Some people have a tendency to look at the world of investing in two very sharply contrasting ways. In one camp you’ve got the advisor-hating, DIY couch potato investors in search of the lowest costs. Opposite to that are those who believe in the value of higher-cost, actively-managed full-service advice.
But in reality, many DIY investors who intended to be passive, end up active. Similarly, there are also many advisors who embrace the couch potato strategy and focus their time providing financial planning.
What often gets overlooked by investors who ascribe to such polarizing views of financial advice is the less salient cost of making avoidable investment mistakes. This is more colloquially referred to as “behavioural drag,” which is the tendency to second-guess investment strategies and make changes to portfolios, generally, at the worst possible times. It can have a big impact on your ultimate bottom line.
To explain the impact of behavioural drag, let’s examine its costs across a few scenarios.
Let’s say our actively-managed/advised investor has a 2.5% management expense ratio (MER) cost on their $100,000 portfolio. Assuming the market grows at 6% and this investor’s portfolio matches the market return before expenses, after 25 years it will be worth $227,909.29.
Meanwhile, our DIY index investor has an MER cost of 0.25%. After 25 years, their $100,000 turns into a much larger $403,152.39. With a $175,243.10 advantage over the actively-managed/advised investor, you can see why the low-cost approach looks so appealing. At least, in theory.
Now let’s model in a behavioural drag on returns. Estimates of the annualized cost of behavioural drag vary widely, but the lowest estimates are around the 1.5% range. So, if we subtract 1.5% from the annual returns of our DIY index investor, his $403,152.39 ending value decreases to $282,312.35. This means we’ve closed the gap between the actively-managed/advised investor and the DIY index investor from just over $175,000 down to just over $54,000.
But just as today’s investors are more cognizant of costs, so to are today’s advisors. If they reduce product costs, while keeping their advice costs steady, they can really even up the playing field—assuming they eliminate your behavioural drag.
Let’s say our actively-managed/advised investor sticks with his advisor but switches to passive investments, knocking his MER cost down from 2.50% to 1.25%. The passively-managed/advised investor (without a behavioural drag) now beats the DIY index investor (who has a behavioural drag) by over $31,000 after 25 years.
|Passively Managed/DIY w/ Behavioural Drag||$282,312.35|
|Passively Managed/Advised w/o Behavioural Drag||$313,382.14|
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So far in this series, we’ve discussed the cost of the various types of advisor compensation models, the two main types of advice you can pay for, and how your own behaviour can negatively impact returns. In the next and final part of this series, we’ll show you how to put all of this advice together to help you put your best investing foot forward.
Go back to:
Part 1: How to measure the value of financial advice »
Part 2: Just how are you paying your financial advisor? »
Part 3: What kind of financial advice do you actually need? »
Or proceed to:
Part 5: The right financial advisor model for you »
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