What Hungry Investors Really Want from Their Financial Advisors

What Hungry Investors Really Want from Their Financial Advisors

by Ron Surz, via CFA Institute

Meir Statman draws analogies between investor behavior and nutrition, in his book What Investors Really Want. For example, we all know that the best way to eat nutritious, low-cost meals is by dining on healthy food at home. But that’s just not fun for most of us: We’d much rather indulge in rich foods at expensive, fancy restaurants.

Investors want what Statman calls “utilitarian benefits.” We know that a diversified, low-cost portfolio is theoretically best, but we’d rather have the amusement and bragging rights of expensive, risky investments like hedge funds and specialized equity managers.

In keeping with the dining analogy, investment advisers are like waiters catering to the diverse appetites of their clients. Clients want their advisers (waiters) to guide them through their investment choices (menu selections). A successful financial adviser recognizes that the ingredients for satisfying clients are as follows:

• Menu: A successful waiter needs a good menu with tasty selections that serve a variety of palates. A successful financial consultant needs a variety of solutions that meet a wide range of investor needs.
• Selection: A successful waiter helps diners select something from the menu they will like. A successful consultant identifies client needs and matches them to a solution that will make them happy.
• Follow up: A successful waiter asks for feedback and makes changes as necessary. A successful financial consultant monitors progress toward the achievement of goals and recommends changes along the way.

Menu of Models

A tasty menu item has quality ingredients and is skillfully prepared. In investing, we create models, each designed for a specific type of investor. Risk is the quality ingredient, and packaging that risk to provide the highest return is the skillful preparation.

Most models start by identifying points on the efficient frontier, like the five points shown in the graph below. Each numbered portfolio theoretically provides the highest return for the indicated level of risk. Harry Markowitz won a Nobel Prize in 1990 for his theory of portfolio choice, recognized as the birth of modern portfolio theory (MPT). The efficient frontier is the centerpiece of MPT.

Efficient Frontier

Most do not realize that another Nobel Prize-winning theory refines the efficient frontier. William F. Sharpe also won the Nobel in 1990 for his capital asset pricing model (CAPM), which demonstrates that risk control is best achieved with cash, among other things. As shown in the graph below, the capital market line, which blends the “market” with cash, dominates the efficient frontier by providing higher returns for the same level of risk. (It’s important to realize that the “market” in this context is the entire world of risky assets, not just the US stock market.) This represents a challenge, because we can’t know the real composition of the current market, but we can guess. Here is an example:

Example of a World Market Portfolio Estimate

Capital Asset Pricing Model (CAPM)

Other refinements to models are like the house specialties that set some restaurants apart. Models can be refined in two ways:

• Market views can adjust asset weightings — timing. For example, the current bond manipulation to zero interest argues for shorter duration bonds because there is no reward for taking duration risk.
• Active rather than passive managers can be used. Investors want active managers, and advisers want to give clients what they want, but it’s very difficult to identify skillful active managers. Advisers don’t want to spend the time, energy, and money that it takes to identify skill (as summarized in this infographic), so active managers who underperform are the norm.

Choosing a Model

Selecting a model is like placing a dinner order. There are three ways in which investors can choose:

• Risk-based is like the diner who asks the waiter for a recommendation. Investors don’t know their risk capacity. They want their advisers to tell them. Risk questionnaires can help, with the guidance of an adviser.
• Age-based uses a target date fund glide path to identify an appropriate asset mix. It’s like older diners ordering bland, soft food versus youngsters ordering the more exotic dishes.
• Goals-based uses a model that is expected to earn a return that will produce the desired objective. Calculators help advisers solve for the return that will match cash flows with targeted ending wealth. Then a model is selected that is expected to earn at least that desired return. Goals-based investors are like discriminating diners seeking a culinary treat. Even though they are the most challenging, they are also the most likely to appreciate good service.

Follow Up

Just as waiters help diners through the various courses of the meal, advisers help their clients navigate through phases of life, monitoring progress toward the achievement of objectives and making changes as necessary. We call this “portfolio navigation.” If we’ve exceeded expectations, we can save less (spend more) and/or reduce risk. If we’re trailing expectations, we can save more (spend less) and/or increase risk. Investors have choices.

Portfolio Navigation

Investors want to make money, just as diners want great food and great service. But both also want to have fun and brag about the experience. Successful advisers are like successful waiters: Both require three key competencies that, while easy to understand, are challenging to do right.

Now you know. Bon appétit!

About Ron Surz

Ronald J. Surz is president and CEO of PPCA Inc. and its division, Target Date Solutions. He is a pension consulting veteran, having started with A.G. Becker in the 1970's. Surz earned an MBA in Finance at the University of Chicago and an MS in Applied Mathematics at the University of Illinois.

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