How to find a financial advisor who will build your foundation on businesses

When families are looking for a "financial advisor", "wealth manager" or "financial planner," the modern landscape is quite crowded.

However, as we have explained previously, the current environment is dominated by an arrangement like that pictured in diagram I above (the upper diagram). The investor (red circle marked A) deals with an intermediary (yellow circle marked B), who selects money managers (blue circle marked C). The intermediary is a "manager of managers".

The intermediary does not pick businesses for his investors. In fact, he usually makes this fact quite clear. He may back up his disavowal of selecting businesses with some discussion of various tenets of "modern portfolio theory."

Modern portfolio theory (MPT) began with the 1952 publication of an essay entitled "Portfolio Selection" by Harry Markowitz, a graduate student at the University of Chicago. Later, academics Bill Sharpe and Eugene Fama further expanded the tenets of MPT, including the central doctrine of the "efficient market" introduced by Fama. While the entirety of modern portfolio theory is more involved, essentially it suggests that risk can be explained using mathematics and that one can only improve return at the cost of greater risk.

Money managers generally ignored modern portfolio theory until the recession of 1973-1974, one of the longest and deepest since WWII, when the combination of a painful bear market and government regulation began modern portfolio theory's move into the mainstream.

Today, the intermediaries -- who owe their existence in part to MPT and who generally accept it wholeheartedly -- are often focused on the manager and the manager's recent performance rather than the individual businesses that the manager places in investors' portfolios. This serves to undermine the very process managers try to emphasize which is built upon longer-term ownership of businesses. As studies have shown, the intermediary's tendency to switch managers and investment styles within a fairly short-term window work at odds with the long-term growth potential of business ownership.

In challenging financial markets, just as much as in better business environments, we know what works: ownership of good businesses.

It may not seem like it, when commodities are soaring and stocks are plunging, but history shows that business ownership has proven itself through the various crises of the past century, as Jeremy Siegel explains here.

The question then becomes, "How do you find good businesses?" The investment process you follow should have a way of selecting business based on a consistent set of criteria, and the best reason to hire a professional is to gain access to a consistent process.

First, make sure you don't already have a consistent process without knowing it! If your advisor has been disciplined in executing his process, over the course of many market cycles, you should probably remain right where you are. Don't go down the road of "churning" processes or strategies by switching every couple of years -- that is the main cause of unsatisfactory long-term performance.

Unfortunately, due to the prevalence of the situation shown in diagram I and the extent to which modern portfolio theory has influenced the behavior of the intermediaries, it is far more difficult for investors to work directly with someone who builds their financial foundation primarily on the ownership of businesses. It may be possible to find an arrangement like that shown in diagram II, in which you work directly with your money manager. Otherwise, the other option is for the investor to act as his own money manager (circle A and circle C become the same).

Perhaps at some point the landscape will be less like diagram I and more like diagram II (as it was before 1973-1974). But don't hold your breath. In a related discussion in his 1988 letter to shareholders, Warren Buffet said:

"This doctrine ["efficient market theory" or EMT] became highly fashionable -- indeed almost holy scripture in academic circles during the 1970s. Essentially it said that analyzing stocks was useless because all public information was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. [. . .] In my opinion, the 63-year arbitrage experience of Graham-Newman Corp, Buffet Partnership, and Berkshire illustrates just how foolish EMT is. (There is plenty of other evidence, also). [. . .] Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians."

If that was true in 1988, it is even more so today. Understanding the current landscape, and the role modern portfolio theory plays in the often-harmful behavior of many intermediaries, is important in finding a process that will work to build wealth for decades to come.

For later posts dealing with the same topic, see also:

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