself as owner and insured, and each of her ten grandchildren as equal beneficiaries. She makes premium payments of $140,000 per year. If advice causes her to create an irrevocable life insurance trust to own the policy instead, the tentative estate tax savings is $5,200,000.[22]

Advice regarding a change in risk tolerance

Assume that a client who invests a $1 million account in a 60% stock/40% bond portfolio suffers a loss of market value of $300,000 in a severe bear market and decides to liquidate the equity investments at a loss and move into guaranteed bonds. If behavioral coaching motivates the client to stay the course, the advantage in market value by the end of five years over the average five year historical period is $152,080.[23]  

Summary

Although these savings vary widely, it is apparent that they are significant and likely to make a large difference in total wealth to many clients over a lifetime of investing. When they are added to the estimated ongoing annual advantage of 3.24% over typical advice, and when the average advisory fee of an excellent advisor is in the range of 1% per year or less, the total advantage gained through a relationship with an excellent advisor far exceeds both the amount paid and the results that are obtained through a typical advisor or as the result of self-advice.

Click Here to See the Quantifying Value Calculations

Footnotes 

[1] Investment Company Institute, trends in the expenses and fees of funds, 2020.

[2] 53 years is not a sufficient period to result in a high degree of confidence 

[3] As measured by standard deviation 

[4] Bogle on Mutual Funds, 1993 

[5] Investment Company Institute 2021 Investment Company factbook.

[6] According to Comcast Data in their report titled Mutual Fund Cash Levels, June 16, 2013. Average Mutual fund cash levels from 1968 through May of 2013 were considerably higher, with levels averaging approximately 7% in the 1970s, 9% in the 1980s, and 7% in the decade beginning in the year 2000. 

[7] In today’s low interest rate environment when cash is earning close to 0%, the actual advantage is .18% 

[8] Note that this difference between mutual fund returns and the returns of fund investors does not capture the full advantage. The aforementioned numbers reflect only the inferior returns of average investors while they are invested in the funds, due to their poor timing of deposits and withdrawals. They do not reflect the poor returns they likely receive during the periods of time when they are not invested. Since mutual fund outflows typically increase after market downturns, we can see that a common motivation for withdrawals is fear. A fearful investor is likely to redeploy the withdrawn funds into cash, bonds, or bond funds. However, some of these funds are invested into other stock funds, and we have no way of measuring what portion of the total this is. Intuition would lead us to believe that the largest portion of these funds are not reinvested into the stock market, and as a result, the average investor suffers a large opportunity cost. 

[9] Further, liquidity needs can trump tax efficiency. For example, an account that will be subject to withdrawals within a few short years may appropriately be invested into fixed income securities rather than tax efficient equity funds, regardless of the tax consequences. In certain situations, tax free municipal bonds can satisfy the need for both liquidity and tax efficiency. 

[10] Assumptions: bank account interest rate .3%; average historical after-cost 60% stock/40% bond account returns: 6.6% 

[11] Assumptions: average historical after-cost equity returns 9%, after-cost bond returns 3%. 

[12] All traditional IRA contributions are assumed to be deducted in the 33% tax bracket; all traditional IRA withdrawals are assumed to be taxed in the 15% bracket. No accounting is made for the time value of money after the retirement date. 

[13] The entire conversion is assumed to be taxed in the 15% tax bracket and is assumed to come from the IRA funds. If the tax were paid from a non- qualified account, the advantage would be greater.

[14] This does not include the added benefit of additional contributions to the Roth 401k in brackets below 40%.

[15] NUA technique, reference Putnam Understanding the NUA rule, and Robert Keebler. The basis in company stock is assumed to be rolled into a traditional IRA within 60 days, and the shares attributable to net unrealized appreciation are assumed to be taken “in kind”, deposited into a taxable account, and sold immediately. 

[16] The new IRA need not be liquidated; as in all IRAs, tax is assessed only upon withdrawals. Nor do the NUA shares need to be liquidated; gains on any shares sold within one year will be assessed tax at the short-term capital gains rate to the extent the gains occurred after the 401k distribution. All gain on shares liquidated immediately or held for more than one year will be treated as long term capital gain. 

[17] If premature death were to occur during the term, the life insurance death benefit would cause a large advantage to the beneficiaries. However, if the insurance is not needed, the death benefit would not accomplish any financial goals, whereas if the insurance is cancelled the funds that otherwise were lost to premiums can be invested and used to accomplish important goals such as achieving a comfortable retirement. Also consider that for insurance companies to be profitable, on average; premiums paid for insurance must exceed benefits. 

[18] No COLA; assuming premiums are invested into a 60% stock/40% bond account 

[19] If the assumed growth rate in the terminal value of the account is accounted for during the five years of long-term care, the advantage is larger. Also, if no long-term care need arises, the advantage is $537,588. On the other hand, if a long-term care need arises in the early years, the insurance carries a sizeable advantage.

[20] Assuming a 3% rate of interest, all interest reinvested 

[21] Assuming no further appreciation in stock price. 

[22] Assuming that gifts under the annual exclusion are made for each beneficiary each year with Crummey Powers. 

[23] Every five-year period is different, but this is the average, historical result