All three of time, interest or passion, and knowledge are required to be successful at anything.  I might have the knowledge of how to mow my grass properly and I might enjoy mowing my grass but if I don’t have the time to mow my grass, then my lawn eventually becomes a mess.  Alternatively, I may have the time and the knowledge, but if I don’t have the desire to go mow my grass, my lawn soon becomes an eyesore.  And speaking from experience, if I don’t know how high to set the blades for different kinds of grass or the different times of year, I’m back in the same predicament of the lawn becoming a mess. 

Missing any one of these ingredients tends to yield undesirable outcomes and missing two or three tends to be a disaster.  This is the very reason why people should hire professional help – whether for finances, legal help, or painting a house.  I often tell prospective clients that if you feel that you have all three of the pieces – investment and financial planning expertise, adequate time to manage your finances, and the desire to manage your investments and personal finances, then you need not pay a financial planner to provide such support.  But if you’re missing at least one of them, a good financial planner will be well worth the cost.

Let’s now assume that you do not have all three of time, interest, and financial expertise so that you hire a financial advisor to assist.  What a shame it would be if your financial advisor lacked one or more of these pieces.  While there may not be a clear way to define what makes the best financial planner just as there is no clear definition of the best mortgage broker or the best heart surgeon, there are certain actions or inactions that loudly speak to a financial advisor’s level of apathy, ignorance, or negligence.  That is, there are several clear signals to assess whether an advisor has the time, interest, and knowledge to do his or her job well. 

What are those signals?  Enter the OIL test – the Overcommitted / Ignorant / Laziness test.  The OIL test provides a helpful way to help determine if your financial advisor is:

  • Overcommitted personally or professionally such that there is not enough time to tend to value additive activities for his or her clients;
  • Ignorant or uninformed when it comes to matters like investment-related tax law; or  
  • Lazy to the point that he or she understands that actions may be useful and valuable for clients but simply lacks the desire to do them.

In fairness, it can be difficult to isolate which of these factors is the cause of harmful action or inaction but that is not the point.  The point is whether an advisor is underserving because he or she meets any one of overcommitted, ignorant, or apathetic.  As such, the following OIL test is simply scoring on the combination of these three items rather than seeking to disintermediate them.

Test 1: Your advisor elects automatic reinvestment of dividends.

An individual investor who chooses to automatically reinvest dividends for mutual funds and exchange traded funds is just being practical.  There are time and effort limitations for most individual investors so that the automatic reinvestment is just a practical reality.  However, for advisors who are getting paid to actually assist time-constrained investors with this very sort of thing, the automatic reinvestment of dividends demonstrates apathy or laziness. 

Imagine that your portfolio allocation is significantly overweight in what your advisor deems to be the most expensive segment of the investment markets – US stocks.  However, this same advisor has been understandably hesitant to sell the US stock fund in your portfolio because of a large unrealized gain that would be taxable if realized.  Now assume that this US stock fund pays a dividend.  Probably the worst capital allocation decision possible would be to have the dividend reinvested in the same overallocated US stock fund.  Yet this is precisely what automatic dividend reinvestment does.  It buys more of the position you least want to add.  Quoting from a prior blog post:

Want to determine if your advisor is apathetic to the management of your investments?  Don’t look to see how often he/she trades – look to see whether dividends are automatically reinvested or whether the advisor is deliberate and thoughtful about how the dividends are used or reinvested.

Test 2: Your advisor fails to consistently tax loss harvest.

As a quick primer, tax loss harvesting is the practice of selling positions that have declined in value since purchase and then immediately replacing them with similar, but not identical, positions to take advantage of the realized loss for tax purposes.  The tax code creates a tax saving opportunity here because of the way gains and losses are only taxed upon recognition.  Academic literature estimates that the educated employment of tax loss harvesting can add 0.5% to 1.0% per year in after-tax returns for a taxable investor.

In the world of investing, there are many either-or decisions that yield healthy debate.  Individual stocks or mutual funds and ETFs.  Passive or active investing.  Market-cap weighting or factor tilts.  Smart people reasonably disagree on all of these items.  And while there may be reasonable debate about the size of tax loss harvesting’s after-tax value, there is no debate about whether it is valuable.  Done well for a high income taxpayer, the consistent activity of tax loss harvesting can by itself pay for an advisor’s fee such that everything else an advisor does is gravy.  As a result, an advisor who fails to employ tax loss harvesting for taxable investors is failing to perform a value-adding activity either because he doesn’t care, doesn’t have the time, or doesn’t appreciate or understand the tax code.

Test 3: Your advisor only tax loss harvests in December.

Cleaning out the house in December and donating items to charity in the hours before year-end makes sense (granted, it now makes less sense for most taxpayers with the passage of the new tax law). You could make these gifts earlier in the year but there’s no tax cost to procrastinating.  Barring catastrophe, your unwanted items in July will still be around to donate in December.

However, this same logic does not apply when it comes to tax loss harvesting.  Investment losses come and go.  You may have an investment loss one day that becomes a gain two weeks later.  Recent calendar years such as 2012, 2014, 2015, and 2016 all experienced stock market losses in the early part of the year that eventually became gains by the time December rolled around. 

The advisor who only looks for tax loss harvesting opportunities in December may occasionally find opportunities but will miss plenty of chances to exploit this valuable benefit.  It is clearly better to do once-a-year loss harvesting in December than no loss harvesting at all.  But advisors who only loss harvest in December are leaving valuable benefits for their clients on the table. 

Test 4: Your advisor fails to utilize asset location.

Previous Astute Angle posts here and here have explained the valuable benefits of asset location for a taxable investor.  The benefit is founded on the reality that different accounts have different tax treatments and that different investments have varying levels of tax efficiency or inefficiency.  Since we know the different tax treatments of accounts in advance and we can make reasonable assumptions about the tax efficiency of investments, we ought to be able to exploit those factors to achieve the same pre-tax returns but higher after-tax returns.  That is the objective of asset location – to intentionally locate investments in the most appropriate account type to achieve higher post-tax returns.

There are several variables that impact the value of asset location but academic literature quantifies this value at between 0.25 – 0.75% per year.  That is, the advisors who employ asset location for a client with $1,000,000 can help that client earn an additional $260,000 over 30-years just by placing the investments in the right account type.  We know, however, from the experience of looking at statements from prospective clients that most advisors completely ignore this opportunity.

Asset location is difficult.  It is much simpler to just have every account mimic one another.  It takes time to employ intelligent asset location and expertise to know how to employ it.  And in all likelihood, you may not appreciate the activity and you won’t give your advisor credit for the reduced taxes over time.  But just because you won’t fully appreciate this valuable activity, does not mean that your advisor shouldn’t be doing it.

Test 5: Your advisor does not systematically rebalance.

Rules-based rebalancing is a boring activity.  When your neighbor brags about the hot new pharmaceutical stock his broker bought, you’re likely not replying with, “That’s cool but my advisor systematically rebalanced my diversified portfolio last week.”  Boring does not mean unimportant and it does not mean unproductive.  In an investment context, boring often means underappreciated and undervalued.

There is again reasonable debate about the optimal frequency of systematic rebalancing.  Should it be executed quarterly, annually, or merely when tolerance bands are breached?  The evidence is unclear on the optimal frequency.  What is clear is that systematic portfolio rebalancing is valuable and critical for two reasons: 1) to maintain a consistent and desired level of risk; and 2) to take advantage of buying assets low and selling assets high.

Note that the terms “systematic rebalancing” and “rules-based rebalancing” are used here.  This is intentional.  Rebalancing is not the arbitrary and/or discretionary buying and selling of investments to get more of this and less of that.  Rebalancing is not selling losers and buying more of the winners.  Rebalancing, in the rules-based sense, is the activity of selling investments that are materially above their pre-set targets and using the proceeds to buy investments that are materially below their pre-set targets.  This form of rebalancing removes the impact of harmful behavioral biases by sticking to pre-established objective rules.

Since we know that rules-based rebalancing provides these two important benefits, there is little justification to not doing it.  But many advisors don’t do it or do apply an inconsistent discretionary process.  Ask your advisor to explain the rules he or she uses to determine when to buy or sell an asset class.  Ask about tolerance bands and what kind of deviations from target are permitted.  Ask your advisor how frequently he or she rebalances.  At the end of the day, it is really not about the frequency but all about whether there is a rules-based discipline in place.

Test 6: Your advisor applies a generic rule of thumb to your account distribution sequence.

There’s a rule of thumb that suggests investors in the distribution phase of their life should distribute first from taxable brokerage accounts, next from tax deferred retirement accounts, and last from tax-free Roth accounts.  This is advice that won’t cause tremendous harm if I know nothing about you and have only 10 seconds to give you advice for the entirety of your retirement.  In reality, it tends to be lazy, destructive advice.  

There are many factors that need to be known to effectively determine which accounts should be utilized for distributions.  Are you charitable?  Are you desiring to leave an inheritance to your children?  How much taxable income do you have?  How soon until you begin required IRA distributions?  Do you have a pension?  Do you have large unrealized gains in your taxable accounts?  All of these questions and more need to be asked and answered to provide helpful advice on the distribution sequence. 

Moreover, the ideal solution in one year may not be the ideal solution in the next year.  In the year you begin a pension or Social Security, for example, the math may favor distributing entirely from a taxable account whereas in the year before the pension begins, some combination of tax deferred and taxable distributions may be preferred.

It is really easy to just apply a standing rule of thumb to the account distribution sequence.  It takes work to gather the relevant information, run multi-year tax projections, and plan for the unique circumstances of your situation.  An especially good way for retirees to understand an advisor’s level of apathy or care is to assess how thoughtful he or she is when it comes to determining from where cash distributions should be sourced each year.  And importantly, this is not of small consequence.  Empirical data suggests that an informed and well-thought distribution strategy can yield as much as 1.1% per year in additional value.     

Closing Comments

There is an obvious Jerry Maguire-like risk in calling out industry peers as lazy or ignorant.  Yet the intent here is not to shoot holes in your advisor’s actions or inactions.  It is, instead, to provide a measuring tool to help you assess whether your advisor has the time, ability, and desire to truly provide helpful service.  Speaking from experience, most people do not really know how to measure their advisor and we find it very frustrating to see actions that should be considered table stakes for a financial advisor not being fulfilled.   

The biggest problem is that the average retail investor often views trading frequency as the quintessential gauge of an advisor’s level of care and responsibility.  The thinking goes that the more an advisor trades, the more he or she cares and the more he or she is doing.  Trading, by itself, is a terrible way to evaluate your advisor on all three of care, time, and expertise – especially when the advisor has an economic incentive to trade.  Portfolio turnover tends to be destructive, not productive. 

The second biggest problem is that the actions described above do not get the credit they deserve.  They are highly valuable but underappreciated activities that take time and resources.  When you have an underappreciated activity that takes meaningful time to do, it’s easier to just not do it.  And as a result, many advisors choose not to do these things even though there is significant value in them.     

In fairness, some advisors may defend the shunning of activities like asset location, tax-loss harvesting, and rules-based rebalancing by suggesting that these actions are not terribly valuable or, at least, less valuable than other activities.  At the end of the day, that’s for you to judge.  But it’s hard to argue with empirical evidence.

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