You may not realize it, but your investment portfolio has built-in economies of scale. As your portfolio grows over time, do you have to spend more time or effort managing it? Not likely. And that’s the basic definition of an economy of scale… increasing rewards or profits while costs remain fixed (or at least grow at a slower rate than profits).
Investor economies of scale are the main reason that investment fund expenses have come down so much over time. Across both active and passive funds, investment managers have been forced to provide investors more of the rewards that come from efficiency and the ability to serve a wide swath of customers on a single platform.
Advisors remain entrenched
However many financial advisors have resisted the trend toward lower fees. In fact, if you work with a financial advisor that charges the typical 1% of assets, then your advisor is confiscating economies of scale that rightly belong to you.
Cost vs excess profit
It all starts with the breakeven “cost” to manage your portfolio. Many advisors will quibble about what exactly their breakeven costs are, but trust me, every advisor has an idea of what level of revenue they need to earn in order to justify taking on a prospective client.
That’s the reason many advisors have asset minimums. If your advisor won’t take on clients with less than $1,000,000, then you can reasonably assume that the advisor’s estimate of their breakeven cost is right around $10,000/year ($1mm x 1%).
A more concrete way to estimate an advisor’s breakeven cost is to look at the value of time.1 I estimate that the average client for a financial advisor will require between 20 – 30 hours of work each year.2 And the average cost for a good advisor’s time is somewhere in neighborhood of $200 – $250/hour. That yields a range of $4,000 – $7,500 per year.
This is the level at which most financial advisors will be able to serve a reasonable number of clients, provide them with great service, and earn a reasonable living. Any fees above this cost baseline, I will call “excess profits.”
An example
It’s import to remember that as the value of your portfolio increases, the cost to service your portfolio stays roughly the same, but your advisor’s excess profits will increase. And this is the core tenet of economies of scale.
If you have a $1,000,000 portfolio with a real return of 3%/year and assume a breakeven cost of $5,750 (the average of the range above), then the next five years might look like:
At the end of five years, your advisor is still spending those same 20-30 hours to serve you. But now their excess profits have grown from $4,250 to $5,074 (+19%).
As I’ve mentioned before, most financial advisors are incentivized to gather assets. What happens if your dear Uncle Buck passes away and leaves you $300,000 at the end of year #3?
Now your advisor’s excess profits have increased from $4,250 to $8,134 (+91%). It goes without saying that gathering some assets can supercharge your advisor’s profit margins (especially when the new assets come from an existing client).
Conclusion
Both of these examples illustrate how your standard AUM advisor is confiscating economies of scale for their own advantage. Many investors could benefit from working with an advisor under an alternate fee arrangement. Either flat fees or hourly based planning offer a great alternative to the typical 1% of assets fee structure.
1Unlike financial advice, most professional services are valued in close proximity to the cost of time.
2I’m specifically focused on the time required for in-depth financial planning and investment management services. Many people don’t need or want that much service, so they can reduce the time required accordingly.
