Morningstar Advisor - April/May 2010 - 11

Behavior Gap

Our Job: Building Better Investors
By Carl Richards
A while back, I started a blog called Behavior Gap. It sprang from a statistic in the annual Dalbar report: The average investor’s return is dramatically lower than the average mutual fund’s return. It’s not an exaggeration to say that this piece of information changed the way I do business—and it certainly changed what I think about the nature of a financial planner’s job. If it’s true that real people pretty dramatically underperform the average investment, then maybe my job as a financial advisor is not so much about finding the best investment. Maybe it’s about helping people become better investors. Placing investors over investments would be a dramatic shift for our industry. As advisors, we seem to be totally consumed with the idea that our job is to find the best investments. But what if the importance of finding the best investments pales in comparison with helping investors behave correctly? If that’s the case—and I think it is—then the most important thing we can do is improve the way clients act. So maybe we’re no longer in an arms race over who has the biggest computers and the best analysts who find the best investments. Maybe it’s indeed true that if our clients owned a mediocre investment and behaved correctly, they would outperform most of their neighbors. Think about this: The debates that so many advisors obsess over—say, whether to use actively or passively managed funds—only matter to the degree that they influence our clients’ behavior. So maybe we shouldn’t be asking whether we believe in passive or active management. Instead, what if we viewed this question, and others like it, through the lens of behavior? It would mean that there’s no right answer. There’s no wrong answer. Instead, the “right” choice would be the one that you and your clients believe will positively influence their behavior. A big part of that means staying true to our own philosophies. If I’m an advisor who believes in passive management, for example, I better be darn sure that I really believe it. Only when I really believe it will I be able to inspire the trust clients need in order to avoid the classic behavioral mistakes. That may mean that not every client is going to fit into my belief system. And if a potential client falls outside of it, I’d be doing myself and that client a disservice to take him on: I’m not going to be able to provide the advice he needs at just the moment he needs it. But the ones who do fit into my belief system will trust me. And that means that when they’re required to behave correctly—even when it’s hard—I’ll have developed the trust to help them do it. So many of our industry’s tools and communication pieces aim to present a logical set of facts to try to convince people that they should act one way or another. But behaving correctly is, at the core, an emotional issue: Real people in the real world often behave in what might seem an irrational way. And you can’t solve an emotional issue by throwing facts and figures at it. Instead, you’ve got to figure out what tools will make the greatest impact on behavior. And they’re not always the ones that show up on a spreadsheet. For example, in many cases it’s empirically true that adding alternative investments to a portfolio will reduce risk and increase returns. But if it also adds complexity and headline risk with which your client isn’t comfortable, it’s going to be difficult to inspire the client to stay the course when times are tough. Here’s why: We are genetically wired to get away from things that cause us pain. We’re wired to want more things that create pleasure, safety, or security. Everyone knows on a theoretical level that selling low and buying high is a bad idea, right? But when tough times come, we just want to get away from the pain. And throwing facts and figures at an emotional problem like that is like trying to put out a grease fire with water: It just makes it worse. So we can educate clients until we’re blue in the face. But in the end, all that matters is that they trust us. And the depth of that trust is a function of the quality of the time we spend together. If this is the case, does it change how you do business? It did for me. K
Carl Richards believes that the world is a better place when people make smarter decisions about their money. That’s just one of the big ideas he promotes at BehaviorGap.com, where Richards asks tough questions about financial planning and investor behavior. Richards puts his ideas to work in the real world through his firm, Prasada Capital Management.

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Morningstar Advisor - April/May 2010

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