How to Calculate An Advisor’s Value: Total Wealth Asset Allocation

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How to Calculate An Advisor's Value: Total Wealth Asset AllocationAllan S. Roth wrote an article for Financial Planning magazine entitled “Calculating An Advisor’s Value.” The article claimed that five different components of intelligent planning decisions comprised the value brought by a smart financial advisor. According to Morningstar, planners can add the equivalent of 1.82% annual return to clients through these five components of what they call “gamma.”

I commented on the introduction and indexed of all five components (plus two additional items) in a previous blog post. In this post I am just going to comment on the first of the five, “Total Wealth Asset Allocation”, to which Morningstar suggests that advisors bring an additional 0.38% to their clients. Here is they describe the component:


Determining how much equity risk a client should take is a key service advisors provide to clients. Although advisors often use risk profile questionnaires to do so, these types of surveys have two critical problems.

First, the way people feel about risk is not stable, and varies with market conditions: When the market is up, clients forget the pain of past plunges, such as the meltdown of 2008 and early 2009, and feel they can accept more risk. The dynamic reverses when markets tank. Suddenly, the market has become the Titanic and clients run for the lifeboats of cash.

This behavior may explain why many studies demonstrate that investors’ dollar-weighted returns lag fund returns by about 1.5% annually. Investors chase returns like heat-seeking missiles, locking onto the hottest asset class. Don’t assume advisors are much better; research shows they chase returns, as well, although many claim they are only carrying out the wishes of their clients.

The second problem with risk profile questionnaires is they don’t measure a client’s need to take risk. The purpose of a portfolio is to support your clients’ desired lifestyle, not to have them die and become the richest people in the graveyard. Thus, for example, if your clients have already won the game and no longer need to take risk, they needn’t take it – even if they have a willingness or desire to.

I tell clients that picking an asset allocation is important, but committing to it is even more important. Princeton psychologist Daniel Kahneman won the Nobel Prize in economics for his work in behavioral finance – more specifically, on prospect theory, which asserts that losses hurt much more than gains feel good. You can apply this theory by helping clients pick a portfolio that tilts toward the conservative side of their allocation range.

For example, in working with a client, you may determine that both tolerance and need for risk dictate an allocation of 40% to 50% to equities. But with Kahneman’s research in mind, consider recommending 40% rather than the 45% midpoint. Picking the lower range will make the client feel less pain the next time stocks tank – and be more willing to stay committed to rebalancing the portfolio by buying more equities. Doing so can make their dollar-weighted returns exceed fund returns.

Perhaps the most important sentence from that section is, “I tell clients that picking an asset allocation is important, but committing to it is even more important.”

“Buy and rebalance” is a principle that is very difficult for investors to live by. And yet statistically it earns better returns on average. Rebalancing is always a contrarian movement, selling what has gone up and buying what has gone down. I’ve written over a dozen articles on rebalancing, but two are probably the best confirmations of this point:

  1. How to Maximize Long-Term Returns
  2. The Driver of Future Behavior

I was surprised that the benefit was described as only bringing 0.38% additional return. A different Morningstar study cited in Richard Ferri’s “The Power of Passive Investing” in the “Journal of Indexes” found that chasing returns lost 1.4%. And prior research by the Yale endowment attributed 1.6% of its annual portfolio returns to rebalancing. In other words, chasing returns loses 1.4% over a buy and hold strategy and rebalancing boosts returns by 1.6% of a rebalancing strategy. That is 3.0% cumulative and it is difficult to see why this suggested only a 0.38% boost.

The article even quotes, “This behavior may explain why many studies demonstrate that investors’ dollar-weighted returns lag fund returns by about 1.5% annually.”

Finally the article suggest that in order to help clients maintain their asset allocation, advisor pick a more conservative asset allocation than they might otherwise. This doesn’t seem like the best advice an advisor can give a client. Many advisors already suggest more conservative asset allocations than optimal. They may be they do this simply to keep clients who psychologically won’t fire them when the markets are up and won’t fire them in down markets so long as they are not down as much as other advisors. We take a different approach and try to educate clients on the optimum age appropriate asset allocation based on their withdrawal rates. We try to help them overcome the natural behavioral finance mistakes that we humans are prone to make and instead aim for a more optimal asset allocation.

For example, studies suggest that the optimum asset allocation at age 65 is approximately 75% equities and 25% fixed income. Yet many advisors suggest 60%-40% or even 50%-50%. Having an appropriate asset allocation should boost returns over the long term. If stocks average 6.5% over inflation and bonds average 3.0% over inflation, a 75% stock and 25% bond portfolio would average 5.625% while a 50%-50% portfolio would only average 4.75%.

That means just having the optimum asset allocation at age 65 might boost returns by 0.875% annually.

Finally, we agree with the problems associated with risk tolerance questionnaires. Two clients in the same financial situation should most likely have a similar asset allocation. If one is a gambler and one is terrified of the markets, their emotions should not necessarily dictate their asset allocation. Financial education from a smart advisor should help them overcome their ignorance and emotions. Only if a client has a great deal more money than they need for all their goals and desires does the asset allocation truly not matter.

Here is an index to the entire “How to Calculate An Advisor’s Value” series.

And here is a link to having us help you with your comprehensive wealth management.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.