Boosting your 'return on relationship'

Malcolm Forbes liked to say, "Advice is more fun to give than to receive." But the right advice in the right framework can be invaluable, including advice that prevents clients from engaging in harmful behaviors.

The triennial Vanguard Advisor Alpha study, which goes back to 2001, finds that a skilled advisor who follows a behavioral finance approach can add about 3% annually to clients' net returns — that's the advisor's "alpha" in Wall Street parlance. But Michael DiJoseph, senior strategist at Vanguard Investment Advisory Research Center, told me on my podcast recently that advisor alpha is based on more than outperforming an unmanaged benchmark like the S&P 500 index. Here are four of the most important ways:

1. Limiting leakage: Advisors add alpha by closing the gap between gross and net returns — i.e., the "leakage" due to investment costs, specifically costs that are higher than they could be compared to similar products on the market. DiJoseph said leakage can also be attributed to taxes and timing.

2. Asset location: We hear all the time about asset allocation — how much is allocated to stocks vs. bonds, and active vs. passive. But most people aren't thinking about where they actually put those assets. For instance, what are the implications of having a tax-advantaged account versus a taxable account? Let's say a client has a $1 million portfolio and $500,000 of it is in tax-advantaged investments, that means they have $500,000 left in "shelf space" for taxable investments, DiJoseph noted.

If you want to use taxable bonds for your client, you're probably going to put those bonds in the tax-advantaged account. But suppose your client has more than 50% of their assets in bonds? Where are you going to put that money? According to DiJoseph, you may start thinking about municipal bonds or using active management, but you don't have "shelf space" for those investments. Maybe you're thinking about direct indexing or separately managed accounts (SMAs) to help with some of the tax inefficiencies. "Huge amounts of value can be added here," said DiJoseph. 

3. Tax efficient drawdown: Let's say a retired client's main goal is to draw down their assets efficiently. Assume they have saved money their entire career in a retirement account. Now that they've finally left the workforce, conventional wisdom says they should start spending from their retirement account. But skilled advisors can be more strategic about spending order. Doing so can contribute 110 basis points in value according to Vanguard research, especially if they are over a certain age. They must take RMDs and they're already paying taxes on that money. If they reinvest that money, they'll have to pay taxes again, said DiJoseph. Instead, he suggests they should spend it since it has already been taxed. If clients have cash flows coming out of their portfolios in the form of interest payments and dividends from funds, stocks and bonds, they are already being taxed, so spend them, advised DiJoseph.

4. Behavioral finance vs. behavioral coaching: We hear so much about behavioral finance, but DiJoseph likes to draw a distinction between behavioral finance — which studies how people make decisions (often poor ones) — and behavioral coaching, which is when advisors serve as coaches and accountability partners to help clients avoid bad financial behaviors. By really leaning into the emotional elements of money decisions, behavioral coaches can help clients through difficult moments in their lives, "whether it's a personal matter or a broad market downturn," observed DiJoseph. Vanguard research shows that a skilled advisor who can tap into the emotional aspects of a client relationship can add up to 200 basis points in alpha — even more during extreme market periods.

Morningstar's annual Mind the Gap report aligns with Vanguard's findings. For instance, Morningstar found that individual investors earned about 9.3% per year in mutual funds and exchange-traded funds over the 10 years ended Dec. 31, 2021. This was about 1.7 percentage points less than the total returns the funds actually generated over that span. This gap stems from poorly timed purchases and sales of fund shares. These factors cost investors nearly one sixth the return they would have earned if they had simply bought and held, according to Morningstar.

Vanguard's research over longer time periods finds a similar gap of up to 200 basis points. According to DiJoseph, that's due to poor timing, locking in losses or simply straying from their investment plan during stressful times in the market. "In a volatile year, you may see a behavior gap that almost doubles relative to longer time horizons," noted DiJoseph. In years like 2020, a terrible year for both stocks and bonds, even a balanced 60/40 investor might have been down by 20%. "Those are moments when a client might be feeling the emotional impetus to make a major change and lock in those losses," said DiJoseph. "It's certainly worth a lot more than 200 basis points, if you can guide them back to staying the course."

My friend Doug Lennick, CEO and co-founder of think2perform, wrote a book, "Financial Intelligence: How to Make Smart, Values-Based Decisions with Your Money and Your Life," in which he argued that our brains are hard-wired to make poor financial and life decisions, especially under duress, such as when the stock market crashes. Lennick argues that you can break the cycle of poor decision-making by reflecting on your core values and your circumstances (while accounting for your inherent biases). That way you can reframe the situation into a more realistic interpretation of what is happening and what lies ahead.

Trust

Several years ago, Vanguard did a study of roughly 5,000 individual investors who were working with financial advisors. Researchers wanted to learn everything they could about how people interact with financial advice, why they hire and fire their advisors, and what they value most from their advisor. According to investors, emotional trust was the single most important attribute an advisor can have — i.e., active listening, asking good questions, treating clients like people, etc. Emotional trust ranked far ahead of even ethical trust (acting in clients' best interests) and functional trust (the advisor's ability to do the nuts and bolts of their job).

So, when you provide clients with advice — whether it's coaching them through a market downturn, or dealing with a difficult personal circumstance — getting them to stay the course and avoid costly moves in and out of the market is worth at least 300 basis points, according to Vanguard research. For instance, if an investor was out of the market for only the 10 best single days since 1988, their return would be 2.4% lower per year than if they had stayed fully invested (8.0% vs. 10.4%). If that investor was out of the market for the 20 best single days since 1988, their annual returns would be 4.0% lower than if they had stayed fully invested (6.4% vs. 10.4%). 

Return on relationship

That is why I trademarked the term Advis-ROR. It's about having a greater return on relationship, which I discuss in detail in my forthcoming book "Holistic Guide to Wealth Management: The Science Behind Integrating Services with the Human Side of Behavioral Financial Advice." 

Being an advisor is a privilege. People trust us to share intimate details about their finances which leads to intimate details about their life — their family, their children, their hopes and their fears. Sure, some aspects of advice can be automated, such as rebalancing the portfolio, but many of the things that are highly valued by successful families and business owners cannot, such as charitable giving, tax, estate planning and trust services. To advise successfully in these areas, advisors must be attuned to the emotional factors at play, since no two clients have the same relationship with money.

The most trusted advisors are the ones for whom clients know we're all in this together. The numbers bear this out and the return on relationship brings it home.