Episode 313 - When Should You Hire a Financial Advisor?

0:03This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, and Cameron Passmore, portfolio managers at PWL Capital.

0:18Welcome to episode 313. The band is back together again. Did you guys know that 313 is my favorite number? Actually. It actually is. Ben, you might know why. I don't know. Anyway, my birthday is March 13th. There you go. Okay. So we're sitting at the phone system years ago in the office. We get to pick what your extension number is. And they said, well, we'll make you whatever it was. 102, I said, can it be 313? They said, sure, it could be 313. So, I've always been extension 313 on the phone for my birthday. So, now you know, it's my favorite number. So, we finally get to 313. You've been waiting for this for years, hey?

0:53I've been waiting six years for episode 313. Congratulations. You made it. Anyways, it's great to have the band back together. And for those on YouTube, you mark your backdrop is phenomenal oh thanks nice fender up there yeah i got my guitars up actually brought the amp downstairs still gotta plug it in i moved my office from a spare bedroom that we had into my garage we've got a one-year-old daughter and she's eventually gonna need that bedroom so my wife kicked me out of that room and i had to rebuild downstairs and through just apathy and other priorities it took me a while to get the thing set up but here we are and you want to tee up today's conversation?

1:29Sure. Yeah. We're going to cover when it makes sense to hire a financial advisor. Pretty factual based tee up. Do you have any backstory or inspiration or anything to share? No, it's kind of a derivative, I guess, of a topic we did a while ago, or I guess a few topics we've done at different points in time, but it's, I think, a different take on it. And it's kind of taking the perspective of even if you don't have an advisor right now, or even if you need an advisor right now, under what circumstances might it make sense to hire one? I do get that question a lot. People reach out and they ask that exact question, like when does it make sense?

2:03And sometimes it makes sense now and sometimes it absolutely doesn't. So I think this is going to be a very enlightening episode. Love it. Okay. With that, let's get to the episode.

2:15Okay, Ben, let's get going. When should you hire a financial advisor? So obviously, low-cost index funds, which we talk about a lot, make investing easier today than it's ever been, I think is pretty fair to say. Easier. It's phenomenal today. I'm saying this to people lately. What's available today in the marketplace is simply mind-blowing compared to the stuff we had 30 years ago. And it's super cheap. Even if you pay the same price, it's much better quality. Also makes you wonder a little bit about expected returns. If investing is that much easier and everybody's doing it, you'd expect the returns to come down a bit, but that's another topic.

2:51There is a paper on that, on how everybody indexing would affect expected returns, but anyway, separate topic, different day. So investing has gotten easy. We've said before, investing is kind of solved, at least functionally. But obviously the other important thing is that household finances go way beyond investments. We've talked about this many times before. Solving investing does not solve household finance in totality. And I think that's one of the reasons why financial advisors continue to exist despite the growing acceptance of index funds. And I mean, the other thing is a lot of financial advisors themselves for their personal stuff, but also for their clients.

3:27And I would probably say that the good financial advisors are recommending index funds as well. So that just kind of goes to show you that there's a lot of other stuff other than choosing that specific product that goes into financial advice. Index funds are not a financial plan. They're a product that helps to solve implementing one component of a financial plan. But considering other aspects of financial planning is what an advisor is ideally going to do. But then even still, I don't think everyone needs a financial advisor. I do want to specify before we keep going that I'm thinking about a financial advisor who's going to manage your investments for you.

4:04When we say financial advisor, financial advisor is a pretty loose title. It's gotten a little bit more regulated in Ontario recently, but even still, it's fairly loose. It can mean a lot of different things basically. I'm thinking about someone who is going to take your investments and manage them for you and then give you ongoing financial advice. That's distinct from when should you go and visit a fee-only financial planner to get a financial plan done for you. We're not talking about that. We're talking about when should you delegate your investment management and financial planning to a full service financial advisor.

4:33It's also distinct from what I think a lot of people expect when they seek out a financial advisor. As we've said many times, I'm sure you guys agree, whenever you tell someone what you do, which I try to avoid, the question back is always something predictive. Always. Why do you try to avoid that? Because you just don't want to get into the discussion or you think it's very difficult to convey? Because it's always about, my neighbor just asked me two days ago, what stock should I be buying these days? Yeah. He knows what I do. I've told him many times, he still like he can't help but ask great guy i'm not about to entertain that and try to explain why that doesn't exactly reflect how we advise people i'm similar like i have friends or like friends parents will go over for dinner and just get into conversations or whatever and you're like oh yeah how do i explain what i do so i just i say i'm a financial planner and i deal with personal finance often it gets into the portfolio discussion that's always the question like oh what's going on in the markets and what's hot what should we be doing it's like oh man this is this could be a really long conversation.

5:29But do you ever successfully convince them the merits of what you believe in? I won't change their behavior more than likely, but I've had conversations with like my friend's parents who were stock pickers, for example. And when we explain things like market efficiency and how markets work and risk, they find it very, very fascinating. And I've had them come back and just want to continue talking about it at subsequent dinners and hangouts. But I don't think any of them have actually changed their portfolio as a result, but they're definitely fascinated in that way. For a lot of people, it's like a totally foreign way of thinking about how markets work, right?

6:00They just think that you just buy the good companies and that's it, right? But yeah. Anyway, sorry to totally derail your thought process there, Ben, but I just thought I'd ask. Back to the program. Well, the funniest answer that I've heard somebody have for that question of what do you do is, I sell life insurance and then nobody wants to talk to you anymore. I've used that a couple of times, I confess. I'm a life insurance agent. Yeah. Less interesting than anything related to financial markets. That's no disrespect to life insurance agents at all. It's just I know people don't want to talk to life insurance agents.

6:32Yeah. Okay. Anyway, back to the topic. Financial advisors let you delegate the majority of your investing and financial decision-making and the related ongoing tasks, and they monitor your financial situation. That's a pretty broad overview, I think, of what a financial advisor does, but I think it's also a pretty good definition. Now, that combination of services can be useful for a lot of reasons, And I'll come back to those reasons in a sec with supporting academic research as usual. But first, I want to mention subjectively why people say that they hire a financial advisor. This is a very different thing.

7:05We'll get into the evidence in a sec, but I think this is interesting. The theory and evidence, actually, in this case. So Morningstar analyzed 312 individual long-form responses to the question, please list some reasons why you hired your advisor. I think they manually analyzed these. And they sorted them into various financial and emotional motivations for why you hired the advisor. The top overall motivations were to alleviate discomfort in handling financial issues and the desire to achieve a specific financial goal. And then the next most common motivation was behavioral coaching, access to behavioral coaching.

7:41Overall, in their analysis, non-financial motivations were identified more frequently than financial ones as the reason that somebody hired an advisor. So I think that suggests that purely quantitative assessments of financial advice probably miss the mark. There's a whole bunch of those out there that different fund companies, and like Morningstar has one too, trying to quantify the value of financial advice. But I think research like this really shows that it's really hard to quantify, first of all, because it's really hard to know what the counterfactual was. What would that person have done otherwise?

8:11Like what's the baseline that you assume financial advice adds value over? but in the other pieces there's this big subjective component that i think is a lot harder to quantify well and even then it varies so much by individual right like i've explained this people before like i can have two clients that are in very similar stages of life and similar financial circumstances and the value that each of them derives from the relationship will be totally different based on the individual decisions and pathways that they take right so it's those studies are out there but it's yeah i'd be very hesitant to try to quantify it even for an individual, let alone a cohort of people.

8:43Yeah. I think it also touches on fees. Fees are obviously a big topic when we're talking about this type of financial advice. It's something that's gotten a lot of attention, which I think is warranted and is a good thing. But it's also like you don't need to expect to get 1.5 % back for spending 1 % quantitatively, because a lot of the value of financial advice is going to be qualitative. I've had that conversation in the past where someone's like, okay, I'm going to pay you 1%. Show me quantitatively why it's worth it. Show me the 1.25 % I'm going to get back in whatever tax savings and so on and so forth.

9:20But I don't know if that's the right question. And I mean, this research from Morningstar suggests that it probably is not the right question. Anyway, Morningstar did another study with 620 survey responses this time, again, long form, and they did manual analysis. Responding to the question, please list some reasons why you continue to have an advisor. So instead of why did you hire your advisor, why do you continue to maintain this relationship? In this case, discomfort handling finances as a broad category with specific reasons as subcategories of peace of mind and money makes me nervous. So that was the top.

9:52Discomfort handling finances was the top overall response, followed by the quality of the advice. So they continue working with their advisor because they've gotten good advice from them and then behavioral coaching. So in this case, they didn't hire their advisor because they wanted to get behavioral coaching. they continue to work with them because they have been receiving behavioral coaching. Those subjective responses suggest, again, that if people could learn the necessary skills and increase their confidence in their financial abilities, they might not need financial advice. And that's true.

10:22I mean, people listening to this podcast will feel that because they're listening to this podcast to gain those skills. But that's kind of true of any skill. But the thing with gaining skills, again, using people listening to this podcast as an example, they're taking their time that they could be spending to learn about other stuff. To listen to this podcast, gaining any skill comes at a cost. This is where we start to get into some of the academic literature on this. That trade-off is addressed in a 2016 paper in the Journal of Financial Economics. Papers titled, Time is Money, Rational Lifecycle Inertia and the Delegation of Investment Management.

10:54They talk about how empirically there's this phenomenon called investor inertia, where investors devote only sparse attention to their personal finances. They suggest that this can be explained by the time costs required for being actively engaged in managing your personal finances. To address that inertia, to address the lack of doing stuff with your personal financial situation, people can do one of two things. They can either delegate their financial decision-making and portfolio management, or they can use their time to gain the necessary skills to do it themselves. It's super fascinating to hear it described that way.

11:31I have a couple of clients and one is a good friend of mine. He's brilliant. He's an engineer, high income earner, very capable, very highly educated. And I've always described him as financially apathetic because it was the best, I guess, term that I could come up with. He's the type of client where we go into meetings and he just tells me like, I don't care what you do. Just do it. Like, I trust you. It's all going to be okay. And to your point, it's not about capability. It's potentially about the ability. It's not about the ability to do it. It's not the trade-off, right? And the cost of their time and their interests.

11:59I mean, he could spend the time to figure it all out himself. I mean, the entire compendium of human knowledge is on the internet. Anybody can go and figure anything out these days, but he just has absolutely no interest in it. So it was really interesting in reading the notes before our conversation today to see it described that way, because it describes him perfectly. Did he do a deep dive from an engineering standpoint on how you operate, or is it a friendship-based trust? I would say with that particular client, it's friendship-based. I have another client that's somewhat similar, also very highly educated, very capable.

12:27And for them, I think it's trust-based as well. They're not an engineer. They work in a different field. They're a physician, but I think that one's trust-based as well. But yeah, we've always talked about money and he's known me for years and years and years. And so I think he just automatically said like, just take my money and figure it out and just call me when you need to kind of thing. Whereas I have an example of someone who I would say is financially apathetic, but did the deep dive, checked all the boxes, built trust, and then he's off to other things he wants to learn about. He doesn't want to relearn and redo.

12:56It's too monotonous to continue to do what we do for people. Yep. Interesting. One of the things about all of this is that it's an ongoing process. And this paper addresses this too. They talk about how this isn't something you just learn once because your situation changes. Tax laws change, as we've just seen recently. Financial products change, new products get created. So there's always things that you need to be learning about in order to do this stuff well. So they model that in their paper, that there's this cost to acquiring this knowledge. And the trade-offs, I think in their model, they're trading off against, I think it's leisure time and job-specific human capital.

13:36So like you mentioned, a couple of people with specialized professions, Mark, depending on what they do and what their career stage is, the opportunity cost of time is going to be different for each person. And that's what this paper is kind of trying to model. So they build and solve a realistically calibrated lifecycle model where the time cost required to manage one's portfolio is traded off with the opportunity to accumulate job-specific knowledge and to enjoy leisure time. That's cool. Investors in the model. Yeah, it is cool. They also have the option to delegate their portfolio management for a fee.

14:06The attractiveness of delegation varies over the lifecycle. in related research by, it's either the same coauthors or a large overlapping group. But in another paper where they kind of referenced this previous paper, I was just talking about a lot sort of similar research, but looking at some slightly different stuff. They show that consumers are always better off in their model when given access to a financial advisor when they can delegate, but the gains to delegation decline with age. So specifically they find that workers can expect a 1.07 % improvement in lifetime welfare when they have an opportunity to delegate, accounting for fees, this includes the cost of fees, to delegate their financial decisions to an advisor from the start of their working lives at age 20.

14:48They do find the biggest welfare gains come if you can delegate as soon as you start working, which can be problematic because people at that stage don't have money to invest, which it makes it hard to start a relationship with an advisor in many cases, but anyway, that's a separate issue. Then on the other hand, in their model, they find that when the delegation option is introduced just prior to retirement, so at age 60, so they say you can't delegate until age 60, the lifetime welfare gain is much smaller. It's only 0.02%. They conclude that it's better for investors to have an early opportunity to hire financial advisors since access to financial management early in life can produce important improvements in lifetime wealth and well-being.

15:32It's very fascinating to me that the gains were so muted later on. In this model, the opportunity cost of time with respect to how it contributes to the value of your human capital is really what's driving the trade-off here. And when someone's retired, that trade-off basically goes away because when you stop working, your future income goes to zero. So there's no more notion of increasing your human capital. Different value trade-off. Yeah. I've got other research on why financial advice starts to matter more for different reasons post-retirement. But does that number still count the leisure trade-off and the job-specific skill training trade-off?

16:10Because I mean, obviously, you'd think that the leisure component of it would go parabolic at that point. I think it does. The number I just talked about was lifetime welfare. So it does include the leisure measure. But again, in retirement, you don't have other stuff to do either. Your time is less limited, right? Yeah, that's true. I think that trade-off is less painful probably. So the other thing that's worth mentioning is that delegation's ability to improve wealth and well-being, this is my own interpretation, I guess, or addition. This is not based on the paper we just mentioned. It's just kind of logical.

16:44That relationship, delegation's ability to improve wealth and well-being is going to be increasingly relevant with increasing complexity. Like a single person saving just enough to max out their TFSA and investing in a Vanguard asset allocation ETF, they don't have that much learning to do in order to manage their finances. Although they could have other stuff like their insurance and legal planning and things like that, that would maybe take a little bit more learning. But anyway, just for the spirit of the example, simple situation, less learning to do. Then if you take someone with a family, with multiple kids, maybe they've got a taxable investment account, maybe they've got a family trust or a corporation, all of a sudden the learning curve is like, that becomes something that not even a single competent professional would know everything about.

17:26Like you might have a team of a tax professional, a legal professional, and a financial professional all giving you advice in those more complex situations. So to think that you can level yourself up without giving up significant opportunity costs of time, I think that trade-off becomes pretty obvious with that increasing complexity. On that note, I think in some cases that complexity is subjective too, right? Like I've got clients that I was just talking with yesterday. And from my perspective, it's not a very complex situation. It's two young individuals, no kids, both have pensions at their job, but they're seeing the complexity ramp up for them.

17:57But maybe it's because of this trade-off in time and leisure, right? So they've got a rental property, for example, and they're just starting to get a little bit overwhelmed with their own finances. So I don't think that you can draw a line in the sand as to where things are complex because it's probably a reflection of those individuals' financial literacy as well. Yep, that's fair. There was one paper that I found in the Journal of Retirement that looks at this, looks at what is the effect of financial advice on household outcomes. So this 2020 paper in the Journal of Retirement, they use a survey of more than 4 ,000 working households to assess the impact of financial advice.

18:30And they find that households using financial advisors on average have higher incomes or wealthier, married, more highly educated, more confident in their retirement planning, and more disciplined in their financial process. Now, all of that, there could be some significant selection bias in there where those people are more attractive to financial advisors. What the authors of this paper do is use regression and nearest neighbor matching methods to control for confounding variables. They find even still with that, with the control for confounding variables, they find an approximately 15 % point increase in the retirement income replacement score resulting from the use of a financial advisor.

19:07In that case, they seem to be confirming what the other more theoretical paper talked about where there can be these overall welfare gains from delegation. Then a separate study looks at the effect of professional financial advice on subjective well-being. Those are the two things we mentioned earlier in the theoretical paper on what is the value of delegation. Well, you could have increased wealth through increased labor income, and you could have increased well-being through more leisure time. In this paper, the authors find that people who receive professional financial advice tend to have higher subjective well-being and that the association is stronger for households that experienced an increase in income, individuals who do not consider themselves financially knowledgeable, and that speaks to your point, Mark, where different people will get different benefits, and individuals that have a weaker internal locus of control and the lower degree of conscientiousness.

19:57Locus of control, I'm going to come back to in a bit. Some other really interesting research on that. Retired investors, we kind of talked about this already, they might gain less from delegation because their human capital is no longer a significant asset. But the other relevant issue that I think starts to become really important in retirement is the potential for cognitive decline. There's a relatively recent paper out on this that found that older people tend to underestimate their own cognitive decline and that those who have experienced a severe cognitive decline but are unaware of it are more likely to suffer wealth losses compared to those who are aware or did not experience a severe decline.

20:32So the study is looking at data from the Health and Retirement Study, which is a representative panel of US population aged 50 plus. And they're studying the relationships between self ratings of memory changes, assessed changes in memory performance, and wealth changes across waves of the survey. So the results of their paper suggest a causal role of unawareness of cognitive decline for wealth losses. And wealth losses among unaware respondents mainly reflect a decrease in the value of their risky assets, like their financial market investments. They also find that wealth losses are concentrated in the highest wealth quartiles, which is an interesting point.

21:10So they interpret their own findings as being the effects of overconfidence, where people who have experienced cognitive decline but do not realize it end up making poor financial decisions largely with their investments. Now, they do talk about hiring a financial advisor in this paper, and they point out that delegation itself is not necessarily the solution. You alluded to this earlier, Cameron, with the idea of doing a deep dive on the person before hiring them. Delegation itself is not necessarily a solution because it requires non-trivial cognitive skills itself to make sure that you're delegating to the right person.

21:41Then we also have conflicts of interest, which make that whole issue even more challenging. So it's the timing of when you make the choice of advisor could impact your outcome. Yeah. They're saying that if we're saying that cognitive impairment is a problem and we want to solve it with financial advice, it's not necessarily a solution because you need cognitive ability to choose a good financial advisor. So if you made the choice before the decline, obviously you'd be better off than making it during because during you might choose an inappropriate type of advisor. Yes. That is so interesting.

22:14Not surprising, I guess, but it's fascinating. we've got the trusted contact person now in the industry this doesn't solve the problem because your point you have to actually hire the advisor prior to some kind of cognitive decline but i think the industry has made strides in this area we've got i think it's mandated now that advisors in canada have to make a reasonable effort to add a trusted contact person to somebody's file and the trusted contact person isn't like a power of attorney they can't actually act on behalf of the individual, but they can be contacted by advisors in limited circumstances.