Last Updated on July 24, 2022 by The MediFi Guy
You are guaranteed to lose money if you have a financial advisor
“Alright, so I kind of understand the point about fees and stuff, but aren’t you being a bit hyperbolic when you say that you’re guaranteed to lose money? Surely that can’t be the case?”
Let us revisit our previous example again:
Notice the rate of return of “6%”. What does that mean? For this discussion, we’ll assume that the 6% is a *real return.
*Tip: whenever you see “real x” in finances, it means x after you subtract something from it. In this case, it’s the nominal return minus inflation.
Let us use a super simple example:
History has shown that the global stock market always goes up over prolonged periods of time (decades). It has its ups, it has its downs, it has its booms, it has its crashes, but overall it always goes up. On average, this upwards growth tends to be a nominal (before inflation) return of 12% p.a.
We also know that in South Africa inflation tends to average 6% per annum. So let’s do some maths (FYI I’m taking liberties with this example to explain the concept):
Example without a financial advisor:
You invest R100 in a stock market index fund. After a year, you receive a nominal return of R12 (12%) bringing your total to R112.
That R12 represents the 12% nominal return.
But remember, inflation was 6%, so your real return after subtracting inflation is 12% – 6% = 6% = R6. So your real return is R6 when you take into account inflation. A total of R106
You then have to pay a 1% fee to your investment company.
6% – 1% = 5% = R5 left. So your real return after fees and inflation is R5, or R105 in total.
Not bad, you made R5 after fees and inflation.
Example with a financial advisor:
Having hired a financial advisor who charges a 1% assets under management fee and signed you up with a high fee actively managed investment, you invest R100 in a high fee stock market unit trust. After a year, you receive a nominal return of 12% (R12), bringing your total to R112.
That R12 represents the 12% nominal return.
But remember, inflation was 6%, so your real return is the 12% – 6% = 6% = R6. So your real return is R6, a total of R106.
You then have to pay a 3%fee to the investment company, which is 6% -3% = 3% = R3 left. So your real return after fees and inflation is R3 or R103 in total.
You then have to pay your financial advisor a 1% assets under management fee. That’s 3% – 1% = 2% or R2. So your real return is R2 or R102 in total.
You only made a R2 real return after fees and inflation.
That’s not too bad, right? But wait, there’s more!
Remember how I said that although the market always goes up overall, there can be periods of minimal to no growth? (Remember, the 12% return is only an average).
So what happens in the case of the market returning, let’s say, an 8% nominal return? In the above examples, in the first case, you would still get a return of 1% after fees and inflation, whereas in the second case you would get a return of -2% (i.e. you would lose money). What about a 9% return? Scenario 1: you get 2%. Scenario 2: you get -1%. A 10% return? Scenario 1 you get 3%. Scenario 2: you finally break even with 0%.
And herein we learn the lesson of how financial advisors guarantee a loss:
The Guaranteed Loss
When you have a financial advisor charging you a fee, you have to consistently have a rate of return that at the very least matches that fee along with all other fees, in order to break even, before you can even start to get a real return above inflation. When you consider this along with the fact that actively managed funds have been shown to only beat the market 20% of the time, you are practically guaranteed to lose money with a financial advisor due to the additional weight of fees that they put on your investment without a corresponding higher return to offset them.
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