Where Investment Advice Falls Short

Step by Step This column examines the state of American investment advice. Where is it succeeding? Where are the gaps?

These are the four steps of investing, as I see it:

1. Establishing the initial account The starting point is to invest. In something. As the Illinois lottery ad copy says, "You can't win if you don't play." Although that is a fib for the lottery, where winning the game consists of refusing to play, it certainly is true of retirement savings.

2. Managing debt Of course, investing isn't only about assets. The other half of the equation consists of liabilities--keeping debt under control, so that the prospective investor has money with which to buy securities. The worker who trots an ongoing treadmill of acquisition by debt, repayment, acquisition by debt, repayment, is the worker who never gets retirement savings into motion.

This, too, could be labeled the first investment step. The two critical duties for any investor are having some assets to invest and doing so. Both aspects are required to get off the ground.

3. Funding additional accounts This third step moves the investor up the food chain. The initial account, likely a 401(k) plan, should suffice when combined with Social Security to bankroll an adequate retirement, assuming that the investor made a reasonably high contribution rate. But only adequate. For a retirement that satisfies happier adjectives, such as "secure" or "comfortable," additional investments are required.

4. Gamma Morningstar's David Blanchett invented the term "gamma" to describe some of the benefits that investment advice can bring to retirees, besides the traditional roles of allocating assets (alpha) and selecting securities (beta). Blanchett used the word specifically, but I am hijacking his term to use more generally.

For me, gamma means all value delivered by investment advice, above and beyond the customary tasks, and for investors in all stages of life: tax strategies, withdrawal tactics, exercising stock options, selling a closely held business, making donations and gifts, legacy planning. You name it: If the task is not choosing an asset mix and selecting the securities, and it helps an investor, then it is gamma.

Gamma is a rich man's problem. Gamma is good.

Pass or Fail? Now, for my assessment as to how the field of investment advice serves each of these needs. The grades are pass/fail.

1) Starting the initial account: Pass. Well back in the day, stockbrokers converted novice investors. They made cold calls, they gave seminars, they spread the word. It was an expensive way to distribute, which explained the 8.5% front-end loads on mutual funds and sky-high stock-commission rates, but it was effective at corralling those who had some assets and otherwise would not have found the financial markets.

Move forward a generation, toward when your father drove your father's Oldsmobile, and the full-service approach was joined by the no-load mutual fund, as advertised by the financial media. Investors who responded to pushes continued to buy load funds; those who reacted to pulls pursued no-loads. Either way, their feet got in the door.

Today's approach is different. For the most part, the employer has replaced brokers and the media. Most people now make their initial investment purchases in 401(k) plans, often unwittingly, through automatic enrollments. This process works well for those who work at large companies, less so for those at smaller firms. It is not perfect. It is, however, a resounding success when compared with the next point.

2) Managing debt: Fail. Let's face it: There not only is little money to be gained by helping people gain mastery over their liabilities, but there is a whole lot of money to be made from the other side. As demonstrated by the deluge of advertisements for credit cards, home-equity loans, and pricey, nonessential consumer goods, there is no shortage of people who benefit from increases in personal debt. In contrast, relatively few profit directly when Americans strengthen their balance sheet.

Whatever counterbalances these debt-encouraging influences must be powerful indeed. That "whatever" does not currently exist. The U.S. economic culture is to spend now, replay later, and save (if possible) much later. There are no strong counterforces.

3) Funding additional accounts: Marginal pass. On the surface, this grade seems odd. Set aside 401(k) plans, and the investment-advice field looks to be as robust as it was 30 years ago, if not moreso. Full-service brokers are still around, as are the media and no-load funds. In addition, "robo-advisors" have sprung up. So, why did I give these entities a passing grade for their efforts with novice investors a generation ago (as I did in the passage directly above) but only a marginal pass for their work with intermediate investors today?

The answer is that these groups have become weaker. To be sure, full-service firms remain powerful--but as they have solidified their control of the wealthy investor, they have lost some of their grip on the intermediates. Dean Witter no longer has brokers sitting in Sears, and the banks are quieter. As for no-load funds, long gone are the days where a cover story on a star manager would ring the sales bell.

The 401(k) plan is a solid foundation. However, most Americans will wish they possessed more at the time of retirement.

4) Gamma: Pass. The top of the investment pyramid has never been better served. Educational programs aimed at financial advisors have expanded; the move from selling investments for commissions to collecting asset-based fees has better aligned advisors' goals with those of their customers (that said, there are some positives associated with the old system); and the cost of advice has been declining, albeit only modestly.

For those investors who do not desire full service for their investment advice, the Internet provides information and tools that were until recently the province only of professionals. They, too, have never seen better days.

Summary Broadly speaking, investment advice succeeds with the upper class, fails the middle class, and bypasses the lower class. That, to be sure, is a whopper of a generalization. We could all recite stories of wealthy investors who were badly treated by poor advisors, middle-class employees who have managed their portfolios well, and lower-class workers who have participated in their companies' retirement plans. But, from 35,000 feet, that is the view.

How to improve the advice system is another, deeper matter. It strikes me that some combination of bricks and technology is required: storefronts to reach people in person, the Internet and telephones to extend that reach and lower the cost of delivery. Perhaps employers can play a greater role with the second and third steps. As they are now the likely home of the American worker's first investment, they are in a sense the logical party to educate and improve that novice investor.

But those are tangential thoughts, not more. The purpose of this column was to outline the gaps, not to fill them.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.