Morningstar Magazine - April/May 2018 - 32

Spotlight: Behavioral Finance

The Challenges of Advisors-as-Portfolio-Managers

Looking across the advising industry, we see
three major changes occurring:
1 The global expansion of advisor regulation,

with the Department of Labor's fiduciary
rule in the United States and MiFID II in the
European Union.
2 The "greater" wealth transfer of $30 trillion
in assets that will be passed down
within the next 30 to 40 years to the next
generation of investors-many of whom will
be millennials.1
3 The growth of robo-advisors, which are attracting
investors with lower fees, enhanced accessibility,
and low-cost portfolios.
Why do these changes matter for advisors
and the value they add for investors? Clearly, there
are implications for advisors' income. Robos
are driving down fees by making portfolio selection
a commodity (at least for standard scenarios
faced by most of the investing public). In addition,
millennials interact very differently with their
finances than do older generations. With easy
access to more information on the Internet,
and a tendency to look to it for guidance, younger
investors are more likely to form their own
strong opinions about the "right" investment
strategy, separate from their advisor, for good or
for ill. And finally, much of the attention in
global regulation is on the investment-selection
process. While this development is good
for investors in the long run, it complicates the
process for advisors in the meantime.
Despite these changes, what remains unchanged
is the psychology of investing: the common
behavioral obstacles that investors face due to the
quirks of the mind. These biases can't be
regulated away or completely solved by technology.
But they can be coached and managed. The
role of the advisor as a behavioral coach is one
of the most valuable contributions advisors
can bring today to the advisor-client relationship.

The Impact of Behavioral Coaching
In 2001, Vanguard began studying the concept

Behavioral Teacher: Focus on the Psychology
of the Mind

of the "advisor's alpha"-the value advisors bring
to clients-and has conducted a series of
studies over the years to quantify it. In its 2016
study, Vanguard found that the single
most impactful service an advisor can offer
clients is behavioral coaching.2 According
to the study, behavioral coaching alone,
on average, added about 150 basis points to
clients' portfolios.

The first thing that may come to mind when
thinking about how to help clients manage their
finances is financial literacy: the teaching of
fundamental investing concepts such as the time
value of money and compound interest.
Industry professionals and policymakers have
traditionally relied on this approach to improve
investors' day-to-day financial behavior.
However, as Sarah Newcomb details in "Stop
Teaching, Start Coaching" (Page 34), the approach
may not be effective. Newcomb cites, for
example, compelling research by Fernandes et al.
on the relationship between financial literacy
and financial behaviors.3 They found that financial
education has a negligible effect on people's
subsequent financial behaviors, only explaining
0.1% of the variance in financial outcomes
participants experienced. Moreover, this small
effect diminished over a matter of months.

Simply helping clients mitigate their biases
had a greater effect on clients than any other
service, such as rebalancing, being costeffective, and asset-location strategies. Stephen
Wendel writes more about the Vanguard
study in "Coaching to Mitigate Panic" (Page 37).
Although more industry professionals are
beginning to appreciate the value of behavioral
finance, investors rarely have the same
level of expertise. Most investors do not seem
to understand the impact their biases can
have on their finances, nor do they have practical
ways to counteract the effects. Without the
guidance of a behavioral coach, many investors
are at the mercy of their own emotions.
What This New Job Description Means
for Advisors

For many advisors, acting as a behavioral
coach isn't new. Even without using the term,
some of the best advisors incorporate wise
and impactful techniques in their practice to help
their clients overcome common behavioral
obstacles. However, for those advisors who are
new to the practice, and for those who are looking
to incorporate new techniques, let's break
behavioral coaching down into three main roles
advisors can play for their clients:
1 Behavioral teacher
2 Behavioral trainer
3 Behavioral counselor

Instead, advisors should serve as behavioral
teachers. A behavioral teacher educates clients
about the psychology of investing and how
common biases may affect their financial behavior.
A good way to begin this conversation is
to talk about how our minds work. According to
the research, our brains have two relatively distinct
modes of thinking-a reactive "System 1"
and deliberative "System 2."4 Reactive System 1
thinking operates quickly in an unconscious,
intuitive way, while our deliberative System 2
operates slowly in a logical, rational way. We use
both systems to navigate through our daily lives.
For example, we use reactive thinking when
driving to a familiar place such as to our jobs. We
rarely think carefully about the hundreds
of minute decisions we make while driving; it just
happens intuitively. In contrast, we activate
deliberative thinking when calculating complex
mathematical problems or making serious
decisions like purchasing a house. Deliberative
thinking is effortful and requires concentration.

1 Pigliucci, A., Thompson, K., & Halverson, M. 2015. "The 'Greater' Wealth Transfer." Accenture.
2 Kinniry Jr., F.M., Jaconetti, C.M., DiJoseph, M.A., Zilbering, Y., & Bennyhoff, D.G. 2016. "Putting a Value on Your Value: Quantifying Vanguard Advisor's Alpha." Vanguard white paper, September.
3 Fernandes, D., Lynch, J., & Netemeyer, R. 2014. "Financial Literacy, Financial Education, and Downstream Financial Behaviors." Management Science, Vol. 60, No. 8, pp. 1861-1883.
4 For example, see Kahneman, D. 2011. Thinking Fast and Slow. New York: Farrar, Straus and Giroux.

Morningstar April/May 2018

Table of Contents for the Digital Edition of Morningstar Magazine - April/May 2018