Vanguard Research recently published a paper on how to assess the value of financial advice. They mention that the global demand for high-quality, cost-effective financial advice is growing. In many countries, increasing reliance on defined contribution systems means more households will be retiring with substantial savings and will need affordable and effective help in managing them. More broadly, the financial services industry faces rising demand to improve client outcomes and value for money. How should investors measure the value of financial advisory services provided?

Vanguard suggests a three-dimensional approach. Investors should evaluate the adviser’s services in three areas.

Portfolio value. The first dimension concerns the portfolio designed for the investor. Value comes from building a well-diversified portfolio that generates better after-tax risk-adjusted returns net of all fees, suitably matched to the client’s risk tolerance. Portfolio value can be quantified in many ways, including different measures of portfolio risk-adjusted return, diversification and allocation metrics (such as active/passive share), the impact of taxes, and portfolio fees.

Financial value. The second dimension assesses an investor’s ability to achieve the desired goal. A portfolio does not stand on its own. It is in service to one or more financial goals, such as retirement, growth of wealth, bequests, education funding, and liquidity reserves. One way to evaluate success is to estimate the probability of achieving a financial goal or wealth target at the end of a specified period. Ultimately, an advisor should seek to improve an investor’s chance of achieving his or her desired future spending goal. To do this, the advisor must consider a myriad of planning-related metrics that extend beyond portfolio outcomes. These include financial behaviours such as optimal savings and spending; the assumption of debt; budgeting; insurance and risk management; various elements of tax-efficient retirement planning; and legacy, bequest, and estate planning.

Emotional value. The third dimension is an emotional one: financial well-being or peace of mind. The value of advice cannot be assessed by purely quantitative measures. It also has a subjective or qualitative aspect based on the client’s emotional relationship with the advisor. Underlying elements include trust in advisor, the investor’s own sense of confidence, the investor’s perception of success or accomplishment in financial affairs, and the nature of behavioural coaching such as hand-holding in periods of market volatility.

I believe that most of the times investors are overly focused on returns and cost of service (portfolio value) and overlook the other two (financial and emotional value) until it is too late.  

John Huber writes about the risk of outsourcing thinking in an update on his blog. There is a famous sociological experiment from the 1950s where 75% of the participants denied completely obvious facts that were right in front of their eyes simply because they were told that the rest of their peers chose a different (incorrect) answer. There are many reasons why many financial frauds occur, but Huber thinks one of the main reasons the frauds became so big and lasted so long is that investors primarily relied on the opinions of others. The fact that so many other smart people had already given the company their stamp of approval led to massive outsourcing of original thought. No real due diligence was performed by this investor group. If they had, they would have likely discovered numerous warning signs.

Huber gives one example each of independent thinking and outsourced thinking. During the last financial crisis in September 2008, Ken Lewis (CEO of Bank of America) hired two different banks to provide him with a fairness opinion so that he could buy Merrill Lynch. Lewis badly wanted to buy Merrill. The banks he hired to value Merrill knew this. And those two banks dutifully performed their job, giving Lewis the value he needed to justify the acquisition. So, on the Sunday of the epic “Lehman weekend”, Bank of America decided to pay $50 billion for a company whose equity would have most likely been worthless just two or three days later.

Earlier in the summer, Warren Buffett got a call from Dick Fuld (CEO of Lehman Brothers) late on a Friday evening. Fuld wanted Buffett to invest fresh capital into Lehman. This was before the crisis was in full force, but Lehman was starting to haemorrhage cash and was clearly struggling to survive. Buffett told Fuld he would think about it over the weekend. That same night, Buffett pulled out Lehman’s annual report required by the U.S. Securities and Exchange Commission (SEC) that gives a comprehensive summary of a company’s financial performance and began reading it, making notes in the margin. After a couple of hours, he put the filing down and called Fuld back and told him he wasn’t interested. There was simply too much about Lehman’s books that he didn’t understand and couldn’t figure out, and so he found it too risky and quickly decided to pass. He came to this conclusion on his own after reading a document that was publicly available.

Buffett didn’t make calls to Berkshire CEO’s in the finance industry, he sent no analysts to talk to bankers on Wall Street, and he certainly didn’t read any third party research. He simply pulled up a filing that any one of us could have accessed, and decided to see if the company was worth investing in. One guy outsourced his thinking, and one guy did the thinking for himself.

Huber’s observation is that independent thought is extremely rare, which makes it very valuable. On the other hand, outsourced thinking appears to be pervasive in the investment community, and because of how we’re wired, this dynamic is unlikely to change. Regardless of how convincing the facts are, we are just more comfortable if we can mould our opinion around the opinion of others. Understanding this reality and being aware of our own human tendencies is probably a necessary condition for investment success in the long run.