'Highly Trained Monkeys' Could Do This Job
If your lawn needs to be mowed, you don't necessarily have to hire someone to do it for you. However, if you need an appendix removed, you should really consult a professional.
In many aspects of life, it's best to tap the services of an expert. But in finance, hiring professionals can often leave you worse off than if you'd handled things on your own.
The wrong questions
Behavioral economics professor Dan Ariely recently ticked off many financial advisors by suggesting that they tend to do a poor job of serving their clients.
Ariely said that the problem in their approach lies in the questions that they ask -- specifically, two that elicit overly simple quantitative answers:
- How much of your current salary will you need in retirement?
- How much of a risk-taker are you?
Ariely points out that an algorithm would serve customers just as well ("probably with many fewer errors") and adds insult to injury by suggesting that "highly trained monkeys could do the same basic job given answers to those two questions."
The monkeys or algorithms don't matter, though. The questions themselves are problematic -- because the clients, and cost of us, just don't know the answers. We're just guessing. That can be dangerous.
How much money will you need in the future? Wrong!
Ariely notes that many people think they'll need 75% of their current income in retirement -- because that's what they've heard from the financial advisor world. If they stick with that, they could end up severely shortchanging themselves. He estimates that on average, retirees will want closer to 135% of their income.
Consider that while some folks plan to spend their golden years babysitting grandchildren, playing bridge, and reading books, others want to finally get around to visiting Antarctica, taking piano lessons, or learning to paint. Different kinds of retirements have different costs.
You should also bear in mind that in retirement, many costs will be higher than they are now. Health-care expenses have been soaring for quite a while, and Fidelity Investments estimates that a typical retired couple will spend almost a quarter of a million dollars on health care alone. Property taxes, gasoline, and other expenses might also rise faster than overall inflation.
Instead of just asking this question, advisors would do well to carefully explore this issue with their clients, arriving at the best answer for each together.
Measuring risk tolerance the right and wrong way
Ariely found that when folks are asked to place their risk tolerance on a certain scale, they're likely to put themselves in the same spot -- typically close to the middle -- no matter how conservative or aggressive the extreme choices in the scale are.
In other words, they don't really appreciate how risky various investments are. Stocks can seem risky, because the stock market clearly does tank on occasion. But over long periods, the market has tended to outperform most other alternatives.
Financial pros and their clients might be better off discussing various investment options and their riskiness, in order to determine how much each client is willing to take on. Some folks may also need reminders about the link between risk and reward. Minimizing risk could also mean that your money may not grow enough.
The good news
Fortunately, it's easy for financial advisors to start asking more sensible questions. Potential clients should also listen closely to what their prospective advisors ask, and both give and request more detailed information about their financial hopes and expectations.
If you use a financial advisor, don't assume you'll be stuck with one who'll skim 1% or more of your assets each year. The National Association of Personal Financial Advisors can help you find fee-only pros who charge for services only when you use them. Beware of advisors who have you buying and selling frequently; that will just rack up commission costs. Warren Buffett and others have demonstrated that as long as the companies in question remain healthy, you can buy and hold great stocks for decades.
Alternately, consider bypassing advisors altogether and investing on your own. It's not rocket science -- you just need to spend enough time reading and thinking about it to cultivate confidence in your decisions. A simple broad-market index fund or two, such as the SPDR S&P 500 (SPY) or the Vanguard Total World Stock Index ETF (VT), will instantly plunk you in a wide array of stocks. The Vanguard Total Bond Market ETF (BND) will immediately have you in all kinds of bonds.
Questions matter. Pay attention to what your advisor's asking you, or seize your financial future by asking smart questions of your own.
Longtime Motley Fool contributor Selena Maranjian holds no position in any company mentioned. Click here to see her holdings and a short bio.