What Hungry Investors Really Want from Their Financial Advisers
Meir Statman draws analogies between investor behavior and nutrition, in his book What Investors Really Want. For example, we all know that the best way to eat nutritious, low-cost meals is by dining on healthy food at home. But that’s just not fun for most of us: We’d much rather indulge in rich foods at expensive, fancy restaurants.
Investors want what Statman calls “utilitarian benefits.” We know that a diversified, low-cost portfolio is theoretically best, but we’d rather have the amusement and bragging rights of expensive, risky investments like hedge funds and specialized equity managers.
In keeping with the dining analogy, investment advisers are like waiters catering to the diverse appetites of their clients. Clients want their advisers (waiters) to guide them through their investment choices (menu selections). A successful financial adviser recognizes that the ingredients for satisfying clients are as follows:
- Menu: A successful waiter needs a good menu with tasty selections that serve a variety of palates. A successful financial consultant needs a variety of solutions that meet a wide range of investor needs.
- Selection: A successful waiter helps diners select something from the menu they will like. A successful consultant identifies client needs and matches them to a solution that will make them happy.
- Follow up: A successful waiter asks for feedback and makes changes as necessary. A successful financial consultant monitors progress toward the achievement of goals and recommends changes along the way.
Menu of Models
A tasty menu item has quality ingredients and is skillfully prepared. In investing, we create models, each designed for a specific type of investor. Risk is the quality ingredient, and packaging that risk to provide the highest return is the skillful preparation.
Most models start by identifying points on the efficient frontier, like the five points shown in the graph below. Each numbered portfolio theoretically provides the highest return for the indicated level of risk. Harry Markowitz won a Nobel Prize in 1990 for his theory of portfolio choice, recognized as the birth of modern portfolio theory (MPT). The efficient frontier is the centerpiece of MPT.
Most do not realize that another Nobel Prize-winning theory refines the efficient frontier. William F. Sharpe also won the Nobel in 1990 for his capital asset pricing model (CAPM), which demonstrates that risk control is best achieved with cash, among other things. As shown in the graph below, the capital market line, which blends the “market” with cash, dominates the efficient frontier by providing higher returns for the same level of risk. (It’s important to realize that the “market” in this context is the entire world of risky assets, not just the US stock market.) This represents a challenge, because we can’t know the real composition of the current market, but we can guess. Here is an example:
Example of a World Market Portfolio Estimate
Capital Asset Pricing Model (CAPM)
Other refinements to models are like the house specialties that set some restaurants apart. Models can be refined in two ways:
- Market views can adjust asset weightings — timing. For example, the current bond manipulation to zero interest argues for shorter duration bonds because there is no reward for taking duration risk.
- Active rather than passive managers can be used. Investors want active managers, and advisers want to give clients what they want, but it’s very difficult to identify skillful active managers. Advisers don’t want to spend the time, energy, and money that it takes to identify skill (as summarized in this infographic), so active managers who underperform are the norm.
Choosing a Model
Selecting a model is like placing a dinner order. There are three ways in which investors can choose:
- Risk-based is like the diner who asks the waiter for a recommendation. Investors don’t know their risk capacity. They want their advisers to tell them. Risk questionnaires can help, with the guidance of an adviser.
- Age-based uses a target date fund glide path to identify an appropriate asset mix. It’s like older diners ordering bland, soft food versus youngsters ordering the more exotic dishes.
- Goals-based uses a model that is expected to earn a return that will produce the desired objective. Calculators help advisers solve for the return that will match cash flows with targeted ending wealth. Then a model is selected that is expected to earn at least that desired return. Goals-based investors are like discriminating diners seeking a culinary treat. Even though they are the most challenging, they are also the most likely to appreciate good service.
Just as waiters help diners through the various courses of the meal, advisers help their clients navigate through phases of life, monitoring progress toward the achievement of objectives and making changes as necessary. We call this “portfolio navigation.” If we’ve exceeded expectations, we can save less (spend more) and/or reduce risk. If we’re trailing expectations, we can save more (spend less) and/or increase risk. Investors have choices.
Investors want to make money, just as diners want great food and great service. But both also want to have fun and brag about the experience. Successful advisers are like successful waiters: Both require three key competencies that, while easy to understand, are challenging to do right.
Now you know. Bon appétit!
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©iStockphoto.com/Hong Li
13 thoughts on “What Hungry Investors Really Want from Their Financial Advisers”
great article Ron.
Ron at the end of the day, older investors want liquid assets in retirement? do you disagree Statman also has advisors as physicians, treating their patients.
Hi Dr. Brody,
Older investors want to be safe. Liquidity is good at Happy Hour.
A physician analogy is too noble. Advisors have a few solutions looking for problems that fit. Physicians identify (diagnose) problems and craft solutions. The Hippocratic Oath of investment consulting should be “Protect my clients from undo investment losses.”
Some good analogies.
I also second Larry’s comments above. Treating clients like a patient means putting their interests first, even it if means encouraging them to do things which at the time may be uncomfortable.
To the original article, I find that while it’s true that most clients enjoy the idea of investing in more exotic portfolios, with some (and in actually fact, not much) counselling most accept the merits of pursuing an optimal asset allocation / tax structures (etc) even though this almost always results in a more “boring” looking portfolio.
I do understand, however, that many advisors feel pressured to offer more exotic alternatives so they can “stand out from the crowd”. In my experience many of these advisers do so primarily for the purpose of marketing themselves, and not for primary benefit of their client.
Financial Consultants draw guide a pathline of Investor’s success in achieving optimum returns over their Investment period.
What most clients want is to be the big winner. This is a natural biological drive for hierarchical social organization that provide real benefits like being able to get a better mate for yourself or your offspring increasing the likelihood of your genes being passed on.
The fact that most advisors are only good at making themselves rich usually at the expense of their clients – in part through recommending yet more advisors, aa when advisor A the financial planner recommends advisors B C D and E, the mutual funds in which his client should invest, which lick investments run by agents (the management) – is the reason most clients don’t do that well.
The real problem is that no one can “advise” you on how to be Mark Zuckerberg. To use your rather weak analogy, the waiter’s skill is about as good as the customers. Both can read the description and understand the menu. The waiter just uses experience (like long term geometric returns) to make guesses about the future (the appeal of the next helping of a dish) that are little better than the customers own reading of the menu.
Except that most investors can’t read/understand the menu. For many (read: most) it’s like trying to read a menu in a foreign language while you suffer from a severe peanut allergy.
In choosing your advisor you can select someone who is fluent in both your native and the foreign language (product specialists), someone who understands your dietary needs and aversions (asset & risk consultants, quants), or someone who considers both aspects of your situation.
As for clients wanting to “win big”, you’re right, however where it is likely to be at detriment to the client it can nearly always be overcome through discussion and explanation of the risk factors. If they reject this advice then it’s likely to be a difficult (or at least not a satisfying) relationship. In this case we will not accept them as a client.
Thanks for the comment, Joel.
I basically agree with your explanation of the ignorance of “investors”. In most cases, it is better to think of them as savers who are willing to accept some level of duration risk for higher yield. Most advice to retail “investors” amounts to the same set of arguments used to sell CDs once upon a time – but without the guarantee. The argument is, you need to accept duration risk to get higher returns.
Alas, the best guesses we have for the future performance of securities are past performance of securities, which are no guarantee that those returns can actually be obtained. Because the “investors” cannot understand the menu, they also cannot understand the limitations or the assumptions of the advice they are receiving. It’s a giant game of “trust me”, which is ok for a dinner (how much downside can there really be… in the end you can always order a pizza), but sort of different when talking about things like retirement.
Many financial advisors, I suspect, are guilty of overselling what they can do or understating the risks. Many of the benefits are intangible, which is what the author of the article was trying to say (he used “utility benefits” which sounds sort of redundant to me) and those are hard to sell, so they promise better returns, since who doesn’t want that?
It reminds me of the hedge fund manager who said I have to promise my (“sophisticated”) clients 20% or else they won’t invest with me.
Since that was a bit uncharitable, let me instead say something different. Most client advisors aren’t “money managers” they are client managers. They primarily create value by eliminating negative alpha: keeping clients from panicking and doing other stupid things.
These are not trivial benefits. But they are hard to sell to clients, because the implication is often – you are going to make alot of stupid mistakes. Now, admittedly, this is kind of how a good waiter works. He steers vegetarians away from meat dishes (regardless of how yummy they might be for other diners). Perhaps he makes sure that they get dishes with lots of protein in spite of lacking meat.
But at the same time, limiting underperformance is not the easiest sell (especially to clients who mostly want *outperformance*). Outperformance only comes from people who are truly superior at a few activities – fundamental research, ability to obtain financing on superior terms (PE), able to invest in non-public companies or to take companies private and to control operations and/or capital deployment within the business. Being able to make forecasts that are much less bad than average is also a factor. In that sense, I think most advisors aren’t really in that business, and so as you say, the relationship is likely to be difficult or unsatisfying.
My Approach would be to monitor the kitchen on a daily basis and to warn the waiter when the cook has his bad days eventually. This to enable him to warn the guest of quality fluctuations and to avoid disappointments which would, if happening too often, make the guests look for a different location. In the best case the waiter would even recommend a different location or try to replace the chef and what makes the waiter to become the trusted advisor to whom the guest will return irrespectiv where he works. By this the waiter will be the key for stable joy and keep the guest in the long run. Sometimes the waiters role can be assumed by a robot if processes are automized but the personal relationship will never fully disappear. This is somewhat our approach.
Doug for the win. How many waiter actually warn their customers that the veggies are old? Mostly if been advised to make moves. Finally, never did the warning come that the kitchen is about to tank. Learning to pay attention on my own time.
My biggest concern is with the concept of those who advertise themselves as an “advisor”, which in my research is NOT a term found in the Securities Act. The term found in the Securities Act is spelled “adviser”, and this article and comments, use both spellings.
That would be fine, (using two spellings) if you were legally assured that either spelling is considered the same. Yes, they are in the dictionary, but not so in the law.
In other countries (Canada for one) it has been found that brokers can earn more trust (and therefore more money) if they conceal their broker-type licenses (dealing rep is the term in Canada) and they can cheat the system just a little bit by calling themselves an “advisor” (which is a mere title, that anyone can use according to FINRA), rather than an “adviser”, which would mean they were breaking the law.
In the end, the public (and most investment industry experts) have no idea if there is a difference between an “advisor” and an “adviser”, and thus the clever companies get to have their cake and eat it too. They can earn the trust of the client, more easily, and not have to hold themselves to the fiduciary standard that the “adviser” licensed person must. Big commissions.
Does any of this make any sense? Does anyone have an interest in commenting upon the different terms, the FINRA explanations about there being two VERY different terms. The fiduciary duty of an “adviser”, verses the suitability duty of an “advisor”, etc.\
I am interested in dialogue with the aim to do serious research and debate into this topic. My own info sent to HBO’s John Oliver, and his 20 minutes production on this topic is found here for more background. Thanks for any dialogue. [email protected]
If that’s how it works in Canada that is very strange. Here in Australia it doesn’t really matter what you call yourself – adviser, advisor, financial consultant etc – they all come under the same regulation.
Ultimately it’s all about what you are doing (the service/advice you are providing), not what you decide to put on your business card.
TRUST!!!! That is a key word in Financial Planning. When Investing money TRUST is IMPERATIVE. What has worked for me over many years is starting off in Low Equity Funds so the client sees you are GROWING THE MONEY. Then once that has been accomplished the client TRUSTS you and now you can direct money to Higher Equity Funds still leaving a good portion of the clients money in the Low Equity Funds as assurance to the client. However the TIME that a client wants to be Invested has a profound influence on where and what to Invest in.