Morningstar - Q3 2020 - 33

aversion in the planning process; risk reactivity is
far more important in understanding the most
impactful decisions people make. What advisors
should care about is not simply what someone
feels now about volatility, but what they are likely
to do when faced with that volatility in the future.
This third step yields insights to model which
people will be most prone to deviate from
their investment plan as markets sour. Reactivity
is a fuel of behavioral risk. The efforts to try
to time markets or chase returns can cost people
dearly; this is a well-known kind of self-inflicted
damage that erodes wealth accumulation. Barber
and Odean (2000) highlight the deleterious
effects of trading and show very clearly that the
investors who trade the least profit the most.
These conclusions have been reiterated by other
research (Dalbar, 2016; Kinnel, 2016), and they
highlight the persistent gap between investment
returns and investor returns (that is, what
investors could earn buying and holding compared
with what they actually earn given their trades).
Step 4: Maintenance to Stay on Course
A plan is only as good as its execution.
Good financial planning, which can include
behavioral coaching from attuned advisors, can
mitigate behavioral biases that undermine
performance. This requires ongoing support, which
is bolstered by two facets from the GoalsBased Risk approach.

First, when people check their portfolio, they are
often just trying to answer the simple question,
"How am I doing?" In answering that question, they
open themselves up to a host of decision biases
that may trigger rash changes in portfolios, much
to their own harm. To answer this question well
and to solve this behavioral challenge, it is
necessary to reply, "Compared with what?" Many
software solutions show investors the daily
performance of their portfolio's individual
investments, but this is not important to long-term
success and provides emotionally charged
noise (such as negative numbers in red) that may
induce anxiety and unwise trading behavior.
Better feedback would be a single number
that shows investors their updated probability of
reaching their long-term goals given their

investment strategy, contributions, and market
conditions. Goals serve as the lodestar for planning
and should remain in focus. When portfolio
performance is reported with the proper long-term
perspective, it damps noise and discourages
investors from checking their portfolios too often.
This is a good thing, as less-frequent looking
is beneficial to building wealth (Thaler, Tversky,
Kahneman, and Schwartz, 1997; Egan, 2014).
Second, people who score high in terms of risk
reactivity may benefit from special attention from a
financial advisor during periods of pronounced
market volatility. Knowing which clients are
the most sensitive to perturbations in value is
highly valuable to advisors, who can reach out to
these apprehensive investors and encourage
calmness. In conversations with nervous clients,
advisors can highlight the experiences of
Step 3 and remind people that, although the
present moment might feel rough, turbulence is
completely normal and expected in the due
course of investing intelligently and keeping on
track to reach long-term goals.
Balancing Wants and Constraints
Financial planning executed poorly introduces its
own risk. Planning risk can manifest itself in
two primary ways. First, potential investors could
make a plan that feels good but that will almost
certainly not achieve their financial goals.
Second, people could make a plan that would
achieve their goals if they could adhere to it,
but that proves too difficult to stick with. Planning
risk would be mitigated if people always felt what
they should feel in order to be successful
long-term investors. As this is obviously not so,
better planning requires effectively addressing and
integrating both what is financially necessary
and psychologically realistic for an investor. A good
plan is both plausible and palatable.

The Goals-Based Risk approach provides an
integrated and dynamic framework to use for
discussion with real people as they grapple with
making trade-offs and balancing important
wants with unavoidable constraints and market
realities. The framework addresses different
problems sequentially to build a solution. In doing
so, it improves the financial planning process.
The purpose of the Goals-Based Risk approach is

to improve the quality of financial planning,
bolster investors' risk resilience, and in
doing so, better help investors succeed and reach
their financial goals. K
Ryan O. Murphy, Ph.D., is head of decision sciences with
Morningstar Investment Management.
Stephen Wendel, Ph.D., is head of behavioral science
with Morningstar.
References
Barber, B.M., & Odean, T. 2000. "Trading Is Hazardous to
Your Wealth: The Common Stock Investment Performance
of Individual Investors." The Journal of Finance, Vol. 55,
No. 2, PP. 773-806
Blanchett, D., & Kaplan, P. 2013. "Alpha, Beta, and
Now ... Gamma." The Journal of Retirement, Vol. 1, No. 2,
PP. 29-45.
Blanchett, D. 2015. "The Value of Goals-Based Financial
Planning." Journal of Financial Planning, Vol. 28, No. 6.,
PP. 42-50.
Dalbar, Inc. 2016. Quantitative Analysis of Investor Behavior.
Boston, MA.
Egan, D. 2014. "High-Frequency Monitoring:
A Short-Sighted Behavior." Betterment, Sept. 16.
Kahneman, D. 2011. Thinking, Fast and Slow (London:
Macmillan).
Kahneman, D., & Tversky, A. 1979. "Prospect Theory:
An Analysis of Decision Under Risk." Econometrica, Vol. 47,
No. 2, PP. 263-292
Kinnel, R. 2016. "Mind the Gap 2016." Morningstar
White Paper.
Ratner, H. 2017. "Build Savings to Expand Wealth:
Contributions Have the Greatest Effect on Investors
Achieving Their Goals." Morningstar magazine, February/
March 2017, PP. 35-41.
Sironi, P. 2016. FinTech Innovation: From Robo-Advisors
to Goal Based Investing and Gamification (Chichester, U.K.:
John Wiley & Sons).
Thaler, R., Tversky, A., Kahneman, D., et al. 1997. "The
Effect of Myopia and Loss Aversion on Risk Taking:
An Experimental Test." The Quarterly Journal of Economics,
Vol. 112, No. 2, PP. 647-661.
Victor, B. 2013. "Media for Thinking the Unthinkable."
Talk at MIT's Media Laboratory, April 4.
Waring, M.B. 2004a. "Liability-Relative Investing."
The Journal of Portfolio Management, Vol. 30, No. 4, PP. 8.
Waring, M.B. 2004b. "Liability-Relative Investing II."
The Journal of Portfolio Management, Vol. 31, No 1, PP. 40.
Waring, M.B. 2004c. "Liability-Relative Strategic Asset
Allocation Policies." CFA Institute Conference Proceedings,
Vol. 2004, No. 6, PP. 43-63.

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