PLUS: Behavioral finance vs. behavioral coaching.
By Rory Henry
The Holistic Guide to Wealth Management
Malcolm Forbes liked to say, “Advice is more fun to give than to receive.” But the right advice in the right framework can be invaluable. And sometimes, the best advice you’ll ever receive is what prevents you from engaging in harmful behaviors.
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Michael DiJoseph, CFA, a senior strategist at Vanguard Investment Advisory Research Center, has spent a large portion of his career studying how financial advisors advise clients, how they can get better at providing advice and how we can measure the value of advice because these days, everyone from salesclerks at the mall to NASA rocket consultants seem to have the word “advisor” attached to their job title. More on that in a minute.
The triennial Vanguard Advisor Alpha study, which goes back to 2001, finds that a skilled advisor and behavioral coach following Vanguard’s framework can add about 3 percent annually in net returns for your clients and help you differentiate your skills and practice.
In simplest terms, alpha is industry jargon for the investment returns a manager delivers over a benchmark they’re tracking, say the S&P 500. However, Advisor Alpha is based on the concept that there’s more to investing in financial planning and being a financial advisor than just trying to beat the market. Instead of beating the S&P 500, we would say let’s compare your potential outcomes with the help of an advisor vs. your outcomes without the help of an advisor. As DiJoseph told me on my show recently, if you have a 50 percent chance of reaching your goal without the help of an advisor and a 75 percent to 85 percent chance of reaching your goal with an advisor, that 25 percent to 35 percent difference is the advisor’s alpha – not a trivial amount!
Limiting Leakage
However, according to DiJoseph, another important way advisors add alpha is by closing the gap between gross and net returns. If you think about it this way, the gap between gross and net returns is the “leakage” because of investment costs, specifically costs that are higher than they could be compared to similar products on the market. Leakage is also attributed to taxes and timing. Again, costs, taxes and timing are the three areas where you can help clients minimize leakage, says DiJoseph. “Our research shows that asset location is often underappreciated,” he says. “We always hear about asset allocation – how much you have allocated to stocks vs. bonds, and active vs. passive. But most people aren’t thinking about where they put those assets.” For instance, what are the implications of having a tax-advantaged account versus a taxable account? Let’s say a client has a $1 million portfolio, and $500,000 is tax-advantaged; we’d say they have $500,000 in “shelf space,” DiJoseph says.
Shelf Space
If you want to use taxable bonds for your client, you will probably put those bonds in the tax-advantaged account. But suppose your client has more than 50 percent of their assets in bonds. Where are you going to put it? You may start thinking about municipal bonds or using active management, but you don’t have shelf space. So, maybe you’re thinking about direct indexing or self-managed accounts (SMAs) to help with some of the tax inefficiencies. “Huge amounts of value can be added there,” says DiJoseph. “For most clients, it’s probably close to the amount of the fee they’re charging, and that’s just during their accumulation phase. This is something that also matters during decumulation. We call it tax-efficient drawdown.”
Benefits of Tax-Efficient Drawdown
Let’s say a retired client’s main goal is drawing down assets. The conventional wisdom is that they’ve saved their whole career in a retirement account. Now that they’re retired, they should start spending from their retirement account. But Vanguard finds advisors can be more strategic around spending orders, and that alone can contribute 120 basis points in value.
Particularly, if your client is over a certain age, they have to take RMDs, so they’re already paying taxes on that money.
If you reinvest it, you will pay taxes again, says DiJoseph. “Okay, we’ll spend that. It’s already taxed. You might have cash flows from the portfolio in the form of interest payments and dividends from funds, stocks, and bonds that are taxed. So, spend them,” he added.
But this is where it gets interesting, says DiJoseph. “Our rule of thumb for someone looking to maximize their drawdown and minimize their tax liability over time is to spend from taxable assets first and let the tax-advantaged assets continue to grow.”
Behavioral Finance vs. Behavioral Coaching
We hear so much about behavioral finance, but DiJoseph likes to draw a distinction between behavioral finance, which studies how people make decisions (often poor ones), and behavioral coaching, which is about acting as a coach to help clients overcome some of their behavioral tendencies and leaning into the emotional elements. “We start to get into the analytics, and we’re modeling out tax rates, and then all of a sudden, you have to be emotional and help clients through some of the most difficult moments in their lives, whether it’s a personal matter or a broad market downturn,” observed DiJoseph. Our research shows a skilled advisor who can tap into the emotional aspects of a client relationship can add up to 200 basis points or potentially more during extreme market events.
Starting at the outset of the global financial crisis, Vanguard studied 50,000 IRA investors covering the tumultuous 2008 to 2012 time period. Researchers asked respondents about their investment outcomes if they made even one trade that altered their asset allocation by more than 5 percent. Vanguard found that clients whose advisors helped them avoid making big risky trades – who actually stuck to their plan and maybe de-risked over time – outperformed investors who made big trades by 150 basis points.
Morningstar’s annual Mind the Gap report finds investors earned about 9.3 percent per year on the average dollar they invested in mutual funds and exchange-traded funds over the 10 years ended Dec. 31, 2021. This was about 1.7 percentage points less than the total reduced. 31ir fund investments generated over that span (see chart below). This shortfall, or “gap,” stems from poorly timed purchases and sales of fund shares, which cost investors nearly one-sixth the return they would have earned if they had bought and held.
According to DiJoseph, Vanguard’s research over a longer period finds a similar gap of up to 200 basis points because of poor timing, locking in losses or simply straying from their investment plan during stressful times in the market. “In a volatile year, you may see a behavior gap that almost doubles relative to longer time horizons,” says DiJoseph. In years like 2020, a terrible year for stocks and bonds, even a balanced 60/40 investor might have been down by 20 percent. “Those are moments when a client might feel the emotional impetus to make a major change and lock in those losses. It’s worth more than 200 basis points if you can guide them back to staying the course.”
Why Rational Humans Keep Making Irrational Investment Decisions
As humans, we make very successful decisions in everyday life based on online reviews, Amazon advice, Michelin star ratings and “official” college rankings. Why doesn’t that decision-making strategy or methodology work with investing?
According to DiJoseph, people make decisions based on things that have worked in the past, such as online ratings, rankings, and word of mouth. “If you go to a nice restaurant with a Michelin star and strong Yelp reviews, you’re going to have a high probability of a good experience,” says DiJoseph. “Same with colleges. The top 10 or 20 colleges are top 10 or 2s. A school is not suddenly going from number one to number 50.”
However, according to DiJoseph, investing is different because billions of participants in the global marketplace are constantly updating their opinions of assets and instantly repricing them. Ironically, the current and past success of a stock, bond or fund often “sets the seeds for future underperformance.” That’s because as a fund or asset class starts doing well, it tends to get more expensive as more and more investors pile in. It would be like a restaurant raising its menu prices every day that it receives a good review, and diners eventually tire of the high prices, long waits for tables and difficulty making reservations, and eventually go elsewhere.
“If you have a year in which emerging markets do well, or the commodities sector does well, you’ll see a ton of money fly into those investments, which drives up the price,” observed DiJoseph. “But that strong performance tends not to persist over long periods, and so that late money that came in after the performance already occurred not only fails to get the actual performance that you see on paper, but it’s also probably going to underperform.” And then it gets hard to disentangle a fund manager’s skill versus his or her luck.
Skill vs. Luck
Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, wrote a provocative handbook called “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.” He argues that some games, like roulette, the lottery and rolling dice, are pure luck. But others, like chess and professional sports, rely almost entirely on players’ skills. But skill and luck are entangled in most areas of life – from business to investing to sport. The trick, argues Mauboussin, is to learn how to distinguish when our good fortune has come from luck and when it has come from skill so we can repeat it. Very few people, including investment managers, can do so, so eventually, their hot hand runs out, and their outsize performance reverts to the mean.
“The more an endeavor has skill involved, and the higher that skill is, the more that luck matters,” says DiJoseph. Why? Because every other player in the game is highly skilled. Take our industry. “There are so many smart, talented people who work in the investment industry who have humongous amounts of resources and large amounts of liquidity,” says DiJoseph. “They’re competing with each other all the time, so it gets really hard to outperform when we’re mining data down to the millisecond. So eventually, it requires luck as an investment manager to keep winning,” he added. That’s not sustainable, of course, but because funds tout their past results, they’ll continue to get new money even though they’re no longer delivering outsize returns.
4 R’s and 3 P’s
My friend Doug Lennick, CEO and co-founder of think2perform, wrote a handbook titled “Financial Intelligence: How to Make Smart, Values-Based Decisions with Your Money and Your Life,” in which he argued that our brains are hard-wired to make poor financial and life decisions, especially under duress, such as when the stock market crashes. Lennick argues that you can start breaking the cycle of poor decision-making by reflecting on your core values and circumstances (while accounting for your inherent biases) to reframe the situation into a more realistic interpretation of what is happening and what lies ahead. He writes that learning to accept the “certainty of uncertainty” means you can prepare for the ups and downs of life (and investing) so the next time you face a crisis, you have the tools to act wisely. He distills those tools into the “4 R’s”: Recognition, Reflection, Reframing and Responding.
Likewise, Vanguard has the 3 P’s for helping investors and their advisors make rational decisions: planning, proactivity and positivity. DiJoseph walked me through the 3 P’s on my show recently:
1. Planning is about focusing on your goals and values. It may seem like you’re putting together a financial plan and building a portfolio, helping people reach their goals. But all of those things are ultimately just a means to an end – and that end is fulfilling an important value such as charity or independence or family, etc. Focusing on those long-term goals takes some of the anxiety away from short-term market fluctuations. According to DiJoseph, people don’t mind the market being down 20 percent if they can still accomplish their goals. However, they do mind if their ability to accomplish their goals is diminished by 20 percent or more. However, the only way to see your goals diminished by 20 percent is by bailing out of the market or abandoning your plan at the depths of the downturn. A skilled advisor prevents them from doing that. In a sense, alpha is probably best measured in thousands of basis points or existential to clients’ ability to meet their goals.
2. Proactivity is about preparing for extreme market fluctuations. Here, we use the fan chart (below), which goes from a 100 percent bond portfolio to a 100 percent stock portfolio with 10 percent increments. It shows the best and worst one-year calendar year returns over history and the average return.
At some point during your investing life cycle, things could be worse (and better) than ever. Based on those allocations, you should prepare accordingly for those outcomes. Unfortunately, in 202,2, we had one of those outlier years in both stocks and bonds. Almost every portfolio, from 100 percent bonds to the 40/60 bond/stock portfolio, had the worst one-year return in our data set that year. “If you’re being proactive and preparing for the worst, you won’t be bound by history and will be prepared for whatever happens next,” says DiJoseph.
3. Positivity. It doesn’t mean that everything will always be fine and nothing will ever be wrong. It just means that you’re prepared for that. And it means not being too hard on yourself. “Even the best investors in the world will lose money sometimes,” says DiJoseph. “That’s part of risk. You can’t have outsize returns without taking on some risk.”
Three Components of Trust
Several years ago, Vanguard studied roughly 5,000 investors who had advisors to help them. Vanguard wanted to learn everything it could about how people interact with financial advice, why they hire and fire their advisors and what they value the most from their advisors. The biggest factor driving their outcomes as investors and the advisors’ outcomes as providers was the level of trust. Regarding trust, Vanguard says there are three components: functional, ethical and emotional.
Functional trust – which 17 percent of respondents rated as the most important – relates to confidence in the advisor’s ability to do the nuts and bolts of their job, such as building portfolios and doing financial planning.
Ethical trust – which 30 percent of respondents rated as the most important – involves clients feeling like the advisor’s interests align with theirs and that the advisor is always on their side with a vision of shared success – not just trying to sell them something.
Emotional trust – which 53 percent of respondents rated as being the most important – involves the softer skills of active listening, asking good questions, and treating clients like people, not like portfolios.
“Having clients who know you care about them was the biggest driver of referrals,” says DiJoseph. “It was the biggest driver of client retention and asset consolidation for an advisory practice.”
So, it stands to reason that the most important thing an advisor can do for clients is to be there for them. Help them through those emotional moments. “Clients with a high trust in their advisors are not only likely to stay with them and refer new clients to them, but they’re more likely to follow their advisor’s recommendations,” says DiJoseph.
So, when you provide clients with advice – whether coaching them through a market downturn or dealing with a difficult personal circumstance – getting them to stay the course is worth at least 300 basis points, according to Vanguard research. Helping clients stay the course and avoid hasty moves out of the market (or back in) can save them from making extremely costly decisions. For instance, if they were out of the market for only the 10 best single days since 1988, their annual returns would be 2.4 percent lower than if they had stayed fully invested (8.0 percent. 10.4 percent). If they were out of the market for the 20 best single days since 1988, their annual returns would be 4.0 percent lower than if they had stayed fully invested (6.4 percent vs. 10.4 percent).
Return on Relationship
“The No. 1 thing that determines an advisor’s success is not their positive impact on the portfolio, but the extent to which they helped coach clients through all of their life events,” observed DiJoseph. “The portfolio is just a means to an end, a tool for helping them reach their goals. Advisors who truly care about their clients have thousands of stories to tell about seeing them through the good and difficult moments in their lives.”
From where I sit, I find being an advisor a privilege because people trust us to share intimate details about their finances, leading to intimate details about their lives. They’ll open up about their family, issues with their children, hope, and fears. It is rewarding to dive deeper and help people with their finances and all aspects of their lives.
That is why I trademarked the term “Advis-Ror™.” It’s about having a greater return on the relationship (ROR). Sure, some aspects of advice can be automated, such as rebalancing the portfolio. However, many things that tend to be highly valued by successful families and business owners cannot be valued, such as charitable giving, tax, estate planning, and trust services.
DiJoseph says, “The return on relationship is a great concept because it speaks to the importance of the relationship, the return that accrues to you as the advisor, but also to the client’s ability to receive better advice.”
As I’ve always said, “We shouldn’t be a servant to a service; we should be a service to a relationship.” I get frustrated by terms like “tax advisor,” “business advisor,” and “financial advisor.” That’s a very narrow way of looking at advice. As holistic advisors, we can help clients with whatever is most pressing in their lives at any time. We’re looking at the whole picture. For instance, investments are affected by taxes. Some have a majority of their money in their family business. We want to ensure that we’re working with the accounting firm to understand what’s happening on that side. That can’t be done by machines or software.
DiJoseph recalled that, back in 2015 and 2016, a lot of atmuchwas paid to robo-advice. Naturally, we were concerned about robo-advice. So, Vanguard’s investment strategy group did an in-depth study into the future of work. He says one of the biggest takeaways was that jobs don’t get automated away; tasks get automated away.
“Throughout history, jobs have evolved to take on more of what’s called uniquely human elements. The report had a chart listing basic, medium, and advanced tasks, with the advanced tasks being unique,” recalled DiJoseph. “When I saw ‘advanced task,’ it hit me: That is the job description of a financial advisor!”
DiJoseph says those early robo days reminded him of where we are now with generative artificial intelligence. Is it the final innovation, or is it another in a long line of technologies and tools that make us even better at what we do because they free us up from menial tasks so we can spend more time building relationships, building our practices and providing highly personalized advice to solve complex problems for clients?
“In my first job in finance,” recalled DiJoseph, “I worked for an advisory firm. One of my responsibilities was rebalancing portfolios. I manually typed weights into an Excel spreadsheet, calculated the new weight, went back and updated it at the end of the day when everything was priced, and then filled out a trade ticket by hand and faxed it. That was considered rebalancing. I was spending hours and hours a week doing that. Fast forward to today, and now we’re rebalancing portfolios with the click of a button. So where has all that freed-up time gone?” he asked. “It’s gone into having uniquely human conversations, enhancing client relationships and growing your practice.”
The job of a financial advisor is very entrepreneurial. You need time to run a good business, ensure that your processes and technology are figured out, and hire, train, and develop your staff. That’s where automation can help: by removing you from routine tasks, you can be freed up for higher-level thinking.
That’s why I am going back to the return of the relationship. If used correctly, AI will free up advisors to be more human, like therapists and coaches who can help people avoid making harmful decisions and learn to make better ones, even when faced with crashing markets or the death of a spouse, divorce or job loss. Clients don’t just want an answer; they want to talk to a human. They trust that person making tough, complex decisions and want to ensure they’re doing it correctly and confidently.
Quantifying Advice
DiJoseph says it’s still hard to develop a benchmark that measures what someone would do without your advice. So, it’s important to think about creating alternate histories, and that’s where Vanguard’s market hindsight tool comes in.
You can enter a start date and an end date, and you can enter, you know, a bail to cash date. Let’s use 2020 as an example. Let’s say you started the year with a $1 million portfolio. Say your client called you on April 1st when the market was down 20 percent. Assume they’re an aggressive Apr. 1 So, they want to get out of the market. You successfully leveraged your emotional trust in their relationship and your ability to coach them. They stayed the course. And ended the year plus 18 percent to 20 percent instead of having locked in a 15 percent to 20 percent loss. The tool will show those alternate histories in which you say, “Hey, like we went through this together, and instead of having an $800,000 portfolio today, you have a $1.2 million portfolio.”
Being an advisor is a “noble profession,” says DiJoseph. “I’m very proud to be part of this industry. We hear a lot about how hard it is to be an investor and how hard the last few years have been. We want to emphasize that. It’s been a really difficult few years for advisors, too, from both a business perspective and a mental health perspective,” he added. “It hasn’t just been the stress of the markets but helping clients with many stressful personal situations.”
The most trusted advisors are the ones for whom clients know we’re all in this together. The numbers bear this out.