Here are guidelines regarding whether Is it worth paying Fee for Financial Advice?:
Particularly as regards structured products like mutual funds, a lot of confusion looms around. You may come across two alternatives. In the first case, people invest in regular plans and seek free advice from the distributor.
In yet another case, you may find investors who have hired fee-based Advisors, and they are paying them an annual fee. Along with that, they invest in direct plans of mutual funds.
So, now you are unable to make up your mind. You keep wondering “Why should I pay for financial advice when it’s available for free?”
It’s not your fault. Your brain starts freaking out when it’s about investing and financial advice. On the face, it can’t analyse the harm free-advice might cause to your Return on Investment. It’s unaware that there lies a hidden fee in the form of expense ratio in regular plans. And this expense ratio would dent returns more than the nominal fee-based advice.
At this juncture, it becomes critical to demystify the reluctance surrounding fee-based advice.
You need to know why you get freaked out to pay for financial advice. What prevents you from choosing a rational alternative over an irrational free-advice?
It’s a behavioural folly that you need to overcome.
But before that let’s look at the reasons behind this weird phenomenon.
The above figure represents various parts of your brain. The topmost layer is the human brain. It uses logic and reasoning for decision-making. The middle part is called the dog brain. It depends on emotions of love and hate for making decisions. The lower part is the lizard brain. It seeks a pattern in the environment. It believes that patterns would repeat in future.
You can see the behavioural follies are emanating from middle and lower part of the brain. You make mistakes when you use dog & lizard brain. Following points emphasise on using human brain to decide on investments.
1. Prospect Theory
Prospect Theory gives in-depth insight into investing behaviour. It says that your appreciation of a proposition is based on the benefits. Moreover, you feel double the pain from a loss compared to the happiness upon profit. There’s always a tendency to escape risk and avoid losses. The manner of advisor’s explanation determines your willingness to invest.
Suppose there are two advisors: A & B. Both of them approach you with the same mutual fund scheme. A says that the fund has given above-average returns over the past decade. B says that the fund returns dropped below 12% during the last 3 years. You are going to prefer A over B.
The presentation carries more weight than what lies underneath. Many times you won’t find the advisor convincing. He may be highlighting the fund negatives to aid a holistic appraisal. But you might think he lacks the edge to suggest a profitable fund. You won’t agree to shell out fee on the advisor.
You need to be logical in the assessment of the advisor. The one who always shows you rosy dreams might not facilitate in their achievement.
2. Pain of Paying
There’s this “Pain of Paying” theory behind your reluctance to pay the advisor. It helps to describe cash-based financial behaviours. It says that you feel hurt whenever you have to make payment in cash. It’s like you can see the money going away from you. And, that you don’t want to sacrifice your money at any cost.
Let’s take the case of Ram and Shyam.
Both of them wants to start monthly SIP in equity mutual fund X. The investment horizon is same of 15 years.
Ram has got a financial advisor who charges an annual fee of Rs 10000. The advisor advises him to invest in the Direct Plan of equity mutual fund X.
Here, you need to know that direct plans have a low expense ratio than regular plans. So, automatically direct plans give higher returns than regular plans.
Shyam doesn’t believe in paying for financial advice. So, he opts for a regular plan of equity mutual fund X. Usually, the difference between expense ratio of the direct & regular plan is around 0.75-1%. In this case, the difference has been assumed to be 1%.
Ram earns annualised return of 12% on direct plan. Conversely, Shyam earns only 11% on regular plan owing to higher expense ratio.
Seemingly looking lesser, compounding effect of free advice has drained the returns of Shyam. On the contrary, fee-based advice has boost Ram’s RoI year after year.
At the end of 15 years, Ram is richer than Shyam. Ram could accumulate around Rs 17 lakh more than Shyam.
The following table enlists the advantage of fee-based advice over free-advice:
3. Linking returns to fees
In fee-based advice, the fee is neither linked to any product sales nor assets under management. You may smile till such time the returns tend northwards. The moment your portfolio starts making losses, you may lose your cool.
Questions might pop up in your mind. “Why should I pay the advisor when I am suffering losses?” “Why should advisor gain when my portfolio is bleeding?”
But you didn’t consider that when you make sky-high returns, the advisor doesn’t raise his fee. So, it’s your dog brain which makes you emotionally overloaded upon sudden market fluctuations.
It’s high time that you stop linking your gains with advisor fee. Have a broad-based approach and long-term vision.
It’s expected of you to be rational while investing. But actually, irrationality prevails all the time during investment horizon. Your lizard brain needs to be blamed for that.
The lizard brain is very much pattern-seeking and backward-looking in nature. It assumes that past patterns would repeat in future. When you glance at fund past performance, you ensure that it must repeat in future. You are unable to consider these as reference points.
You fail to understand that market dynamism. Historical patterns would repeat only if similar conditions prevail. But in reality, it doesn’t prevail. Hence, the probability of earning historical returns is weak.
Ultimately, you don’t want to pay any longer when you notice patterns ain’t repeating. Here, the advisor’s not at the mistake. It’s you who needs to exhibit composure and rationality.
Start thinking logically and rationally. It will help you to maintain a symbiotic relationship with the advisor.
You need to overcome certain faults in your investment behaviour. The fee-based model will enable you to get the best out of your investments. Stop worrying and start paying for financial advice.
To know more about fee-based advice, schedule a FREE CONSULTATION.