What Training does your advisor have in Retirement Financial Planing?
First, let's review the basics of what your financial advisor knows about retirement investing or simply investing in general. It is not required that a financial advisor have a college education or even a high school education. To be a financial advisor, one must only pass the series 7 exam which is permission to sell securities for commission. The second requirement is to be hired by a broker dealer, a firm that has a license to deal in securities. Since the broker-dealer's goal is to maximize profits, they are interested in hiring great salespeople, not necessarily great financial advisors.
Passing the series 7 exam proves nothing about one's ability to advise people about their finances. The exam tests a bunch of arcane rules made up by the Financial Regulatory Authority (FINRA) which have little to do with making you money. In fact, FINRA, the body that is supposedly protects you when investing in securities, is only interested in the fairness of the sales process, not that the advice is good. Therefore, it is quite possible that your financial advisor has gained their advising knowledge from reading the Wall Street Journal and listening to the other brokers in their office.
Even those that have some basic training, say a college degree in economics or finance, are often not very good advisors. The reason being is that they are immersed in a sales culture. This culture pushes them to sell products and services which are not necessarily the best for you but because your advisor does not have much of a financial background, he cannot distinguish between what's good and what's bad. Most advisors unfortunately have very little background or refined knowledge necessary to advise you well.
Does Your financial advisor focus on the wrong things?
People who sell securities or manage portfolios are fixated on prices of those securities. That fixation could be on the price of your stocks, your bonds or your mutual funds. This is also where you are fixated. But have you noticed that prices cannot be forecasted? And the guy you see on CNBC who says he knows where the stock market is going is either a liar or just a damn fool. Some of the greatest investors of my lifetime, Peter Lynch and Warren Buffett, readily admit that they have no ability to forecast the stock market. If these uncommonly astute and outrageously successful investors can't forecast the market, I assure you that neither can your financial advisor or anyone at his firm. Therefore, whatever the analysts a your advisor's firm say about price movements and interest rates, GDP, stock market direction -- it's all a bunch of nonsense to which you bought in. Shame on you.
You'll remember in a previous paragraph I stated that FINRA has the job of protecting you in your investment dealings. One of those protections is to make sure that information you receive in writing fully discloses the risks. Every time a past return of a particular product or investment is mentioned, FINRA requires that it is followed by words such as "past performance is not a guarantee of future results." And this is an accurate disclosure because as stated already, prices cannot be forecasted. What no one has ever told you is that while prices cannot be forecasted, risk can be forecasted.
Understanding Risk (even some financial advisors don't understand it)
Let's first define what we mean by risk. Risk simply means volatility or choppiness in the movement of a price. So while the direction of a security's price cannot be forecasted, the choppiness of the price can be forecasted.
Visual Representation of Risk
In the above chart, Investment B is the most risky because it is the most "choppy" and you have a higher probability of losing (or making) money. Next would be Investment A of the scale of risk. The least risky is Investment C as its price has remained in the narrow range from 2 to 3.
Would it be valuable for you to know when a security you own is in a particularly choppy as opposed to a particularly calm (since risk profiles can change over time)? That can be discerned but few advisors ever look there. Let's take an example and see why this information is valuable to you.
Above is a chart showing you the price of the Standard & Poor's 500 index over a 13 year period from 1990 through 2013 (the blue line) and the volatility or choppiness index of the S&P 500 (the orange line).
Risk can be Accurately Forecasted
Notice that if you were at any place on the blue line, it would be impossible to know if the price will continue up from where you are or if it'll continue down or just move sideways because prices can't be forecasted. However, what if you were somewhere on the orange line? With great confidence you could tell me the following: that when the orange line gets close to 10 it is low (see the scale on the left side). And when the orange line gets above 40, it is high. You will notice that almost never over this 13-year period did the choppiness index, more accurately call the VIX, go above 40 or go below 10.
Additionally you may notice that at the times when the VIX did exceed 40, it was a signal that the S&P 500 rose from that point in time. So while prices of different securities gyrate and cannot be forecasted, we see that the risk profile of a given security or in this case, a stock index, can be accurately forecasted in that we know it hardly ever exceeds or dips below certain levels. So why does your financial advisor focus on price rather than this risk profile which is far more certain? The only answer I have is that he doesn't know any better.
While we do not have a model of an easy way to build portfolios around this idea (or at least a model that would be easy for your financial advisor to understand and use), we do know that the simplistic answer of advisors to "just diversify" is usually a recommendation that helps them sell you more stuff. And because the various securities he sells you have different risk profiles at different times (e.g. the risk of owning bond mutual funds is much higher when interest rates are close to zero as they are now), the portfolio that may have been "diversified" is hardly diversified in any systematic way to reduce your risk as time passes. And this is why, even though you have a supposedly diversified portfolio, everything in that portfolio can decline or rise at once.