Earlier last week, the Department of Justice did not petition the Supreme Court to challenge the US Court of Appeals for the 5th Circuit Court’s decision to vacate the Department of Labor’s long anticipated “fiduciary responsibility” rule, effectively turning back the clock 2 1/2 years and unwinding years of work by the DOL regulating-restricting-directing financial advisors to act in clients’ best interest when managing qualified retirement accounts. While many firms are now breathing a heavy sigh of relief, the reversal of this decision will have no material impact on the direction of the industry. Acting in clients’ best interest whether it be qualified or unqualified accounts is well underway.
Underperformance
For years now, DALBAR has tracked and reported consistent investor underperformance against fixed and equity market indexes. In its more recent “Quantitative Analysis of Investor Behavior” published in April, equity investor underperformed the S&P Index by 191-basis points over the last 20 years. While that gap is significant, it pales in comparison to the 416-basis point gap that fixed investors underperformed the Barclays Aggregate Bond Index over the same time period. For 24 years in a row now, both equity and fixed income investors have consistently lagged their respective market index by significant margins. The only explanation is bad investor behavior; buying and selling their investments at the wrong time.
Investors haven’t achieved this consistent level of underperformance all on their own. For decades, financial advisors and financial services firms have sold to the consumer what is emotionally easiest for them to buy. How can I make that claim? When is it easiest to sell an equity? When the market is rising. When is it easiest to sell a fixed asset? When the market is tanking. It’s not the asset class that creates the problem. It’s the use of the asset class that creates the issue of underperformance. Consumers are waking up to the fact that while their financial advisor may be winning, they’re losing.
Managing Emotions: The Triple Win
I entered the industry as a new financial advisor in 1985. Back then financial planning was the new cutting-edge tool in the industry. Planning helped clients be better investors because they now had longer term goals with defined time horizons. It also incented them to save more money if they weren’t on track for their goals. The net result was clients saved and invested more, advisors as a result also made more commission and their firm had more assets to manage. This was the “triple win”.
Since then we’ve realized that many of the fundamental tools of financial planning, while necessary, are no longer sufficient. Why? Because investors aren’t rational. They act on emotion too often and when they do, it contributes mightily to their underperformance. Tools like Modern Portfolio Theory, asset allocation and Monte Carlo simulation don’t account for investors getting emotional with their money.
Behavioral finance helps us understand why that happens; that between our emotional reflexivity and psychological decision-making-pitfalls we have a tendency to make poor choices often. Industry leading financial advisors here in the US, Canada and around the world are now equipping themselves with the tools and skills to recognize and manage client emotion. These new tools when used effectively, enable clients to make better investment decisions and create an even more powerful value proposition for the advisor. By acting rationally, clients have more assets by improving their return on those assets. Advisors and their firms leveraging the powerful tools of Behavioral Financial Advice, exercise their fiduciary responsibility by acting in clients’ best interest, have more money to manage and therefore, generate more revenue.
