Deciphering the Value of Financial Planning: Qualitative and Quantitative Perspectives
Written by Hazel Secco, CFP ®, CDFA ®
Financial planning is often misunderstood as a means to solely generate wealth through stock market maneuvers and market timing. However, this perception is contrary to its true essence. At its core, financial planning is about orchestrating your financial future by exerting influence over controllable variables. It encompasses an array of factors, including the duration of your employment, salary increments, bonuses, and even unexpected events like medical leave or, as we’ve seen, a pandemic-induced lockdown.
Drawing parallels with health management, one can appreciate the value of financial planning. This analogy allows for a more relatable understanding of its significance. Much like maintaining one’s health, effective financial planning demands proactive decision-making, thoughtful choices, and a forward-thinking outlook. Both endeavors necessitate a deliberate and long-term approach.
1. The Power of Efficient Delegation
Quantifying the value of financial planning in precise numbers is challenging, but its overall positive impact is apparent. Financial planning operates on the principle of efficient delegation. I firmly believe that our daily reserves of energy are limited and not easily quantifiable. Let’s consider, for instance, an arbitrary energy level of 100 units per day. These must be allocated for various demands such as work, family, and personal hobbies. Engaging with family brings joy and bolsters our energy, while hobbies likewise provide a positive boost. Moreover, a fulfilling job can exponentially enhance your financial potential, as contentment and proficiency often lead to increased earnings.
Conversely, activities like cleaning, for those of us who don’t find it invigorating, require extra energy input for what I’d call a baseline result. Similarly, if one lacks the energy to prepare a meal for the family but pushes through, the outcome may lack the usual vigor and passion. Hence, my argument centers on playing to your strengths and engaging in activities that bring you joy and proficiency. This approach yields a surplus of positive outcomes, even as you conserve your limited energy by avoiding tasks where you lack specialization.
Additionally, as a business owner, I can emphasize the significance of this in monetary terms. The practice of efficient delegation holds immense importance, especially in the initial phases of business ownership. Failing to grasp this early on can lead to significant missteps down the line. For instance, if you earn $200,000 annually and work 40 hours a week, your hourly earnings amount to roughly $96. In such a scenario, it’s a clear decision to delegate tasks you find less appealing, such as marketing, HR, or administrative work, to someone who excels in those areas. By doing so, you not only enhance your own positive energy, which ultimately leads to amplified business growth and revenue, but also leverage other professionals’ expertise, yielding a compounding benefit for your business.
The same principle holds true in financial planning. Even if you’re reasonably adept at handling finances, you may not be the most efficient person to navigate the intricacies and optimize your financial landscape. Considering our daily energy constraints, it’s challenging to assign a monetary value to the benefits of effective delegation. However, the tangible outcomes and enhanced financial well-being make it clear that not engaging a financial planner would be a missed opportunity in terms of financial growth and stability.
2. The Human Element in Financial Decision-Making
Furthermore, finance may appear to be primarily about numbers, but in reality, it is deeply intertwined with emotions. You can check out my podcast episode, “Emotions and Financial Decisions“, to learn more. Various biases come into play in your investment and saving decisions, such as overconfidence bias and confirmation bias. Overconfidence bias can lead to more mistakes because it causes individuals to overestimate their knowledge and control over a situation. This can result in hasty decision-making and a failure to adequately assess risks. Confirmation bias prompts individuals to actively seek information that aligns with their pre-existing beliefs or opinions. This tendency can deter people from investing the time to comprehensively analyze a situation or contemplate alternative viewpoints. In addition, the herd instinct often leads people to follow the crowd, making it difficult to make coherent and logical decisions.
These biases can prevent you from making rational choices, potentially leading to costly mistakes in your overall financial outlook. Emotional decision-making, such as buying or selling based on feelings, can hinder your ability to be optimally invested, especially when markets are volatile. For example, people tend to panic and pull their investments out of the market during a downturn. Unfortunately, this often leads them to miss out on potential gains when the market eventually rebounds. If $1,000,000 had been invested from January 1, 1999, through June 30, 2023, even missing just a few of the market’s best days would have significantly impacted returns. For instance, missing the 10 highest peak days in the S&P 500 would have resulted in the investment growing to 5.72 million, compared to 2.62 million if those 10 days were missed. This underscores the importance of behavioral financial coaching in the realm of financial planning.
Much like doctors refrain from operating on their own family members to maintain objectivity, individuals should approach crafting their own financial plans or portfolios with caution. Emotions can significantly increase the likelihood of making mistakes in critical decision-making. Achieving complete objectivity in financial planning is challenging due to our human tendencies and emotional connections to our finances. Consider the scenario of a surgeon tasked with operating on their own child’s brain – during the surgery, their primary concern would naturally be avoiding any potential mistakes, which might prevent them from performing at their full capacity.
3. Opportunity Cost and Timing in Financial Planning
The concept of opportunity cost looms large in financial planning. Consider this scenario: missing the optimal window for tax planning, such as a Roth IRA conversion, can have a substantial financial impact. For instance, if you miss the window of opportunity for converting to a Roth IRA at a lower tax bracket (say, 19% instead of 24%), the 5% difference in taxes on the value of the IRA slated for conversion becomes a significant consideration in your decision-making process. This could potentially lead to a missed opportunity for utilizing the backdoor Roth IRA strategy.
Drawing a parallel to healthcare, it’s akin to detecting cancer at an advanced stage (like stage 4) rather than in its early stages (1a or 1b), when treatment might not even necessitate chemotherapy—a considerably less taxing aspect of recovery for patients and their families. While hindsight might reveal that early detection would have offered a significantly better experience, the reality is that the opportunity for change has passed, and you’re now facing stage 4. Witnessing a loved one suffer through severe illness serves as a poignant reminder that health is invaluable, transcending the realm of material exchange, and unfortunately, it’s something that can’t be altered even if one wishes to.
Similarly, financial planning mirrors health management in that you can’t retroactively optimize your financial situation from 5 or 10 years ago. How do you quantify what’s lost when the opportunity has already passed? Another example might be the “three-year rule.” If you didn’t proactively address estate planning and didn’t transfer ownership of a property into an irrevocable trust three years ago, you can no longer exclude that property from your estate. It will be included in your estate if it hasn’t been out of your estate for the full three years. Timing plays a pivotal role in financial planning, as does recognizing the significance of actions taken—or not taken—in years past.
It’s abundantly clear that financial planning holds immeasurable qualitative value. Moreover, the worth of financial planning far exceeds the fees incurred for the service. In an endeavor to quantify this value, a research paper written by David Blanchett, CFA, CFP®, on behalf of Morningstar introduced the concept of gamma, which serves as a unique metric in evaluating financial planning. This sets it apart from traditional metrics such as alpha and beta. Gamma encompasses all your financial assets, encompassing elements like pension value and property worth, which may fluctuate over time due to various life events. While it may be challenging to express in exact dollar terms, it’s apparent that gamma covers a broader spectrum of assets than merely portfolio value. For retirees, its worth is estimated at 1.59%. Even if your total asset management fee amounts to 1.59%, it’s a clear-cut decision to engage in financial planning, considering that gamma surpasses the value provided by your portfolio manager.
Vanguard wrote a research paper regarding “Advisor’s Alpha,” which delves into how financial planning’s value translates in terms of asset management fees. According to Vanguard, the comprehensive value of financial planning can be estimated at around 3% or more. This study encompasses cost-effective investment implementation, where your investment vehicles are managed in a more efficient and economical manner. The formula emphasizes that it’s not always about the lowest costs, but rather gross returns minus expenses. Vanguard doesn’t dismiss active management, stating that over the long term, both index and talent-driven active funds with higher gross returns at lower costs are expected to surpass the returns of the average mutual fund in their benchmark category. It’s noteworthy that Vanguard, known for its low-cost ETFs, underscores the value provided by actively managed funds, as long as the value justifies the fee. Once again, it’s not always the case, but when the cost provides substantial value, the cost becomes relatively less relevant. Additionally, the sequencing of asset withdrawals can add up to a 1.2% increase in value for the client. Crafting a withdrawal strategy is crucial, as certain approaches can be more tax-advantageous, efficient, and optimal, depending on the mix of retirement accounts, non-retirement accounts, and other types of assets.
It’s clear how diverse the value of different financial planning approaches can be and how crucial it is for everyone to grasp these benefits, particularly when we aim to focus on what we can control. Even portfolio managers and stock pickers acknowledge that we don’t have full command over the market due to the multitude of variables and unexpected events like the pandemic and interest rate hikes, which significantly affected the fixed-income market in 2022. While witnessing the stock market rise can be enticing and lead to boasting about performance, planning may seem less exhilarating in comparison. However, considering the emotional aspects of investing and managing personal finances, seeking advice from a professional is a wise move. This ensures you understand how to potentially optimize your financial assets and make the most of what you have, whether it means reducing risk or gaining more time for yourself, among other considerations.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
No investment strategy assures a profit or protects against risk.
Securities and advisory services offered through LPL Financial, A Registered Investment Advisor. Member FINRA/SIPC.