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Updated: February 6, 2021
Many people assume that if they are not financial wizards, they should use a financial advisor. Another common assumption (especially among high income earners with little time) is that a financial advisor could manage their money more quickly or effectively than they can.
I believe, for most people, using a financial advisor is not only unnecessary, but even detrimental to their financial future. Here’s why, and what you should do instead.
Note: I used a lot of information from “A Random Walk Down Wall Street” to write this article. If you’re interested in more in-depth data and information, I highly recommend reading that book.
Financial Advisors Don’t Outperform the Overall Stock Market
Data shows that professionally-managed mutual funds do not outperform the market (outperforming the market means your investments provide a higher return than the market as a whole). The average mutual fund from 1993-2013 returned 8.36%, while the S&P 500 as a whole returned 9.22%.
Even if an actively-managed mutual fund does well one year, data shows they are unlikely to do well consistently year after year. At that point, managers of mutual funds merge the poorly performing funds with new ones with better performance to make their record appear better.
The authors of “A Random Walk Down Wall Street” asked 19 Wall Street firms for their earnings estimates for some S&P 500 companies, and then compared them to actual results in future years. Not surprisingly, their “informed” answers did not do better than simple extrapolation of past trends. And any analyst who made better predictions for one year did not make superior forecasts in the next year.
Keep in mind many financial advisors do not have your best interest at heart. Many financial advisors make a commission if they sell you certain products. These products are not necessarily the best for you. They likely come with high fees that will eat away at any returns.
So on top of the fact that financial advisors charge you for their time, you’ll also pay higher fees for the actively-managed funds that they sell you. Why would you pay for someone who doesn’t beat the market?
You Can’t Time the Market
Some advisors claim they can time the market—they invest when the market is down, and sell when it’s high. But that’s almost impossible, since no one can predict the future.
Here is some data from “A Random Walk Down Wall Street” to support that:
“95 percent of the significant market gains over a thirty-year period came on 90 of the roughly 7,500 trading days. If you happened to miss those 90 days, just over 1 percent of the total, the generous long-run stock-market returns of the period would have been wiped out.”
“A buy-and-hold investor would have seen one dollar invested in the Dow Jones Industrial Average in 1900 grow to $290 by the start of 2013. Had that investor missed the best five days each year, however, that dollar investment would have been worth less than a penny in 2013.”
That’s why you should invest your money yourself, and hold it there. You should run from anyone who claims they can time the market.
Additionally, if anyone tries to time the market, that means they must buy and sell often. Those gains are taxed and the trading likely comes with fees. Even if someone could make a small profit timing the market, it would likely be outweighed by the taxes and fees.
Why You Shouldn’t Pick Stocks Yourself
While I believe most people should not use a financial advisor, I also don’t recommend picking your own individual stocks. Many people like to pick stocks because they think it’s fun or they think they can outperform the market. However, most people really don’t do the in-depth analysis required to pick stocks in an informed manner. Usually, people pick businesses they like or guess which businesses may do well in the future.
To make informed decisions about investing in a particular company, investors should analyze the business’s expected growth rate and length of growth rate, the expected dividend payout, the degree of risk, and market interest rates. Does that sound boring, or even impossible? I would argue that if you’re not willing to do that degree of research, you’re better off using a passive investment strategy (I’ll get into index funds more below).
Even if you were willing and able to do research on the above factors, they come with some warnings. No one can predict the future, so that makes predictions about growth rate little more than gambling. You could also justify any stock price by changing your assumption about expected growth rate and growth timeline. Finally, there is no objective answer about exactly how much more you should pay for higher growth, more dividend payout, or less risk.
Alternatively, instead of doing the research themselves, some people make investment decisions based on other people’s analyses. But again, no one can predict the future. If someone was sharing knowledge about a stock that was undervalued, enough people have probably already acted on that information to drive the value of the stock down. Stated another way, stock prices adjust so quickly when information comes out, that no one can buy or sell fast enough to benefit (the efficient market hypothesis).
So if you shouldn’t use a financial advisor, and shouldn’t pick stocks, what do you do?
Because professionally-managed funds do not do better than the market, you are best off investing in a broad stock market index that represents the market as a whole (and will give you the same returns). For example, you can invest in an S&P 500 index fund that will give you the same returns as the S&P 500 market as a whole.
Index funds have extremely low fees since they are not actively managed. Additionally, you can invest in them simply by purchasing them through an online broker such as Vanguard or Charles Schwab. No need to pay a financial advisor, and a few minutes a month is all it requires!
A Winning Strategy
I’m convinced most people don’t need a financial advisor—in fact, I think they’re better off without one. But I understand it can be daunting to handle your investments all by yourself. In this section, I’m going to list out the exact steps you can take to create a winning money strategy. Following these steps will work for anyone—but of course, you can tweak and optimize it for your specific situation.
1. Save money each month
To invest money, you first must have money available. The only way to do this is to spend less than you earn. The most effective way to do this is to track your spending and make a budget (download my free budget spreadsheet here). Once you’re saving at least 10-20% of your income consistently, move on to the next step.
2. Build an emergency fund and hold in a high yield savings account
Once you’re saving money, start building your emergency fund. You should always have an emergency fund with easily-accessible cash. You should have this before you save for anything, invest in anything, or even pay off debts. An emergency fund is to be used only for emergencies, such as losing your job, or for a large unexpected bill. This is what keeps you from going into debt when these unexpected expenses arise.
3. Pay off debt and invest your tax-advantaged retirement accounts in index funds
I included these two items in the same step because whether you pay off debt or invest first depends on your debt interest rates, employer matches, and your personal preference. In general, you’ll want to first invest the minimum to receive your employer 401(k) match, because that’s free money. Then pay off any high-interest debt (such as credit cards, personal loans, or auto loans). Then continue to put any additional money into your 401(k), Roth IRA, and HSA.
4. Invest your tax-advantaged accounts in index funds
I break this out as a separate step, because it’s important to understand that index-fund investing is something you can do within your retirement accounts. First you contribute cash to your 401(k), Roth IRA, or HSA. Then you purchase index funds using that money. Don’t forget this step! You don’t want to leave cash in your accounts without investing it, because then it will not grow.
5. Diversify as desired
You’re somewhat diversified by virtue of investing in index funds, because you’re investing across many companies. However, index funds are still 100% invested in the stock market. You can consider some other investing options, like real estate investing, starting your own business, or buying an existing business. It really depends on what you’re interested in.
If you would like your investments to remain as simple and passive as possible, you can consider paying off low-interest debt (like your mortgage), or using passive investment platforms such as Fundrise.
Because of all the factors above, I believe most people should skip the financial advisor, and concentrate their efforts on saving money and investing it in index funds. Do you agree? Let me know in the comments below.