Where does an advisor add the greatest value? Through knowledge of investing and financial markets? Through the ability to help clients reach their retirement savings goals? By bringing order and a roadmap for the future to otherwise unplanned chaos? Professional financial advice is useful in these and countless other ways, but the greatest contribution, at least for some clients, is actually “behavioral”—advisors protecting clients from their own worst instincts and bring rationality to the planning process.
“Every time I turn on the business news, I'm reminded that it's often the loudest voices that get the press and the air time. In sometimes stark contrast, financial advisors, however, represent a voice of quiet reason,” says J.P. Morgan Funds’ Market Strategist Andrew Goldberg. As Goldberg observes, some clients can be easily distracted by the clutter of the news media. Hearing about the latest hot investment or market forecast from a television guru may be entertaining, but clients who actually pay too much attention to this media “advice” end up paying the price. J.P. Morgan’s own research, utilizing analysis by Dalbar, shows that whereas stocks have boomed since 1991, the average investor’s return has “barely kept up with inflation.”
Advisors are all too familiar with these behavioral mistakes by their clients, including trend chasing and distraction caused by the news cycle. Moreover, many advisors now have familiarity with insights from behavioral finance, the breakthrough field that marries psychology with finance. But perhaps less well known is the key role “reason” plays in terms of improved decision-making as defined by the behavioral research program.
A rigorous albeit very academic research paper written by Daniel Kahneman and Yale Professor Shane Frederick (Kahneman’s former student), lays out the basic psychological insights underlying behavioral economics, namely that “cognitive processes can be partitioned into two main families—traditionally called intuition and reason.” Intuitive judgments are quick and easy, arrived at in a split second. In contrast, reason-based decisions typically take more mental effort, and are not instantaneous. What makes investing in the stock market so difficult is that it isn’t particularly intuitive. Using intuition we chase market trends and try to time markets, shooting ourselves in the foot in the process.
That is where the financial advisor comes in. The planner adds reason to the investing process, tempering the clients’ intuition. As Kahneman and Frederick explain, intuition can be overridden by reason: “Initial impressions are often supplemented, moderated or overridden by other considerations, including the recognition of relevant logical rules and the deliberate execution of learned algorithms.” Clients may come in seeking the hot new investment of the moment that they saw on TV. The cooler—and more rational—advice of the planner acts as a break on these impulses.
Advisors, as people, are vulnerable to behavioral mistakes themselves (and this entire topic is under-researched), but as professionals, they have the “relevant logical rules” and “learned algorithms” to make more rational decisions when it comes to investing. The “quiet reason” noted by Andrew Goldberg may be advisors’ most important “value add”—to protect the clients from themselves.