Seeing The Forest For The Trees

July 01, 2002

The Champion Coin Flipper During the summer of 1994 at a conference in Phoenix, Arizona, a large group of fee-only financial advisors was listening to a speaker discuss efficient markets, three-factor analysis, and how active management is a loser's game. Someone in the audience was not drinking from the same Kool-Aid and asked how, if markets were efficient and active management doesn't work, do you explain the likes of Peter Lynch. The speaker responded:

'Let's assume we were the host of coin-flipping contest and we invited 500 of the best coin flippers in the country. We set up the tournament as a single-elimination draw where the winner of each round is the participant who is able to flip heads the most times. At the end of the tournament we would award the crown to the coin-flipping champion. Everyone in the country would learn about this amazing coin flipper. We would write books about how he could flip coins better than anyone in the country. He would be on Good Morning America as the champion coin flipper. Do you get my point?'

In a matter of a few simple sentences, the speaker reduced the capabilities of the most successful active manager to nothing more than being a random person who by chance was crowned the champion active manager. It was an illuminating analogy. From that point in 1994, my view of what value a fee-only advisor brings to a client began to evolve.

The Role Of A Good Financial Advisor
Many fee-only financial advisors make the mistake of believing that their main role is to provide clients with superior investment returns. The thought of using index funds, exchange-traded funds, or passively managed funds is foreign since they virtually guarantee that you will underperform the benchmark (albeit by a very small amount). Herein lies the problem. Many financial advisors believe that their main role is to find the star performers, when in reality following such a strategy almost inevitably leads to the underperformance of passively-managed alternatives. Open your Morningstar Principia program and you will see that over most long time periods, 80% or more of actively managed mutual funds underperform the very benchmarks that passively-managed funds are closely tracking. The majority of clients I have are happy to replicate the market's returns in a low cost, highly tax-efficient manner. While giving up the small hope of outperformance, they are also avoiding the high likelihood of underperformance.If the role of the advisor is not to put together a superstar portfolio, what is it?

  1. Know the long-term objective of the client.
  2. Determine the rate of return needed to achieve client's objective.
  3. Understand the amount of risk the client is willing to stomach.
  4. Assure that risk management needs such as insurance are met.
  5. Expose the client to specific risk dimensions that will meet the investment objective while remaining within the risk tolerance of the client.
  6. Most importantly, the advisor should provide the discipline required to stay the course, once it is set.

The role of a good financial advisor is to put together a sound investment plan (asset allocation) that meets the needs of the client and provides the optimal return for a given level of risk. The objective is to give your client the greatest likelihood of meeting their goals. The most important factor to consider is not the individual fund, ETF, stock, bond, etc., that you choose. Rather, it is the combination of these investment vehicles that matters most. The unique degree of risk that a client is willing to assume can be most appropriately satisfied by a specific combination of various asset classes that make up the portfolio.

 

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