Seeking advisor alpha

The best investment advisors can add value to your investment decisions. Research in this area has shown that the difference in returns between an advisor-managed portfolio and a self-managed portfolio can be significant, referred to as advisor alpha. That does not mean that you must hire an investment advisor to manage your investments. Two factors are relevant in this regard. One, if you decide to invest in passive funds, an investment advisor may not add significant value. This is because your investments are likely to be through systematic investment plans (SIPs) for the time horizon for a life goal. The appropriate benchmark could be a large-cap index (NSE 100 Index) or a broad-cap index (NSE 500 Index). Selecting an index fund or an ETF on a benchmark does not require much expertise. And two, if you have the time and expertise, are you inclined to managing your own investments? If not, seeking an investment advisor is optimal.

That said, the outcome of an investment decision is determined by both skill and luck. This is because collective human behaviour drives asset prices, determining whether your investments have positive or negative returns or whether they generate more returns than a benchmark index. That means advisor alpha is a function of both skill and luck.

Conclusion

When you hire an advisor, your objective is to seek consistent (advisor) alpha returns. The more consistent the advisor alpha is, the more you can believe that the advisor’s skill, not luck, drives investment performance. Importantly, ensure that you understand how your investment portfolio is likely to be managed (advised); it is easy to fault an investment advisor when the performance of your investment portfolio does not match your expectations. Also, understand that your advisor can only determine your risk tolerance level- the level at which losses in the future, if any, can cause emotional and financial pain for you. Your loss tolerance is likely to be lower- your actual threshold level of pain when investment losses materialize. You must be mindful that the difference between your risk tolerance and loss tolerance levels could have a bearing on your asset allocation.

(The author offers training programs for individuals to manage their personal investments)