You’ve beaten up on them enough already. That was Charlie Munger’s comment to Warren Buffett at a shareholder meeting when asked if he wanted to add to the Oracle of Omaha’s reasons why it’s best to avoid financial advisors. What is it that Warren said to provoke such a punchy reply from his right-hand man?
The number one reason Warren suggests being wary of financial advisors is that, in aggregate, he believes that they add no value.
He explains this with an analogy. When you have a leaky faucet, you call a plumber and they fix it. That’s a value-added service. When you have a toothache, you go to a dentist and they fix it.
But when you go to a financial advisor they sell you on beating the market average yet in aggregate most don’t when fees are factored in.
And it’s those fees that simple math exposes in plain sight for all to see.
What Does Warren Buffett Think of Financial Advisors?
Warren Buffett thinks financial advisors charge too high fees relative to the value they provide.
Many financial advisors will charge a 1% management fee which seems very reasonable to most ordinary investors.
What the average Mom and Pop doesn’t know when they invest their money with a financial advisor is all sorts of other fees get charged to their account too.
Among the most impactful is the expense ratio. When a financial advisor invests your money in a mutual fund, the fund also has a fee that can be as much as one percent too.
What Jim and Jane see when they walk through the doors to the financial advisor’s office is a small amount of just one percent per year for this smart financial advisor to oversee their retirement portfolio. They usually are not aware of the additional 1% from the expense ratio. So their actual cost is 2% per year.
If they have $1,000 to invest, and the financial advisor pitches them on historical returns of 10%, they will often assume that paying one thousand dollars to the financial advisor in order to make ten thousand dollars seems like a good deal.
The reality is that they may be paying closer to $2,000 to make that $10,000.
But wait, it gets worse, much much worse.
How Fees Erode Portfolio Wealth Quietly
You see that two percent is charged year in and year out. So when you look at a longer time horizon you see how destructive the fees are to a portfolio.
A 2% fee paid every year for 40 years amounts to 80% of the original principal invested, or $80,000.
Now if Jim and Jane knew that over the long-term eighty percent of the economics would transfer to their portfolio advisor based on that little old fee would they sign up?
Hidden Fees Add Up
We haven’t even discussed all the other fees that may be applied from transactions charges to twelve bee one fees. Put them all into the mix and you can see why Buffett shuns financial advisors.
Yet, believe it or not, it gets even worse when professional money managers oversee capital because, in addition to the 2% annual fee, they often take 20% of the upside too.
Now you might still be wondering does it actually make sense? I mean maybe if you make 10% annually and pay the financial advisor 2% it’s a good deal.
But there are two key things to keep in mind. First, that 2% is actually 20% of the portfolio gain if it goes up 10% in a year.
And second, which is even more important, if the market goes down in value, the financial advisor still takes their 2% while you get zero.
So over time in up and down markets financial advisors win which is not necessarily the case for clients.
We should note here that Buffett claims the math doesn’t work out in aggregate. Of course there will be financial advisors and money managers who manage to beat the market and generate superior returns for their clients, but they are the select few not the majority.
What Is A Better Way To Invest?
So if Buffett thinks paying a financial advisor is not the smart way to go, what is?
The short answer is buy an exchange-traded fund that represents the S&P 500, and one of the least expensive is Vanguard’s S&P 500 ETF, with ticker symbol VOO.
Unlike many mutual funds that may charge 1%, Vanguard charges just zero point zero three percent to track the top 500 stocks in America.
If you dollar cost average into the market, meaning invest steadily a similar amount each year over the long-term history has shown the odds of ending up well in the black are high.
Best of all, your performance will likely far outperform the returns of your neighbor who pays those pesky 2% annual fees.
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