Better Than an Algorithm

By Ray Sin, Samantha Lamas, and Michael Leung With the rise of robo-advice, new regulations,and other changes, it often seems like thetraditional role of the advisor—particularly that ofportfolio manager—is under threat. We believe,however, that advisors are in an excellent positionto capitalize on these changes by building onlongstanding skills and roles. Being a good advisorhas always been more than selecting investmentsand managing portfolios. Psychology is anessential part of working with clients. To quoteBenjamin Graham, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”

As investors, we all have behavioral biases,such as overconfidence, confirmation bias,and loss aversion, that lead us astray whenmaking financial decisions. Advisors, however,are in a unique and powerful position tohelp their clients overcome these. To capitalizeon the changing landscape, advisors needto serve as behavioral coaches and helpclients navigate their biases and make morerational decisions. Advisors help investorscultivate good financial habits, stick totheir investment plans, and avoid emotionalresponses that affect behavior and underminelong-term success.

In this article, we will summarize the waysin which the best advisors already serveas behavioral coaches, and we’ll offer additionaltechniques to help advisors improve byapplying recent lessons from behavioral scienceto their practice.

The Challenges of Advisors-as-Portfolio-Managers Looking across the advising industry, we seethree 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 advisorsand the value they add for investors? Clearly, thereare implications for advisors’ income. Robosare driving down fees by making portfolio selectiona commodity (at least for standard scenariosfaced by most of the investing public). In addition,millennials interact very differently with theirfinances than do older generations. With easyaccess to more information on the Internet,and a tendency to look to it for guidance, youngerinvestors are more likely to form their ownstrong opinions about the “right” investmentstrategy, separate from their advisor, for good orfor ill. And finally, much of the attention inglobal regulation is on the investment-selectionprocess. While this development is goodfor investors in the long run, it complicates theprocess for advisors in the meantime.

Despite these changes, what remains unchangedis the psychology of investing: the commonbehavioral obstacles that investors face due to thequirks of the mind. These biases can’t beregulated away or completely solved by technology.But they can be coached and managed. Therole of the advisor as a behavioral coach is oneof the most valuable contributions advisorscan bring today to the advisor-client relationship.

The Impact of Behavioral Coaching In 2001, Vanguard began studying the conceptof the "advisor's alpha"—the value advisors bringto clients—and has conducted a series ofstudies over the years to quantify it. In its 2016study, Vanguard found that the singlemost impactful service an advisor can offerclients is behavioral coaching.[2] Accordingto the study, behavioral coaching alone,on average, added about 150 basis points toclients' portfolios.

Simply helping clients mitigate their biaseshad a greater effect on clients than any otherservice, such as rebalancing, being cost-effective,and asset-location strategies. StephenWendel writes more about the Vanguardstudy in "Coaching to Mitigate Panic".Although more industry professionals arebeginning to appreciate the value of behavioralfinance, investors rarely have the samelevel of expertise. Most investors do not seemto understand the impact their biases canhave on their finances, nor do they have practicalways to counteract the effects. Without theguidance of a behavioral coach, many investorsare at the mercy of their own emotions.

What This New Job Description Meansfor Advisors For many advisors, acting as a behavioralcoach isn't new. Even without using the term,some of the best advisors incorporate wiseand impactful techniques in their practice to helptheir clients overcome common behavioralobstacles. However, for those advisors who arenew to the practice, and for those who are lookingto incorporate new techniques, let's breakbehavioral coaching down into three main rolesadvisors can play for their clients:

1. Behavioral teacher
2. Behavioral trainer
3. Behavioral counselor

Behavioral Teacher: Focus on the Psychology of the Mind 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", 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. 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 isto talk about how our minds work. According tothe research, our brains have two relatively distinctmodes of thinking—a reactive “System 1”and deliberative “System 2.”[4] Reactive System 1thinking operates quickly in an unconscious,intuitive way, while our deliberative System 2operates slowly in a logical, rational way. We useboth systems to navigate through our daily lives.For example, we use reactive thinking whendriving to a familiar place such as to our jobs. Werarely think carefully about the hundredsof minute decisions we make while driving; it justhappens intuitively. In contrast, we activatedeliberative thinking when calculating complexmathematical problems or making seriousdecisions like purchasing a house. Deliberativethinking is effortful and requires concentration.

When investing, investors may, without realizing,evoke reactive thinking. For example, clients maybe so overwhelmed by investment optionsthey avoid taking any action to start investing(we call this choice paralysis).[5]As behavioral teachers, advisors help clientsrecognize the conditions under whichtheir reactive thinking is activated and nudge themtoward making more deliberate decisions.Research shows that helping people understandand recognize their biases improves decision-makingprocesses and that the effect persists atleast two months later.[6]In short, the teaching aspect of behavioralcoaching means educating clientsabout the psychology of investing—not justfinancial concepts.

Behavioral Trainer: Change the Environment,Not the Person As a behavioral trainer, advisors can establishan environment that supports their clients'success. Here's a familiar example to show whythis matters.

Let’s say John is a new client who says heplans to set aside 10% of his aftertax paycheck toa retirement account. In the first month, Johnsuccessfully invests 10% of his salary. However,over the subsequent months, John begins tofall short of his monthly goal—he either saves lessthan 10% or fails to put any money away.

Despite John’s good intention of saving more forretirement, something prevents him from followingthrough. This is what behavioral scientists call theintention-action gap, and it’s one of the mostcommon behavioral challenges that investors face.In fact, researchers estimate that only about halfthe time do our intentions translate into action.[7]

Some advisors may interpret John’s failure as apersonal shortcoming, a tendency to procrastinateor to disregard future needs. Some might evenassume that John just isn’t serious about savingfor retirement. However, behavioral researchsuggests that the tendencies to procrastinate andovervalue immediate rewards are inherentin everyone; that’s just the way our minds work.Researchers have found that by changingthe environment—with nudges and a supportingstructure such as a trainer—we can keep clientson track, despite the mind’s quirks.

John’s advisor could lecture him on the importanceof staying on track. But chances are, that won’tbe helpful. Instead, the advisor as trainer couldhelp John change his environment to overcome hisbehavioral obstacles. The advisor could helpJohn set up a voluntary payroll deduction thatautomatically invests 10% of each paycheck.This way, John does not have to make a consciouseffort to put money aside—it’s done out ofsight and out of mind. Next, the advisor could helpJohn develop good investing habits such asavoiding minute-by-minute market-watching andinstead doing quarterly check-ins.

Behavioral Counselor: ManageEmotional Reactions Market volatility is part and parcel of investing. Yetduring market fluctuations, some investors panicand liquidate investments, causing them toveer off course. This panic, in part, is derived fromtheir behavioral biases. During these emotionalperiods, investors might believe that what has justhappened (a drop in the market) is going tocontinue to happen in the future. This arises fromwhat is known as recency bias. In their minds,market volatility turns into long-term capital loss.During trying times like these, advisors playing therole of behavioral counselor can have a largeimpact by helping clients manage their emotionsand stay focused on long-term goals.

One way to help clients control their emotionsduring market volatility is to intentionally introducefriction into the advising process—such asa prearranged three-day waiting period beforemaking major trades. This will allow clientsto take a step back from their emotions and bringdeliberative System 2 thinking to the forefront.Another technique is to prepare clients forfuture market corrections and the possibility thatthey may be tempted to jump ship. Advisorscan have clients think through the scenario andwhat they will feel and want to do. This isakin to the process of inoculation in the medicalfield. Mentally preparing clients for volatility is likegiving a vaccine against panic, before it arises.

Another exercise involves using a “precommitmentdevice,” such as a personal commitment letter.Advisors can ask new clients to put in writing theirlife plans, goals, values, and for whom theyare investing—the root reasons of why clients areinvesting. Then, during times of panic, advisorscan forward this letter to their clients, remindingthem why it is important to stay on track.

A Challenge Is an Opportunity in Disguise The advisor ecosystem is undergoing majorchanges, from new regulations to robo-advisingto the unique expectations of millennials.These changes will have an impact on anadvisor's bottom line, but they also provide anopportunity for financial professionals toshowcase and build upon the value they bringas behavioral coaches.

While the industry shifts, what remains unchangedis the psychology of investing. One of thegreatest sources of value an advisor can provideto clients is to help them navigate the emotionalups and downs of investing.

[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.

[5] Iyengar, S. & Lepper, M. 2000. “When Choice Is Demotivating: Can One Desire Too Much of a Good Thing?” Journal of Personality and Social Psychology, Vol. 79, No. 6, pp. 995–1006.

[6] Morewedge, C.K., Yoon, H., Scopelliti, I., Symborski, C.W., Korris, J.H., & Kassam, K.S. 2015. “Debiasing Decisions: Improved Decision Making With a Single Training Intervention.” Policy Insightsfrom the Behavioral and Brain Sciences, Vol. 2, pp. 129–140.

[7] Sheeran, P. 2011. “Intention-Behavior Relations: A Conceptual and Empirical Review.” European Review of Social Psychology, Vol. 12, pp. 1–36.global.

This article originally appeared in the April/May 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.