Financial Advisors say a lot of things that they inherently know are false because they sound good, market well, and attract new clients. Worse yet from a competency standpoint (albeit better from an integrity standpoint) are financial advisors who promote the same agendas without the awareness of their misguided promises. Both embarrass and discredit the industry of financial advice. While the list of such misguided or deceitful statements is long, we highlight three common ones that should concern – if not frighten – clients.

1) Promoting investment hedging strategies that reduce risk without compromising return or investments that offer high returns with low risk.

Look, we all want low risk and high return. It is an alluring concept – the holy grail of investing. Yet it does no good for investment managers, financial media, and financial advisors to promote this fictitious concept of low risk and high return investment opportunities or strategies. A hedging investment strategy that promises to reduce risk also reduces returns. An insurance product or variable annuity that limits the downside also sells off some of the upside to create the downside protection. A hedge fund promising stock-like returns with bond-like risk often relies on investment returns being normally distributed when robust historic evidence proves they are not. Financial advisors peddling investment strategies that dynamically reduce risk in periods of market stress fail to similarly peddle the resulting cost of lower long-term returns.

There is no free lunch. It really is that simple. Hedging, covered calls, dynamic risk management, guaranteed income benefits, market-linked CDs – whatever the label – they are all forms of insurance that reduce upside in some capacity. Suggesting that there is a free lunch promotes bad investing behavior. And this is not to say that downside protection is a bad thing for risk-averse investors but we need to call a spade and spade. Advisors peddling strategies that provide downside protection without explaining the sacrifice to returns or the secondary risks are either intentionally misleading customers or they are naive to how these strategies actually work – both of which are concerning.

2) Using “stay the course” as an excuse for apathy and inattentive service.

Humans are inherently hard-wired to make poor investment decisions. Among a long list of flaws, we overweight events of the recent past, we are overconfident in our prediction abilities, we are lousy at decision-making in times of stress, and we treat equivalent gains and losses differently. As a result of all these behavioral flaws, there is great value in setting a discipline and sticking with the discipline to avoid letting our emotions and behavioral tendencies deter our financial success.

However, let’s be clear on what staying the course actually means – it means intelligently assessing and setting an appropriate risk level and then consistently maintaining that risk level. It does not mean letting sharp market movements dictate your personal risk level.

Consider a ship that sets sail from London to Miami but then encounters bad storms and choppy seas which put it on a path towards Nova Scotia. Either the captain makes the necessary adjustments to stay the course towards Miami or the captain just lets the boat end up in Nova Scotia.

Investment markets of 2020 provide clear example of this storm and the wide gap between staying the course and doing nothing. An investor starting the year with an asset allocation (and targeted mix) of 60% stocks and 40% bonds who did nothing would have deviated to own an equal amount of bonds and stocks by March 23rd. This significant change in portfolio risk – the equivalent of going off course to Nova Scotia – is precisely why inactivity and staying the course are in clear opposition during periods of sharp market movement. Investors who let the market movements adjust portfolio risk without staying the course – in the honest sense – had a lower risk level than they targeted when the market rebounded and coincidentally captured more downside than upside. As a result, it will take them longer to get to the intended destination.

Advisors who preach staying the course but fail to rebalance to the targeted risk level when markets move in one direction (redirect the ship back to Miami during the storm) effectively use this stay-the-course message as an excuse for laziness at the ultimate expense of the client.

3) Using phrases such as “We are unbiased” or “Our fee-only model eliminates conflicts of interest”

Fee-only financial advisors are justifiably proud of their fiduciary responsibility and their legal commitment to work in the best of interest of their clients. Very proud. By completely avoiding product sales or commissions, fee-only advisors (of which we are proudly one) face fewer conflicts of interest than a commissioned broker or someone who sells insurance.

But here’s the thing: any fee-only fiduciary advisor who publicizes that he/she is free of conflicts is either outrageously naive or intellectually dishonest. Fee-only fiduciaries face plenty of meaningful conflicts of interest. Consider, for example, that fee-only advisors who charge a fee tied to assets under management have an incentive to recommend that clients employ a larger mortgage, sell a business sooner than might be appropriate, hold a smaller cash reserve, maintain expensive student loans, or avoid buying real estate, second homes, and immediate annuities. That just covers a few of the many conflicts.

There are conflicts of interest in the advice industry. Conflicts are unavoidable, regardless of the business model or the fee structure. Advisors who fail to embrace and communicate these conflicts of interest are doing a terrible disservice to their clients. Either a) the advisor is aware of the conflicts but denies they exist – a clear signal of dishonesty; or b) the advisor is ignorant to the inherent conflicts of interest – a signal that the advisor may not be fit to provide advice.

In the corporate world, businesses have a CEO who makes operating decisions and a CFO who makes financing decisions. The CEO decides to expand a business line. The CFO determines how that expansion is going to be paid for.

When you choose to buy a home, you have made an operating decision. When you elect to use a mortgage in lieu of paying cash for the home, you have made a financing decision. These are separate decisions. The problem is that home buyers often fail to separate these decisions. In my experience, many people treat their home purchase as a financing decision while ignoring the operating decision. This can have dramatic long-term consequences that are not appreciated until long after the initial decision.

Consider a couple, Dan and Susan, with $200,000 saved in an after-tax brokerage account who determine that their after-tax cash flow leaves them an extra $3,000 per month after covering their core household expenses. With a 30-year mortgage rate of 3.125%, they can borrow $700,000 and afford the resulting $2,999 monthly mortgage cost. Armed with that information, Dan and Susan calculate that they can buy a home valued at $900,000 by using their $200,000 savings for the downpayment and financing the other $700,000.

What’s wrong with this thinking? Absolutely nothing if their singular objective is to buy as much home as financing will allow. Dan and Susan will have $3,000 of excess cash flow each month and they can use all this money to pay the monthly mortgage cost (with $1 left over each month).

But consider how this home purchase is reframed if we think of it as an operating decision rather than a financing decision. Dan and Susan first contemplate – based on circumstances – whether it is more appropriate to buy a home or rent a home. That means considering whether their family is likely to expand (more kids) or contract (kids going off to college) in the next 5-10 years, whether the family might relocate to a different state or a different part of town over the next 5-10 years, and the costs of renting versus buying in their specific location.

Fast forward and assume that Dan and Susan evaluated circumstances and decided to buy a home. They now have to make an operating decision about allocating resources to this new home. The CFO says “we have $3,000/month in excess cash flow” and the CEO has to decide how much of this cash flow should go towards the home, how much towards retirement savings, how much towards college, how much towards vacations, or how much towards philanthropy. If coming at this from an operational perspective, Dan and Susan effectively need to decide how much money should be allocated or budgeted to each business line. Ultimately, this means deciding which family business lines are going to get cut and by how much to take on this new business line (buying a home).

And what happens if Dan and Susan elect to allocate the entire $3,000/month towards the mortgage (i.e. only view this as a financing decision of how much home they can afford)? They have inherently made an operating decision to discontinue or de-emphasize funding of their other business lines: retirement savings, college, vacations, philanthropy, etc. As with the business that decides to focus all R&D and marketing on one business line at the expense of all other lines, Dan and Susan are choosing to buy a bigger house at the expense of a delayed retirement, fewer family vacations, more limited college choices they will be able to afford, and cut-backs to other discretionary items in the future.  

There’s another important point here – once Dan and Susan make the operating decision and buy this house, future financing decisions don’t change this operating decision. What does that mean? There is a pervasive myth that the way someone finances or does not finance a home changes their exposure to the home value. People think that if they have more equity in their home, they benefit more if the home appreciates in value. This is decidedly not true.

Assume that you own a home worth $500,000. If you have an extra $1,000 in the bank and you decide to use that money to pay down your mortgage, that decision does not change your net worth (you’ve simply moved reduced assets by $1,000 and reduced liabilities by $1,000). Paying down your mortgage also does not change your exposure to the home’s value (your home is still worth the same $500,000). If your house value increases by 10% to $550,000, your net worth increases by $50,000 whether you have a mortgage or not. Same if the home value decreases by 10%.

So when someone says “I have too much money tied up in my house” – that is an operating issue, not a financing issue. The only way to reduce that exposure is to downsize to a smaller home, not change how the home is financed. If Dan and Susan come upon an unexpected bonus and decide not to pay down their mortgage because they “already have too much exposure to the house”, they’re using misguided logic.

All of this is to say that we overwhelmingly tend to treat home purchases from the vantage of the financing decisions while not giving enough respect to the operating decisions. In contrast, we’d be better served by clearly separating these decisions.