Holistic advice. What, truly, does that mean? Let me give you my lens on it.
About 35 years ago, after leaving Australian National University and studying economics, I launched an advice firm called ipac, with a few friends, including Paul Clitheroe. I thought financial advice, or investment advice, as it was then, was all about maximising return and minimising risk, after tax.
Being a slow learner, it took me a couple of decades but I worked out that financial advice had, at its heart, planning. If you go back to the basics, planning is an intertemporal problem. Intertemporal means it’s about optimising things over time.
So what are we trying to optimise? We are not trying to optimise risk and return, we’re trying to optimise happiness. When you were all saying what you want to do in retirement, did anyone say, ‘Optimise risk and return’? No.
It was about travel and activities that link fundamentally to happiness. Consider someone who is 21 years old. If their life ambition is to optimise happiness over their lifetime, how do they think about decisions? What’s the framework they have got to think about that? Should they put a fair bit of money into optimising happiness today? Does a “good life” mean coming to the Ivy every Friday and spending lots of money socialising, including having smashed avocado for weekend brunch? Should I defer some of my spending today so I can send my future kids to a private school? What difference does it make to my happiness if they go to a private school or a public school?
What difference does it make to my happiness if I live 50 kilometres out of Sydney versus closer to Sydney but in a fundamentally different house?
When we started our business, people had a life expectancy in retirement of five to seven years. Now we’re talking about 30 years. It’s a huge intertemporal challenge and opportunity. In terms of what I put on my wish list, do I, in fact, spend my money on Italy, on travel, on lots of activities while I have my health? How does that feel if 10 or 15 years down the track I get an illness that doesn’t kill, but disables me for the last 10 years of my life? And I’ve blown most of my money and I can’t really afford the private nursing? What’s going to optimise my happiness? These are deep, deep questions. And they are questions that our industry fundamentally doesn’t tackle, but this is what financial planning should be about.
A revolution in economic research
The good news is that economic research has gone back to the time of Adam Smith, posing some basic questions about how people behave, rather than assuming that people make decisions according to some sort of abstract rational mathematical model. Most of the Nobel prizes in economics in the past 20 years have gone to the area of behavioural research, most famously, in 2002, to Daniel Kahneman. Daniel Kahneman is professor of psychology at Princeton University. He asked some very basic questions, which economists and financial advisers should have been asking decades ago, fundamentally linked to money and wellbeing.
My most recent book, How Much Is Enough?, poses that question as if the answer is a number. The answer is not a number. The purpose of How Much Is Enough? is really to integrate behavioural research from the areas of finance, economics, psychology and neuroscience to explore more deeply the relationship between money and happiness. For the first time really in the past couple of decades, there’s a research foundation from many disciplines to help inform how planners can help clients optimise this relationship. I don’t think we’re ever going to come up with the perfect answer, but we can come up with better answers.
So what are some of the problems we need to contend with in answering this fundamental question? One is that the human brain has been evolving for about 200,000 years. For the vast majority of those 200,000 years, we woke up in the morning, and having lunch and not being lunch was a pretty good day. If you made it through to the evening and had the chance to reproduce, that was about as good as it got. Life in Sydney hasn’t really changed all that much. So what’s automatically wired into the brain is surviving behaviour. It’s not about happiness; it’s about surviving. Now, for the first time in human history, there’s the opportunity to thrive. But to make the most of our new found potential to thrive, we need to train our brain to learn new behaviours.
Our brains are not naturally geared towards this, but the good thing is that the brain is plastic and so we can learn. There are 101 biases that stop us from thriving and planning though and in many ways, it is about overcoming these biases.
INERTIA Clients stay with customised default (Payne)
LOSS AVERSION People are much more sensitive to losses than to gains (Kahneman)
SALIENCY Overreacting to new information (Fuller)
HYPERBOLIC TIME DISCOUNTING Emphasising short-term rewards at the expense of the future (Ainslie)
HERDING People blindly follow the herd (Cipriani and Guarino)
Financial markets, well used, do enable us to boost the value of our savings. The problem is that while everyone intends to buy low and sell high, in practice, for behavioural reasons, we do exactly the opposite. A famous organisation in the US called Dalbar looks at the timing of money going in and out of the sharemarket. It then compares the average return from the sharemarket each year, with the return that investors get, on average. The difference reflects whether on average investors get their timing right or not. Over the past 20 years, the US sharemarket did 8.2 per cent a year, and the average investor managed to halve that return, getting 4.7 per cent a year, before transaction costs. That’s a massive destruction of wealth.
Overcoming behavioural biases
Psychology plays an important role in this, complementing mathematical tools. There’s a key emotional side to this and a whole set of important skills around emotionally engaging clients.
It’s about giving the client a sense of ownership and deep involvement in decision-making. It’s not us being the expert providing a solution, it’s almost, in a sense, walking side-by-side with the client in the exploration of what is emotionally important to them, then exploring options and the client feeling that they’ve got a variety of strategic options and owning the decision making process. It’s putting advice in terms where the client can evaluate it in terms of what’s important to them.
|How advisers can manage behavioural biases
ACTIVE DECISION Engage individuals and encourage them to make active choices (Previtero)
EVALUABILITY Use language to describe the strategy in ways that make it easy to evaluate features (Payne)
FRAMING Frame future income in terms of the monthly income a client will receive (Brown)
VIVIDNESS Make the implications of today’s financial decisions vividly presented so clients see how their lives will be affected (Goldstein)
How problems are framed has a profound effect. How Much Is Enough? has an American edition launched at the University of California, Los Angeles (UCLA) by one of the world’s leading behavioural decision researchers, professor Shlomo Benartzi. He’s done some famous work in the area of how people spend, save and invest. We live in a world where there’s a relentless message that more and more and more is better – it appeals to a primitive part of our brain. Try and buy a lousy hamburger and we are asked: do you want chips with that? Go and try and buy a mobile phone: do you want another 50 megapixels or megabytes or some other mega thing which I have no clue about. There’s always this pressure to spend more.
In a UCLA experiment, researchers observed a local BMW franchise where people were looking at buying say an X5 versus an X3. The salesman would say the X5 has more horsepower, more cubic metres, and more everything else, and the human brain says, ‘I want that’, without evaluating what difference it really makes to their lives. In the US the price difference is about $10,000, and 75 per cent of people who went to the BMW franchise wanted to buy the X5 when they heard the salesman’s pitch. Then half the people going to the franchise met the UCLA researchers, who converted that $10,000 from a dollar number to say, ‘By the way, $10,000 equals five years of free petrol’, or gas, as the Americans would say. So if you buy the X3, it comes with five years of free gas. Simply that reframing caused 75 per cent of people now to go for the X3. Just converting it from an abstract dollar concept to something more tangible can change people’s behaviour.
We focus on improving people’s saving and investment. But how about if we also focus on helping them to spend meaningfully?
Cognitive words and tables of numbers do absolutely nothing to change people’s behaviour. Pictures and stories – that’s the guts of the skills we need to have.
In the absence of emotional engagement, what drives decision making is essentially impulse and what the peer group is doing. It produces ugly results. Trust me, this is not the way to optimise lifetime happiness. If we can engage both our right brain as well as our left brain and bring that to life in a goals-based approach, that does make a difference.
A large US-based group that supports advisers found that going through the GFC, the vast majority of clients who had gone through the typical advice process of optimising risks and returns, sold out. They abandoned their portfolios at the worst possible time.
The majority of clients, about 80 per cent, who had gone though a properly framed goals-based approach, stayed with and even topped up their strategies. Not necessarily because they fully understood the technical details, but because they understood the strategy was closely linked to the long-term achievement of goals that were emotionally important to them.
A GOALS-BASED APPROACH PREVENTS RASH DECISIONS
Clients who had a single, traditional investment portfolio
20 per cent made no changes
50 per cent fully liquidated the portfolio
10 per cent made significant changes to allocation
20 per cent decided to adopt a goals-based approach
Clients in a goals-based investment approach
75 per cent made no changes
5 per cent delayed implementation
20 per cent increased ‘lifestyle’ pool
The results of this analysis support the assertion that clients using a goals-based investment approach are less likely to liquidate or make other dramatic changes to their investment strategies during volatile markets.
This is an edited version of remarks made by Arun Abey to the Conexus Financial Post Retirement Conference in Sydney on March 15.
TOPICS: behavioural economics, Conexus Financial Post Retirement Conference, intertemporal, investor psychology, post-retirement, retirement