Journal of Financial Planning: December 2017
A client fires his financial adviser because his returns lag the market and the returns of his best friend.
An adviser constructs portfolios from low-cost index funds, and his clients question why he trades so infrequently—only once a quarter when he rebalances portfolios.
An organizer of a conference for financial advisers asks a speaker to refer to the advisers in attendance as “wealth managers,” not “financial advisers.”
An adviser argues that robo-advisers can never replace human advisers.
These are four of the markers of the financial advising landscape; they represent four challenges financial advisers face. The first marker indicates that some clients see beating the market as the primary service of financial advisers. The second indicates that some clients wonder what advisers do for the fees they charge and sometimes question the fairness of these fees. The third indicates that some advisers are insecure about their roles and the titles that commonly describe them. And the fourth indicates that advisers are aware of the challenges posed by robo-advisers, even as they try to dismiss them.
I argue that advisers can meet these challenges by becoming well-being advisers, a role that is rooted in the second generation of behavioral finance, distinct from both standard finance and the first generation of behavioral finance.
Standard finance says that investors’ wants are “rational” wants, restricted to the utilitarian benefits of high expected returns and low risk. The first generation of behavioral finance largely accepted standard finance’s notion that investors’ wants are rational, but described actual investors as irrational and offered methods for correcting cognitive and emotional errors.
The second generation of behavioral finance [see Meir Statman’s 2017 book Finance for Normal People: How Investors and Markets Behave] describes investors, and people more generally, as normal, distinguishing normal wants from cognitive and emotional errors, and providing guidance on avoiding errors on the way to satisfying wants.
Lottery tickets can illustrate the difference between standard finance and the first and second generations of behavioral finance. The rational people of standard finance never buy lottery tickets because their expected returns are low and risk is high. The irrational people of the first generation of behavioral finance buy lottery tickets because cognitive and emotional errors mislead them into exaggerating the odds of winning. Yet a lottery ticket provides the normal people of the second generation of behavioral finance with the expressive benefits of being players with a chance of winning, the emotional benefits of the hope of winning, and the miniscule chance of the utilitarian benefits of vast wealth if they win.
The second generation of behavioral finance guides advisers to become well-being advisers. Well-being advisers identify clients’ wants, and help clients assess those wants, balance them, and avoid cognitive and emotional errors on the way to satisfying them.
Advisers face three kinds of challenges as they adapt to become well-being advisers. One centers on their perception of themselves, another on the expectations of their clients, and a third on their competitive environment.
Advisers’ Perception of Themselves
Some advisers resist the change from attempting to deliver “return alpha” to delivering “well-being” because it is at odds with their perceptions of themselves and their skills. They prefer to manage investments than manage investors, taking more pride in their numbers skills than their people skills. Such advisers are akin to some surgeons who take pride in their surgical skills and prefer limiting interactions with patients to the operating room.
Well-being advisers, in contrast, are akin to family physicians who pride themselves on both their medical skills and their people skills. They enhance the well-being of their patients by getting to know them; they ask about their wants and fears, listen carefully, probe gently for more information when necessary, empathize with patients’ wants and fears even when they do not share them, educate patients about their wants and fears, prescribe medicines and surgery when necessary, and dissuade patients from medicines and surgery when not necessary.
Surgeons are generally paid more than family physicians and some would say surgeons hold higher social status. Patients generally consider these pay and status disparities fair, because surgeons perform “procedures” whereas family physicians mostly listen and talk. Similarly, “wealth managers” performing return-alpha and trading procedures may expect to be paid more than “financial advisers,” and may hold higher social status. This pay and status disparity diminishes the incentives of wealth managers to become well-being advisers. In my experience, many wealth managers resent being called “financial advisers” and bristle at being confused with “financial planners.”
Client Expectations
Clients whose advisers construct portfolios from index funds are presumably persuaded that neither money managers nor advisers can deliver “return alpha,” yet they wonder what “procedures” advisers perform for them, frustrating advisers who know that trading is perceived as a worthy procedure, yet also know that frequent trading is more likely to diminish returns than enhance them.
Some clients have financial wants that are socially acceptable, even laudable. These include the wants listed by SEI (seic.com) as the most important: financial security, helping children become successful, educating children, and helping the less fortunate. But advisers must wonder whether clients truly consider wants for “helping the less fortunate” more important than the wants they place at the bottom of the list: as a barometer of my success, and increasing my social status.
Well-being advisers listen carefully and probe gently for wants that clients are embarrassed to admit. And they help clients trade off and balance wants. For example, a well-being adviser would note that “helping the less fortunate” by contributions to charity can serve as a better “barometer of success” than wealth itself, even as it detracts from wealth and perhaps even from “financial security.”
Well-being advisers are challenged by many clients’ expectations for satisfying conflicting wants without sacrificing any. This is exemplified by methods whereby tax savings accompanying charitable contributions exceed actual contributions, by the insistence of advisers that they can satisfy wants for staying true to values (whether environmental, social, or religious) without sacrificing returns, and by practices whereby alternative investments that enhance social status with their exclusivity are promoted as increasing returns. Advisers respond to these challenges by appealing to particular groups of investors. For example, exclusive investments such as hedge funds and private equity enhance the status of advisers who have access to them and serve as a draw for status-seeking clients.
Competitive Environment
A major part of the competitive environment for financial advisers is the rise of fintech—in particular, the automated investing of robo-advisers. For many years, advisers emphasized their unique contributions to portfolio asset allocation, proud to note that asset allocation is more important in investment success than security selection or market timing. Yet robo-advisers provide asset allocation and much more. Indeed, robo-advisers automate many of the functions of Vanguard’s “adviser’s alpha” and Morningstar’s “gamma,” including portfolio rebalancing and tax harvesting. Moreover, robo-advisers often provide education and tools for overcoming cognitive and emotional errors. For example, investors tempted to chase returns are discouraged from trading by reminders of the extra taxes they will pay if they trade.
Another part of the competitive environment is the increasing realization among investors that passive investment strategies with low-cost index funds and ETFs increase wealth, on average, more than active strategies employed by some advisers. The competitive pressures of robo-advisers are interacting with the investor realization that passive investment strategies may be optimal, exemplified by the fact that many robo-advisers employ passive low-cost index funds and ETFs.
Yet another part of the competitive environment facing financial advisers is the low barrier to entry into their ranks. Advisers do not enjoy the licensing or even certification barriers that limit competition among physicians, lawyers, and accountants. For example, clients and prospects may not perceive a difference between the Chartered Financial Analyst (CFA) certification and the Certified Financial Planner (CFP®) certification, and these are only two in a confusing alphabet soup of certifications.
Competition will continue to weigh down on adviser fees. In a long-ago era, brokers employed “fee for service” pricing, charging for each trade “procedure,” claiming that they bolstered returns by smart trading and enjoying high fees by a cartel agreement that limited competition by fixed commissions. Eliminating cartel pricing turned brokers into advisers who charge fees as a percentage, sometimes exceeding 1 percent, of client accounts. Robo-advisers, however, charge approximately 0.25 percent for services encompassing “adviser’s alpha” and “gamma.” The head of one robo-adviser once described its goal as doing to advisers what the Internet did to travel agents; travel agents remain, but there are fewer of them and their scope of services changed, coming closer to “well-being travel agents” by tailoring travel to fit the individual wants of travelers.
Conclusion
Wealth is only a way station to well-being, where wants are satisfied by the full range of utilitarian, expressive, and emotional benefits. Wants vary from person to person, and so do benefits, costs, and trade-offs.
Well-being advisers enhance clients’ well-being by exploring clients’ wants, educating them about trade-offs among wants, and helping them satisfy wants while avoiding cognitive and emotional errors.
Meir Statman, Ph.D., is the Glenn Klimek Professor of Finance at Santa Clara University and author of Finance for Normal People: How Investors and Markets Behave. His research focuses on behavioral finance.