I accepted his advice. He's a smart and helpful guy, and he convinced me he knew what he was talking about. For six years I watched my portfolio going up and down like a paper-boat on ocean waves. It ended up about 0.18% above the S&P. Not bad, but was it worth it? Over these years, there were good times ("our guys beat the market!") and bad times ("our guys promised to work harder and make up for this 5% lag behind the S&P"). In fact, an average day in the market could easily offset the entire gain (or loss) of those 6 years.
The only thing that remained constant throughout those turbulent years was the 1% annual management fee.
If you are in a similar situation, here's a question you could ask your financial adviser. "If you guys are so confident in your strategy, let's make a deal: instead of a management fee, I'll pay you half the profits above the S&P 500 when I finally withdraw my account. Deal?"
Do you think they'll take it? After all, this is the strategy they're selling you.
They can't accept this offer, since they know deep in their hearts that they can't beat the market. Of course, they'll have good years and bad years, but on average, all the players in the market make just that - the average. This is the definition of average, after all. And why should the good people who work 12 hours a day at Merrill-Lynch or Goldman Sachs or GM Pension Funds be any better than the good people who manage the Harvard Endowment or run the Magellan Mutual Fund or any other professional portfolio managers?
They're not. John Bogle, in his excellent Little Book of Common Sense Investing tells a story about a customer visiting an investment bank and hearing about how successful they are and how they all have fancy cars, homes and yacht. "Where are the investors yachts?", he asks. Where indeed.
The account managers job is not to help you buy your yacht. Their job is to keep you a customer, and let your account bleed 1% annually until the cows come home or until you see the light, whichever happens first.
This is a weird and unique arrangement. I don't know who came up with this brilliant idea. After all, there's absolutely no relationship between the amount of money they manage to the amount of work they do on your behalf. Why would managing a million dollar be 10 times more expensive than managing $100,000?
To their defense, some of the professional portfolio managers truly believe in active management - the myth that by selecting "winners" over "losers" and timing the market, they can beat the average. They use tools from economics, business management, stochastic analysis and a bunch of "tried and true" ad-hoc measures to assess investments. They compute ratios (like "cash flow divided by inventory squared times price over earnings") - a tool designed for businesses but with dubious rationale for stock selection. The shadiest of them use a branch of witchcraft called Technical Analysis, where, like astrologers, they try to see shapes such as cups and saucers in a stock price graph and figure out whether the spout coming next month is going to point up or down.
As plenty of research has shown, these tools are as effective as monkeys throwing darts at stock market tables. Professional account managers are smarter than monkeys, of course. They have learned that 1% of someone else's money can buy them a yacht. The monkeys, after all, are happy to do the same job for a few bananas.
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