Financial advisors get a bad rap. Some deserve it; most don’t. The problem for the financial advisory community stems from the “career risk” they inevitably face.
63% of Americans Open to Using a Robo-Advisor – MagnifyMoney
This problem got highlighted in a recent survey of individual’s views of advisors by different generations.
“One hurdle financial professionals must overcome when working with Millennial clients is perception. Millennials feel advisors are more concerned with selling products than helping clients. Among those Millennials that do not work with an advisor there are a variety of reasons why. The most common reason was that 38 percent of Millennials feel they can do a better job of investing than a professional. Twenty-two percent of Millennials do not feel their advisor will look out for their best interests.
If you are a financial advisor and only offer a “buy and hold indexing strategy,” you already lost the battle. Individuals no longer need you for that. Such is especially the case during “market manias,” where gambling pays off more than proper investing.
Career Risk
In the short term, the pressure from clients on advisors to “chase performance” can be overwhelming. Such is why advisors push boundaries due to the risk of losing clients. To understand the challenges advisors face, you must understand the problem of “career risk.”
“Career risk is the probability of a negative outcome in your career due to action or inaction.”
The financial advisory business IS a business. The financial advisor must make sure clients are happy and satisfied; otherwise, they will leave. With the increasing use of technology in the financial system today, the ease of switching custodians, advisors, and managers is quick, painless, and cheap.
However, before you dump your advisor for another, you need to determine if the problem is the advisor or you.
Is It A “You” Problem?
Over the last 30+ years, I met with literally thousands of individuals. What is always fascinating is, more often than not, what individuals say they want is often far different from the eventual reality.
Let me explain.
Most individuals with serious money to invest most likely experienced a real “bear market” either in 2000, 2008, or both. That experience taught them the brutal lesson of “risk,” and it is something they “say” they want to avoid in the future. Such is also due to their “risk profile analysis” showing a “conservative” bias towards capital preservation.
It is not difficult to model a portfolio that maintains a lower risk profile relative to the market. However, it is crucial to understand that such an allocation will minimize drawdown risk and inherently underperform an all-equity index.
Such is where what individuals “say they want” and what they “emotionally” want tends to go awry.
While the individual was explicit during his engagement with the advisor that principal conservation was vital, they are troubled when the portfolio underperforms the all-equity index. With the financial media reporting index returns on a minute-by-minute basis, it is understandable that individuals get drawn to chase performance even though it deviates from their objectives.
It is at this juncture where “career risk” becomes problematic for advisors. To keep the client from “advisor hopping” to chase performance, the advisor increases portfolio risk to improve performance. However, the problem now becomes the risk of a lawsuit when the next downturn occurs. The client will sue and win over losses because the portfolio was outside of the prescribed risk tolerance.
See the problem here.
It’s A Comparison Problem
The issue is that individuals tend to misconstrue the role of the advisor. Individuals expect that the advisor has some capability to outperform a benchmark index and magically comply with financial risk tolerances and goals. However, the root of the problem inevitably stems back to the issues of comparison.
Comparison in the financial arena is why clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus. For example, if you tell a client their account increased 12%, they are happy. However, if you subsequently inform them that “everyone else” got 14%, now they are upset.
The entire construction of the financial services industry makes people upset. When they are upset, they tend to move their money around in a frenzy. Money in motion creates fees and commissions. Creating additional benchmarks, baskets, and style boxes does nothing more than increase “comparison anxiety.” Such allows clients to stay in a perpetual state of outrage.
Comparing your performance to an index is the most useless and potentially dangerous thing you can do as an investor.
However, the advisor gets trapped between trying to do what is “right” relative to the client’s stated “risk tolerance” and “keeping the client.”
Nevertheless, this brings up another point, “benchmarks aren’t real.”
Benchmarks Aren’t Real.
As noted, Wall Street created a multitude of benchmarks to give you something to chase. Like a greyhound at the race track chasing the mechanical rabbit. The dog will never catch it, but he tries every time the gates open.
The need to “compare” is a psychological need and part of the human condition. The “need to win” leads us into making decisions that ultimately have a cost.
However, the thing we are trying to “beat” is an “illusion.” Like a “Unicorn,” indexes are an illusion of mathematical calculations devoid of the many aspects of an actual portfolio.
1) The index contains no cash
2) It has no life expectancy requirements – but you do.
3) It does not have to compensate for distributions to meet living requirements – but you do.
4) It requires you to take on excess risk (potential for loss) to obtain equivalent performance – this is fine on the way up, but not on the way down.
5) It has no taxes, costs or other expenses associated with it – but you do.
6) It can substitute at no penalty – but you don’t.
7) It benefits from share buybacks – but you don’t.
The successful advisor must consistently coach clients on these differences and establish realistic goals and guidelines.
Do you see the differences? Yet, we all want the “Unicorn.”
The Problem Of Psychology
Every year, Dalbar Research does a study of retail investors. The studies continually show that retail investors consistently underperform markets due to a series of “behavioral biases.”
These biases lead equity investors to do worse than the index consistently.
Such is due primarily to the psychological pitfalls of “herding” to “confirmation bias.”
“When discussing investor behavior it is helpful to first understand the specific thoughts and actions that lead to poor decision-making. Investor behavior is not simply buying and selling at the wrong time, it is the psychological traps, triggers and misconceptions that cause investors to act irrationally. That irrationality leads to buying and selling at the wrong time, which leads to underperformance.” – Dalbar
Of course, since individuals don’t operate in a vacuum, where is the information coming from that promulgates these emotionally driven actions?
The financial media and Wall Street, of course.
Back to the issue of “comparisons” above, “Money in motion creates fees for Wall Street.”
What Should Advisors Do?
For advisors, the issue of “career risk” is an ever real and present danger. Such is why many advisors opt for simplistic ETF or mutual fund-based portfolios that track an index. The question then is, what are you paying for?
Knowing that clients are emotional and subject to market volatility, Dalbar suggests four practices to reduce harmful behaviors:
- Set Expectations Below Market Indices:
Set reasonable expectations and do not permit expectations to be inferred from historical records, market indexes, personal experiences or media coverage. The average investor cannot be above average. Investors should understand this fact and not judge the performance of their portfolio based on broad market indices. - Control Exposure to Risk:
Explicit, reasonable expectations should get set by agreeing on a goal that consists of a predetermined level of risk and expected return. Keeping the focus on the goal and the probability of its success will divert attention away from frequent fluctuations that lead to imprudent actions - Monitor Risk Tolerance:
Even when presented as alternatives, investors intuitively seek both capital preservation and capital appreciation. Risk tolerance is the proper alignment of an investor’s need for preservation and desire for capital appreciation. Determination of risk tolerance is highly complex and is not rational, homogenous nor stable. - Present forecasts in terms of probabilities:
Provide credible information by specifying probabilities or ranges that create the necessary sense of caution without negative effects. Measuring progress based on a statistical probability enables the investor to make a rational choice among investments based on the probability of reward.
When Must Advisors Take Action?
Dalbar’s data shows that the “cycle of loss” starts when investors abandon their investments, followed by remorse as the markets recover (sells low). Then, of course, the investor eventually re-enters the market when their confidence gets restored (buys high).
Preventing this cycle requires having a plan in place beforehand.
When markets decline, investors become fearful of total loss. Those fears get compounded by the barrage of media outlets that “fan the flames” of those fears. Advisors need to remain aware of client’s emotional behaviors and substantially reduce portfolio risk during major impact events while repeatedly delivering counter-messaging to keep clients focused on long-term strategies.
Dalbar notes that during impact events, messages delivered to clients should have three characteristics to be effective at calming emotional panic:
- Messages must get delivered at the time the fear is present. Statements made well before the investor experiences the event will not be effective. On the other hand, if the messages are too long after the fact, investors already made decisions and took actions difficult to reverse.
- Messages must relate directly to the event causing the fear. Providing generic messages such as the market has its ups and downs is of little use during a time of anxiety.
- Messages must assure recovery. Qualified statements regarding recovery tend to fuel fear instead of calming it.
Messages must ALSO present evidence that forms the basis for forecasting recovery. Credible and quotable data, analysis, and historical evidence can provide an answer to the investor when the pressure mounts to “just do something.” Providing “generic media commentary” with a litany of qualifiers to specific questions will likely fail to calm their fears.
Conclusion
An experienced advisor does more than “invest money in the market.” As professionals, their job is to provide counsel, planning, and stewardship of your financial capital. In addition, their job is to understand how individuals respond to impact events and get in front of them to plan, prepare and initiate an appropriate response.
Negative behaviors all have one trait in common. They lead investors to deviate from a sound investment strategy tailored to their goals, risk tolerance, and time horizon. The best way to ward off the aforementioned negative behaviors is to employ an approach that focuses on one’s goals and is not reactive to short-term market conditions.
The data shows that the average investor has not stayed invested for a long enough period to reap the market’s rewards for more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.
The reality is that the majority of advisors are ill-prepared for an impact event to occur. Such is particularly the case in late-stage bull market cycles where complacency runs high.
However, such is an opportunity for advisors to avoid “career risk” by being prepared in advance to:
- Respond to the event,
- Deliver clear messaging; and,
- Implement an action plan for both conserving investment capital and the eventual recovery.
These actions will limit the loss of clientele during the event and obtain new clients from advisors who failed to prepare.
You can stop getting trapped by “career risk.”
