Journal of Financial Planning: October 2018
Richard Jakotowicz, CFP®, CFA, is the director of the financial planning and wealth management program at the University of Delaware. He is also president of Benchmark Financial LLC.
I first heard of the O-ring theory of economic development from an economics professor in college. The theory gets its name from the 1986 Space Shuttle Challenger disaster that was caused by a simple rubber O-ring failing to make a tight seal. O-ring theory proposes that certain functions have multiple processes that must work together without error for the product to reach full value. Like many things we learned in school, the theory went in one ear and out the other.
But I was recently reminded of the theory as I read the book, The Numbers Game: Why Everything You Know About Soccer Is Wrong. (If you liked Moneyball or Freakonomics, you’ll probably like this book, too.) The authors, Chris Anderson—a former professional soccer player, and David Sally—an economist, use statistics to think about what matters more in soccer: how good your best player is, or how good your worst player is?
It turns out that in soccer, what matters most is how good your worst player is. If you want a winning soccer team, allocate resources to improving the worst player rather than improving the best player. Soccer is a sport where the team is only as good as its weakest player.
The implications of their research caused me to consider our profession. As financial planners, are we playing a weak link or strong link game?
Weak Link
Why do Anderson and Sally propose that soccer is a weak link sport? Soccer relies on every player doing their job well and working together. They can’t afford to make mistakes. If there are five perfect passes moving the ball down the field followed by one bad pass, it’s as if the good passes never happened. In a weak link sport like soccer, you want to focus on recruiting 11 above-average players who minimize mistakes. In games where the final score is often 2–3, one little mistake can be the difference between winning and losing. This is O-ring theory applied to sport.
Their research found that if the top teams in Europe upgraded their worst players instead of their best players, they would score more goals. Upgrading your No. 1 player certainly helps, but upgrading your No. 11 player helps much more in a weak link sport. From a pure finance perspective, the cost to pay 11 above-average players may be the same as the cost of paying 10 average players plus $40 million for Lionel Messi. However, the team with 11 above-average players will score more goals by minimizing errors. Despite this research, many soccer teams pay a premium to recruit superstar players like Messi. Why? The authors suggest the superstar is more glamorous, sells more T-shirts, creates more exciting plays, and so on.
Strong Link
The perfect contrast is basketball, a strong link sport. In basketball, if four of the players are simply average but the fifth player is LeBron James, LeBron will still score. Given the nature of the sport of basketball, the mistakes of a weak player are not as costly as in soccer. In a strong link sport like basketball, you gain more points by upgrading your No. 1 player rather than your No. 5 player.
A basketball team is as good as its strongest player. In basketball, it makes sense to spend $30 million to get LeBron James on your team, because he can single-handedly take the ball from one end of the court to the other and score. In soccer, Lionel Messi relies on his team to successfully move the ball down the field so that he can score the goal.
Applying This to Financial Planning
Let’s consider weak link and strong link theory in the context of financial planning. At the highest level, we can think of six players in the financial plan: ethics, taxes, insurance, investments, retirement, and estate planning. A mistake in any of these categories could spell disaster for our clients.
Financial planning is similar to a weak link sport, and we should consider O-ring theory. We can’t afford to make a simple mistake in a part of the plan when other parts of the plan are dependent.
Here is a similar comparison to soccer: all parts of the financial plan need to work together for our clients to achieve their goals. For example, we try to minimize taxes to save more money, then use that money to protect our clients with insurance and invest to get to retirement. But what if we simply overlooked the fact that the client was previously married and never updated the beneficiary of their IRA to the new spouse? If our client were to die, would it matter that we saved taxes or picked the best investments? No! The ex-spouse would inherit everything. A financial plan is only as good as its weakest link.
Yet, it appears that some of us have been employing a strong link strategy.
Many of us, myself included, allocate resources toward the pursuit of the best active fund managers. In other words, we are paying for Lionel Messi to be on our team of fund managers. What if at the end of the year we end up with one superstar fund that significantly outperformed, and the rest of the funds were average or underperformed? Would we be better off with a portfolio of average funds? Using index funds is a weak link strategy.
Another perspective is that while pursuing a superstar fund that could significantly outperform its benchmark adds value to the client, it doesn’t add as much value as the decision to own the fund in a tax-efficient account. The benefit of tax deferral exceeds the benefit of the 1 or 2 extra percentage points that the active mutual fund may generate. An investment strategy is only as good as its weakest link.
Last, consider weak link theory in the context of practice management. If you build a firm and have a specific budget, which of the following strategies has higher odds of success? Strategy 1 spends most of the budget to hire the superstar salesperson and then hire an average operations team and average client services team for support. Strategy 2 spends less to hire an above-average salesperson and uses the savings to then hire an above-average operations team and an above-average client services team who provide a better overall client experience.
Strategy 1 is strong link thinking; strategy 2 is weak link thinking. Although strategy 1 may result in acquiring more clients and high initial success, it also will result in losing more clients due to the operations and service experience. Strategy 2 allocates more resources to ensuring that once a client is acquired, they stay. Strategy 2 ensures there are no weak links in the firm.
It seems to me that to increase the odds of creating a successful financial plan and running a successful firm means we should execute a weak link strategy. We should allocate our resources in such a way that we ensure that there are no weak links in our models. Focusing on being above average across all measures should serve our clients better than the strategy that pursues one superstar measure.