Wall Street Self-defense

The Wall Street Self-Defense Manual, Part 4

What financial advisers are good for … and what they probably aren’t.

Read Part 1 of the Wall Street Self-Defense Manual here, Part 2 here, and Part 3 here. Read Henry Blodget’s detailed disclosure statement here.

I have now written three articles about financial advisers without once mentioning what many people assume is their raison d’etre: stock-picking. When I was covering the Martha Stewart trial, I heard “experts” bellow about Peter Bacanovic’s apparent failures in this arena: “Terrible broker. Couldn’t pick a stock to save his life.” Actually, Bacanovic generally appeared to have been an excellent broker (with the striking exception of putting his client in a position to be convicted of four felonies), and he was even right about ImClone. The point, however, is that the last reason you should hire a financial adviser is to learn which stocks to buy or sell.

In the bull market of the late ‘90s, the stock-picking mantra for the casual investor was, “Do it yourself!” In 2001, after the crash, it became, “Hire someone to help.” Unless you just enjoy the stock-picking game—a common and perfectly acceptable reason to play—the permanent mantra should be, “Don’t do it at all.” As numerous studies have shown, the vast majority of professional investors can’t beat the market. This is not because the professionals are lazy or incompetent. It is because beating the market over a sustained period is extraordinarily difficult. As hard as it is for professional investors, moreover, financial advisers (and, thereby, you) face even longer odds.

Financial advisers have dozens of things to worry about before they can help you pick stocks: recruiting new clients, coaxing new money out of old clients, schmoozing, hand-holding, keeping up-to-date on the torrent of financial-industry products and deals, monitoring positions, executing trades, moving money, processing paperwork, soothing bosses, training assistants, attending “compliance” seminars. If not for technology, most advisers would barely have time to follow the market, let alone analyze stocks. At a big firm, an adviser’s views on a stock may be improved by the work of research analysts, but even this often isn’t enough (and not because of “conflicts of interest”). Big brokerage firms have hundreds of analysts covering thousands of securities in dozens of markets, so, at any given time, they will have several hundred stocks or bonds rated “buy.” Even then, your adviser would have to sift through hundreds of buys to find the ones appropriate for you.

And this isn’t even the real problem. The real problem is that, in any stock-picking effort, you and your adviser will be competing with thousands upon thousands of full-time professionals engaged in nothing but trying to find and exploit tiny information advantages that other full-time professionals miss. These full-time professionals are smart, nimble, experienced, well-trained, well-equipped, and deeply plugged in, so much so that they often finish exploiting valuable information before you (or CNBC) even know it exists (and, even so, most of the pros still can’t beat the market!). To beat the market, you have to capitalize on other investors’ mistakes, and, in this effort, no matter how alert and dedicated your adviser is, the two of you will be at a major disadvantage.

Importantly, the advantage of professional investors is not (usually) the result of lax regulation or corruption. It is the result of a hyper-competitive industry staffed by career professionals trying as hard as they legally can to win. Weekend warriors rarely imagine that they could hop on a bike and win the Tour de France. For a variety of reasons, however, many casual investors imagine that, with a modicum of effort, they can ride wheel-to-wheel with the Lance Armstrongs of investing (a delusion, it must be said, that is actively encouraged by much of the financial press).

Odds are only a handful of financial advisers can beat the market over the long haul. Unfortunately, the time it will take you to determine whether your adviser is a member of this elite group will probably render the effort irrelevant. The proof will not be that the adviser often picks stocks that go up: Stocks can only go two ways—up or down—and lots of people seem smart when they have 50/50 odds. The proof will be to compare the performance of the adviser’s picks with the performance of an appropriate market benchmark over a decade or more (the time it takes to eliminate the possibility of the performance being luck). And long before then, of course, if the adviser really is a proto-Buffett, he or she will probably have decamped for a hedge fund.

So what are financial advisers good for? The best ones, in my opinion, will do less, not more. They will be decent, trustworthy people you feel comfortable with. They will help you allocate your assets appropriately and keep your costs low—a strategy that will usually generate less compensation for the advisers but higher returns for you. They will warn you not to expect to beat the market (and explain why) and encourage you not to trade actively or change your strategy every year (unless, again, your primary goal is to have fun playing the game). They may offer expertise on estate planning, insurance, mortgages, or banking services. They may buy you dinner occasionally, or get you U.S. Open tickets. (This used to be my adviser’s specialty. When I was a big shot, I got passes to an air-conditioned suite with a television and cheese plates. The next year, as I was falling from grace—like a stone—I got a seat so far up that I had to watch the match on the stadium TV screen. The last two years, I have watched on the USA Network from my kitchen table.) Above all, the best advisers will dissuade you from being stupid—an invaluable service, one we can all benefit from.

This is why the advice the brokerage firm gave me was sound, even if, as I suspect, their projected returns prove too optimistic. The firm and the financial adviser listened to what I wanted (low risk, income). Then they focused on what they could control (asset allocation and costs), rather than what they couldn’t (performance). They probably set me up for disappointment—9 percent returns!—but I would also probably be better off following their advice than doing nothing.

If you are comfortable making your own asset allocation decisions, you should probably forgo an adviser and use a low-cost firm like Vanguard. If you’re uncomfortable or if you want someone to help you keep your financial house in order, then find an honest, straightforward adviser at an independent financial planning or brokerage firm. But if the adviser ever calls with a foolproof plan to beat the market, scram.

Next week: Gambling on Google.