How can you Evaluate the Performance of an Investment Advisor?

While there are many factors that make a good investment advisor, expected performance is a central one. Many choose an advisor that had good performance in recent years. While easy to evaluate, it can lead them to a choice that is even worse than a random selection, since there is often a negative correlation between the past 5-year returns and the next 5-year returns (relative to a benchmark or the long-term average). Here are some steps for a more educated evaluation of performance:

  1. Repeatable performance: Identify repeatable factors, for example (for stocks): US/developed/emerging markets, size, value/growth, profitability.
  2. Statistically Significant Horizons: Evaluate at least 30 years for stocks, and longer for bonds, to get statistical significance. Since most investment vehicles and advisors didn’t operate for this long, you usually have to depend on simulated data, using indexes in the same categories. While not perfectly accurate, it is far better than using statistically insignificant data from the past 5 or 10 years.
  3. Deduct Fees: Deduct the advisor’s fees from any performance presented to you (both live & simulated), if not done already.
  4. Discipline: Check the track record of the advisor’s discipline, by asking about changes to the allocations that were later reverted. Reverted changes are often a sign of market timing, and often (but not always) result in buying high and selling low. Make sure to ask how the advisor behaved at extreme points (the peak of 10/2007 and the bottom of 3/2009 are great examples). In some cases the advisor’s behavior can hurt the returns by more than a number of other factors combined.
  5. Risk Analysis: Just like discipline, a portfolio that is too risky may work on paper, but fail in real life. There is no investment that is 100% safe under all circumstances (picture a 100% short-term government bond allocation subject to retirement withdrawals at times of high inflation). A good advisor would structure your plan to protect you from the highest risks, leading to a high likelihood of success, given your goals and needs.
Disclosures Including Backtested Performance Data