Asking the right and wrong questions
From a behavioral economics point of view, the field of financial advice is quite strange and not very useful. For the most part, professional financial services rely on clients’ answers to two questions:
- How much of your current salary will you need in retirement?
- What is your risk attitude on a seven-point scale?
From my perspective, these are remarkably useless questions — but we’ll get to that in a minute. First, let’s think about the financial advisor’s business model. An advisor will optimize your portfolio based on the answers to these two questions. For this service, the advisor typically will take one percent of assets under management – and he will get this every year!
Not to be offensive, but I think that a simple algorithm can do this, and probably with fewer errors. Moving money around from stocks to bonds or vice versa is just not something for which we should pay one percent of assets under management.
Actually, strike that. It’s not something we should do anyway, because making any decisions based on answers to those two questions don’t yield the right answers in the first place.
To this point, we’ve run a number of experiments. In one study, we asked people the same question that financial advisors ask: How much of your final salary will you need in retirement? The common answer was 75 percent. But when we asked how they came up with this figure, the most common refrain turned out to be that that’s what they thought they should answer. And when we probed further and asked where they got this advice, we found that most people heard this from the financial industry. Sort of like two months salary for an engagement ring and one-third of your income for housing, 75 percent was the rule of thumb that they had heard from financial advisors. You see the circularity and the inanity: Financial advisors are asking a question that their customers rely on them for the answer. So what’s the point of the question?!
In our study, we then took a different approach and instead asked people: How do you want to live in retirement? Where do you want to live? What activities you want to engage in? And similar questions geared to assess the quality of life that people expected in retirement. We then took these answers and itemized them, pricing out their retirement based on the things that people said they’d want to do and have in their retirement. Using these calculations, we found that these people (who told us that they will need 75% of their salary) would actually need 135 percent of their final income to live in the way that they want to in retirement. If you think about it, this should not be very surprising: If you add 8 hours (or more) of free time to someone’s day, they will probably not want to spend this extra time by going for long walks on the beach and watching TV – instead they may want to engage in activities that cost money.
You can see why I’m confused about the one-percent-of-assets-under-management business model: Why pay someone to create a portfolio that’s 60 percent too low in its estimation?
And 60% is if you get the risk calculation right. But it turns out the second question is equally problematic. To show this, we also asked people to tell us how much risk they were willing to take with their money, on a ten-point scale. For some people we gave a scale that ranges from 100% in cash on the low end of the risk scale and 85% in stocks and 15% in bonds on the high end of the risk scale. For other people we gave a scale that ranges from 100% in bonds on the low end of the risk scale and buying only derivatives on the high end of the risk scale. And what did we find? People basically looked at the scale and said to themselves “I am a slightly above the mean risk-taker, so let me mark the scale at 6 or 7.” Or they said to themselves “I am a slightly below the mean risk-taker, so let me mark the scale at 4 or 5.” In essence, people have no idea what their risk attitude is, and if they are given different types of scales they end up reporting their risk attitude to be very different.
So we have an industry that asks one question it’s giving the answer to, and a second question that assumes that people can accurately describe their risk attitude (which they can’t). This saddens me because, while I think that financial advisors are overpaid for the service they provide, in principle they could contribute much more, and they could even deserve their salary. But only if they start offering a more useful service, one that they are in the perfect position to provide. Money, it turns out, is incredibly hard to reason about in a systematic and rational way (even for highly educated individuals). Risk is even harder.
Financial advisors should be helping their clients with these tough decisions! Money is about opportunity cost. Every time we think about buying a car or going on vacation we should be asking ourselves what we won’t be able to afford in the future if we go ahead and make this purchase. And that’s where the financial advisor should come in.
It’s possible that the best financial advisors already do help in this way, but the industry as a whole does not. It’s still centered on the rather facile service of balancing portfolios, probably because that’s a lot easier to do than to help someone understand what’s worthwhile and how to use their money to maximize their current and long-term happiness.
The fact is that money is hard to think about and we do need help with making financial decisions. The financial consulting profession has an opportunity to reinvent itself to service this need. And if they do, it will be beneficial for both financial advisors and their clients.
——————–
A shorter version of this appeared at hbr.org
The Honest Truth About Dishonesty: How We Lie to Everyone - Especially Ourselves
I sure hope your wonderful fundamental advice here is getting noticed!
How does this relate to those financial professionals who maintain the portfolios of mutual funds? Clearly a fund has particular goals for helping investors but doesn’t directly ask these personal questions. I’m invested in socially-aware mutual funds that invest only in socially responsible (and largely environmentally responsible) businesses. I’d love if you did research and/or provided your thoughts on these parts of the financial service sector.
I read this piece a couple days ago, and had two very contradictory reactions (contradictions can’t exist?) My first reaction was to take tremendous offense to your comments. I certainly don’t believe a client’s live to be particularly simple, nor quantifiable in algorithms or numbers. And many financial planners I know fall into that same camp, particularly those of us who have an affinity for life planning.
But it struck me that your perception of “financial advisor” is exactly what many people, including advisors, perceive. Those of us who accept and even relish the complexity that is humanity make up the exception, not the norm. And you makes it clear your looking at the financial services industry broadly.
There is certainly an element of the narrative of money in this piece, most importantly this never-ending focus on “investment.” Despite your call to understand complexity, you end with the same tired “how much money do we need question.” This is one of the chief failings of our current narrative of money, IMO. This concept of “need money.” Nobody…yes, full of hyperbole here, NOBODY needs money. We can produce our own food, build our own shelter, trade goods without money.
“NOBODY needs money. We can produce our own food, build our own shelter, trade goods without money.”
While I suppose it’s theoretically possible that a person or household could be entirely self-sufficient without money, in practice I don’t think that would happen. How many people do you know will grow all their own food, build their own homes, live entirely off-grid, and sew their own clothes? And that’s not counting modern “necessities” like fridges, stoves, gasoline, cars or bikes, internet access, and phones. And sooner or later, the government is going to expect some taxes and will expect it in the currency of the land, not goats.
In short, yes, there might be some modern-day David Thoreaus out there. But for the rest of us, we do need at least some money.
“Nobody…yes, full of hyperbole here, NOBODY needs money. We can produce our own food, build our own shelter, trade goods without money.”
That’s an outlandishly BULL comment I have read so far. Hope you follow your own advice.
What a wonderful post! It is so true that we are focused on the wrong metrics for determining how to invest. I also think in addition to determining what you want to do in retirement, as you get closer you have to take a harder look at your actual expenses. What do you pay for today that won’t go away and how does that work with what you want to do in retirement. I for one am targeting a bit above 100% for retirement!
Unfortunately, I think you’re still missing the boat. Fact is, “most people” (a huge and vague group that, in this case, includes me) are unable to change their outflow enough to accumulate even the 60% or 75% they “think” they’ll need, regardless of investment strategy or risk tolerance.
One or two big setbacks–long layoff, buy the wrong house, marry the wrong person, get sick on the wrong insurance plan–and savings/investments sufficient to allow ANY sort of retirement become virtually impossible.
I’ve done all the mainline financial planning, tweaked my estimates, looked at my plans and %ages. When I twisted her arm, my financial planner agreed: “You’re doing everything right, you’re not going to make it, and you need a bigger number on the “income” side.” She didn’t have much to offer there. I suspect few planners would.
I’d really like to see an answer to this that doesn’t include any mention of how I should have started 30 years ago, when I graduated. That’s magical thinking, too, but it’s what most planners and economists keep resorting to.
Ms. Tiede
Most planners point to numbers when, in fact, the importance of planning is to make you aware and comfortable with your alternatives. Once you understand the possible actions, only then can you become an important part of the process and solution. I believe that many in the industry use numbers to confuse and lever one solution over another.
While pouring more pre-retirement income on the fire may help, you must also understand what you can do now to prepare for a less eventful retirement event.
>only then can you become an important part of the process and solution.
With all due respect, I don’t need a financial advisor of any sort “to become an important part of the process and solution.” I am the ONLY part of the process, and the ONLY part of the solution, that really matters. Rich Chicks below said, “90% of financial decisions are made without advice,” and I would suggest the real total is closer to 99.99999%.
If and when Match.com starts hiring financial planners to guide one’s selection of a life partner, or the cigarette companies hire financial planners to advise buyers on the financial implications of smoking (could say the same for any grocery store and its offerings), I’ll maybe think financial planners matter more than I do right now.
But my argument remains: our long-term financial outcomes are driven much more by choices that have no initially obvious financial element, often made at a time before we’ve even thought of the word “retirement.” Even The Millionaire Next Door makes the point that one of the biggest things you can do to become a (male) millionaire is marry a frugal woman.
I read your comments and agree that the focus for financial planning is a balanced portfolio. This is all well and good but should only be a part of the planning. What we are missing and what I emphasize with my clients and anyone who will listen is that we have to return to the days of our parents and focus on savings and the discipline required to do so. It will mean sacrificing something–plan how much can be set aside a day to save (and then invest). A single parent on welfare may only be able to save $0.50 a day but that will build over the year. Think small and then grow.
Great insight. I too agree people must turn to themselves to gain the proper financial education in order to provide for their own retirement.
Thanks for the post Dan. It’s made me think about how I ask questions to try and get it how much people will need during their retirement.
A couple thoughts related to the article….
There’s research in Canada (respected actuary Malcolm Hamilton) that suggests people actually need less than 70% of their income during retirement: http://www.theglobeandmail.com/report-on-business/retirement/malcolm-hamilton-offers-retirement-planning-advice/article1325008/
I find determining risk tolerance very difficult to do in theory. There’s not a ‘magic bullet’ question that i know of! I inevitably find out much more about risk tolerances when the market is dropping and I have a chance to talk to clients.
Also, it’s a nuanced conversation because some young investors with good earning power, emergency reserves and no debt are risk averse and are inclined to own mostly cash-like instruments. Not a good allocation for a young person with a long-time horizon looking to beat inflation. This is when I find this visual helpful: https://personal.vanguard.com/us/insights/investingtruths/investing-truth-about-risk
thanks again for the enlightening blog, chris
Maybe risk tolerance isn’t the right question in the first place. In reality, what we’re being asked is 1. how would we feel if we lost a boatload of money on route to our retirement? and 2. how well could we weather those losses? We all know from the behavioral science that the answer to 1 is only loosely related to the actual feelings in the event, so 2 is really the issue. As you (Dan) point out, that’s something that is estimable based on age to retirement, positions already taken, etc.
Most Americans became enamored with the financial industry during the 80′s and 90′s when the stock market, for the most part, went straight up. This led to cries for more emphasis on savings plans versus pension plans. Since 2000, when the economy came face-to-face with our over-use of credit, the markets showed that investing is not a hobby and risk and security are really the same word. Buy and hold investing really is only a compensation model conceived by the financial industry and the people that work within.
Your survey results are based on the current thinking of credit and the things it can let us all do and enjoy. I know people (and banks) that re-finance their primary home for 30 years when they are within 10 years of retirement. How foolhardy and restrictive is that?
As you state, the basic investment processes are not complex. Investing is not a short term endeavor but a long term effort at understanding risk and market fluctuations. The difficulty starts when you explain the sacrifice necessary to live a worry-free retirement. For many, the only lever they can pull is to lower their expectations significantly. The financial industry has constructed many products which, supposedly, will fix all of this – for a price.
A financial planning relationship must extend beyond gathering assets to collect management fees and the sale of one-size-fits-all products. The client cannot be spending themselves into oblivion while the advisor diligently watches their retirement assets. Financial planning is too often a gateway to the sale of products and services when it should form the foundation of a long term relationship.
THANK YOU! One of members sent this in for us to tweet. Getting a better relationship to wealth is what our company message to the world since 1998. I would add that 90% of financial choices are NOT made with a professional so consumers do need to stay on task with what goals and outcomes are important. Keep this conversation going!
I generally agree with your argument, Dan, but the questions are problematic in other ways too. I am not surprised that when looked at in terms of actual desires, people in general want 135% of current income. That sounds like our electorate — we want more and better services and lower taxes too! It seems to me that we should start with a careful assessment of actual need and then try to get *there* if we can before moving on to “wants.” I have seen a fair amount of research putting actual “need” (with qualifiers) in the 70-75% range for most people. That said, we still need to do more.
With respect to risk tolerances, it remains unclear to me what risk really is. The probability that I will reach my goals with given assumptions? How much I can lose before I start to panic? How aggressive I need to be to reach my goals (however defined)? The drawdowns I can weather and still have a reasonable chance of financial success (again, however defined)? Something else? Whatever else is true, it doesn’t look to me like risk = volatility….
P.S. Is the research published? I would like to see it.
My definition of investment risk is panicking and selling low, then buying high. Each person needs the portfolio that will prevent this behavior. Then given that portfolio, how much must you save to meet your retirement goals? I realize this definition is impossible for a novice to establish. Therefore, I err on the conservative side until my client decides they hate missing out on a bull market more than they fear losing in a bear market. I really appreciate the statements by Karen Tiede concerning risk. Investment is only one of many types of risk and is actually the most trivial for a beginner because their portfolio is so small. After many years and battles with the other types of risk(divorce,job loss,health,stupid kids), investment risk becomes paramount because the size of your portfolio means a 10-30% drop costs you hundreds of thousands. Hopefully ,by then, you will have the experience to appreciate return “OF” investment over return “ON” investment!
“Know any good brokers?”
My friend…who was a broker at the time
“The only safe investments are soup cans and shotgun shells.”
Same guy
Assuming health insurance or health costs don’t get extremely high when I am in retirement, I can confidently say that I could retire with less than I make now since I devote a large percentage of income to retirement. I won’t have to do that while in retirement.
But I am like rpseawright. The meaning of risk can have different meanings when it comes to personal finance and I am never clear what meaning is being used at different times.
For example, a indiv. stock is seen to have more risk than say an S&P 500 index fund because the indiv. stock has the particular risk of the company doing well in addition to what people are predicting on the macro economy over the future.
But when people look at Monte Carlo type models of asset allocation portfolios, they are looking at a different aspect of risk. They are using historical data and using it to try to predict the future.
Ssy a client believes they will need a nest egg of X dollars.
Should a financial advisor inform a client that with Option A portfolio, usingin historical data have a 70% chance of hitting X dollars but 30% chance of losing 20% of the nest egg.
Option B they will have 25% of hitting X dollars but based upon historical data that have only 5% of losing 20% of the nest egg
And then the advisor should point out that historical data isn’t that good for short term predictions. Using historical data is using averages but there is a lot of statistical noise in performance and there are black swans that people should have seen but historical data has not incorprated them into the models yet.
As stated in several of the comments, financial planners canot provide all of the answers necessary for an enjoyable retirement. Retirement planning is a life long effort, not something to start thinking about at age 45 or later. The label itself, “Retirement Planning” probably does more harm than good. We have created a retirement system in this country that requires long term diligence and restraint in a time where immediate concumption and enjoyment are at a zenith.
I always point out to my clients instances in the media where hints of things to come are first published for consideration. Examples include the suggestion that families with little or no retirement savings pair up and co-habitate (AOL front page) a condo to save money or the the one where the head of a major US investment management firm’s financial planning arm stated that people should “live-it up” because many will be working into well into their 70′s (MarketWatch). These examples are not meaningless and may well pose the beginning of a great wave of austerity as children watch their parents struggle during retirement.
I agree with a lot of the post but am surprised and sceptical of the 135% of final income spending after retirement. If this referred to 135% of current income I would be shocked. I suppose the increase would sound reasonable if it were 135% of current spending level. Assuming you have a mortgage, schools and weddings to pay for now and you are putting a portion of your money aside for retirement, all of which you won’t be doing in retirement, it seems unlikely (for me personally anyway) that spending during retirement will be significantly more than my total current income (adjusted for inflation of course).
This is true for people in their 40s or 50s. However, I am expecting that in 10 years, my kids will be finished their schooling (at least the part I expect to contribute to), my mortgage will be almost paid off and any weddings paid for. That means that I personally can expect to be working for almost another 15 years after that and I hope my income will stay steady/increase during that time. I don’t think that I am in any way unique. It would/will be VERY easy to slip into spending that extra disposable income and coming to rely on it. For many people thinking about retirement – those kinds of expenses won’t apply; their lifestyle will probably reflect that and I am guessing that is where the 135% number comes from.
Instead of a 0-10 sliding scale of risk, financial advisors should give 95% confidence upper and lower bounds. For example if you put away X% of your income per year would you rather have a 95% confidence level of living off of 70-75% of your current income per year or 65-85% once you hit retirement?
I think this would make the acceptable risk
Thanks for provoking some thinking and soul searching. By and large I have avoided financial counselors because they’re always looking to make the sale. That’s why iffy products like variable annuities, with handsome commissions, are presented as an ideal investment. Fee only advisors are harder to find.
Being retired I offer two bits of advice:
1)You CAN live on a lot less than 75% of your pre-retirement salary – you just have to bite the bullet on the extras. My wife and I are at about 40% right now.
2) Personal risk tolerance is nebulous. The shotgun shell quote above seems appropriate at times. The past 10 years have tought us a lot of hard lessons.
Your point is very valid re: the % of income needed at retirement. I often have clients that ask me if they can afford to retire and I tell them that without knowing what they spend now and how that expects to change in retirement, I have no idea!
Having the discussion in a financial planning context adds huge value and hopefully makes some more of that 1% fee (I, unfortunately, often see higher) worth the expense.
One useful thing financial advisors could do for their clients would be to encourage them to find work that they can be happy doing well into their 70′s. This is the goal, finding work that is so enjoyable and rewarding that your whole life isn’t geared toward that day you can finally quit. Some grown up talk to people might be a good idea, too. We are living decades longer than our forebears did. So you’ll have to work longer than you thought. Too bad. You won’t be dead!!!! Obviously, it’s not easy for a 65 year old to get a decent job. So the financial advisor would do his clients a HUGE FAVOR to get their clients focused on developing some skill set early in their careers that will be marketable and relevant for years to come.
The first question to ask a financial advisor is “what is your net worth” if it is less than the yours go to someone else. The second question to ask an advisor is “how are you licensed” that will tell you how they will steer you to make money off you. Securities guys steer you to securities, insurance guys steer you to insurance. Third question to ask: “What are you going to do to make sure that you don’t lose my money?” The fourth question to ask is “would I trust my banker or financial advisor with my life? If the answer is No why would you trust them with your life savings? Fifth question to ask. Do you use the substituted or fiduciary standard? substituted has less strenuous disclosure requirements than fiduciary standards which forbid conflict of interest and require full transparency. Lastly, if you aren’t worth at least as much today as you were in 2007 then you need to find another advisor. Your advisor will hate you, but you will walk out with money in your pocket.
One other thing, go to jdpower.com to see their 2011 investment advisor customer satisfaction survey results. If your advisor works for a below the median company find another advisor.
You’ve got to love academics with their theories. They’re really in touch with reality, aren’t they?
The real crux of the matter is that the facts of the reality do vary tremendously from person to person.
It’s easy to follow if ‘money is no object’ and ‘no one faces any adversities’ such as health problems, aging parents, ongoing inflation, etc.
Mr. Ariely’s advice ignores the fact that the vast majority of people cannot simply put away the 20% to 40% of their income required to meet the goal of a portfolio that will produce 135% of their current income.
In addition, it is a fact that most people spend their income at different rates through their retirement years as they age. Generally most people in their 80′s and 90′s spend far less for leisure activities than younger retirees.
Contrary to the ‘cookie cutter’ advice given by Dave Ramsey which actually can benefit over 90% of the public, Mr. Ariely’s advice may only prove useful to about the 2% of the public who might fit ‘his mold’.
Quenitn,
First of all, did you spell your own name wrong? Is it Quentin? LOL. Secondly, the fact that you love Dave Ramsey (an idiot who knows less about finance than my infant son) and have a fear/disdain for academia, says to me that you were a little biased against Mr. Ariely and his opinion right off the bat. I can hear you drawling “Hehe, dem damn schoolboys ain’t got no common sense.” Third, thank you for the “90% and 2%” figures you pulled out of your butt. Please put them back in there where they belong. Read “Predictably Irrational” or have someone read it to you.
As seen by the current discussions in Congress, many of our retirement systems were designed to safely provide retirement for only a short, limited retirement period. Social Security and Medicare were fashioned to provide safety net income for a brief period of time. With increasing longevity and a changing perception of when retirement should actually begin, these systems have been put to a test. Personal savings would naturally have to make up the difference.
Post retirement living expenses are difficult, if not impossible, to model accurately. Most retirees may spend more during the early years when health is good and restrain spending as health concerns creep in. The biggest fear for retirees is running out of money due to unforeseen circumstance. Risk management during this period plays an equally important role when compared to investment management. Many of these risk management tools should be addressed many years prior to retirement.
Believing that retirement is a single day exposes many new retirees to the marketing of products and services by the financial industry that promise to fix any problems that they may have. In my opinion, planning should begin far in advance of the actual date so that adequate re-positioning of the portfolio can occur and risk management tools can be put in place so as to avoid impulse purchases.
Of course dream retirements cost more than current income. Many people have fantasies about living better in retirement (travel, second home, etc) than they do now, but are not able or willing to save what it would take to get there. Part of a good financial adviser’s job is helping clients determine what it would take to achieve their dreams and whether following that path is realistic. Good financial advisers don’t just do investing. They help clients analyze choices in areas such as home buying and mortgages, life and property insurance, paying for college, etc. Investment management fees may pay for more comprehensive help if you have a good adviser.
Dan,
I applaud your bold statements relating to the lack of depth “financial advisors” are using in working with clients as I am a financial advisor myelf, and it irritates me to see other advisors selling products and using a cookie-cutter approach to financial planning. It is only logical to believe that individuals will spend more money in retirement for the exact reasons you stated. However, aren’t you contradicting your own work and philosophy by saying, “Financial advisors should be helping their clients with these tough decisions! Money is about opportunity cost. Every time we think about buying a car or going on vacation we should be asking ourselves what we won’t be able to afford in the future if we go ahead and make this purchase. And that’s where the financial advisor should come in?”
It is obvious that humans should always weigh the opportunity costs. But because humans are irrational as you say they are, and which i agree with you in believing that we are, simply having an advisor guiding them in the right direction isn’t going to help. It is clear that you have spent most of your life in an academic setting and have not actually spent time working with clients because you would know that clients are going to make their own decisions. And they will make those decisions, good or bad, based on their own emotions and thoughts, not based on the facts and advice given them by an advisor. It’s one thing to sit back and tell advisors what they are doing wrong and what they can do differently. It’s completely different to get out of your sheltered acadmeic world and step foot into the real world working one-on-one with irrational human beings. Your theories are great but do not hold up in practice. When you find an academic process that will hold up in practice, you may just become the richest man on earth.
“Look at me, I have a 3 week course in selling you mutual funds.”
Pesonally I have found that in my experience “financial advisors” (i.e. bank-employed mutual fund salespeople) know remarkably little about wealth. They will take a percentage of your assets to put you in funds which typically underperform the market by a wide margin. What do you expect? They are bank tellers with a bit of extra training in how to exploit a conflict of interest.
Robert Kiyosaki said it right when he said: when you get financial advice, ask the question “Does this person profit from the advice he gives me, or is he paid to give me advice?” In the latter category, well, disregard the advice. it is probably dumb at best, and more likely it is an attempt to exploit your ignorance by making salesmen look like trusted advisers.
After 30+ years in the financial services industry, my conclusions are that most financial planners are legends in their own minds, they have no clue about risk management and charge for services that most investors can get for free through their mutual fund or variable annuity providers. I wouldn’t pay a nickel for ongoing advice from the average advisor, unless the service provided was risk management. Clients want to open up their statements and see more money in their account than they had before, not hear rationalizations and excuses from the planner when they have lost significant amounts of their retirement assets. Most planners are geniuses during rising markets and want no accountability during declining markets. Financial planners are long on fees and short on everything else.
From the start of this article it is clear you do not understand what a good financial planner does. We do not ask the question of what you think you may spend, we run long-term cash flow scenarios based on your current expenses, incomes, expected large purchases, etc. to develop a plan that maintains the same lifestyle of the client given their inputs. We then build a portfolio that can maintain the lifestyle they would like and also take into account their goals (do they want to maintain their wealth, grow their wealth, or dip into as they want to be overly conservative?). It is not two questions and it is not based on non-financials.
I’ve seen much wealth destroyed by individuals not planning that they many planners can easily justify the fee. Not to mention finding problems and extra expenses in individuals estate plans, insurance policies, tax returns, etc. etc. that planners can assist with as well as manage the assets for the 1%.
You’re right, Dan. It’s most important for a prospective retiree to first address what he’d (or she’d) like to do in retirement. Far too many retirees grab for the calculator to figure out “how much money” without first thinking about what in the world they’d like to do after they’ve finished eating breakfast. Bill
The real issue is that once folks understand what they really want they are faced with the hard truth that they likely can’t achieve it.
How did the author arrived at his premise about most financial advisors asking those two questions? What surveys and data were gathered? Is the premise simply anecdotal?
I recently met with a financial adviser, and you pegged the discussion. Fortunately, I already had a strategy in place and just wanted his take on it. (He was surprised and impressed by my plan. I asked him if his non-profit financial management company could offer me something I didn’t already have with my commercial provider, and in the end he admitted he couldn’t — not even in fees!)
I have my retirement funds invested in a passively managed, no-load S&P Index Fund, as the Motley Fool suggests for lazy investors (like me) who want to set it and forget it: http://www.fool.com/mutualfunds/indexfunds/indexfunds01.htm
That’s financial management by algorithm!
I may adjust this strategy as I get closer to retirement, but for now it suits me quite well. Ignore the market news, take advantage of my full employer match, let the algorithm do its work, and pay minimal fees.
Not having exposure to small cap, value, international, etc does not give you exposure to investment classes that have been identified by academia as having a better risk/return spectrum. How did you feel that the S&P had a negative compounded return for the first decade of the 2000s?
I suggest that, as a person who claims to do science, you gather some data before you start wildly hypothesizing.
You could, say, gather data about what financial planners actually do before spouting off.
Abigail,
I suggest you do some research into the kind of research Dan does before you spout off
Financial planners are in the business of earning fees
It is important to note that investment management and saving for retirement can be very different for different people. To label an investor as conservative to produce a pie chart allocation does not really reflect how being a conservative investor may view the world. Conservative investors may or may not be conservative in other parts of their lives. To point at a single percentage of salary that must be saved each year and then overlay a portfolio allocation does not include the effects of other lifestyle decisions.
Too many investors separate investing for retirement from the rest of their daily lives. I see many investors whose pre-retirement lifestyle does not match their supposed retirement goals and risk tolerance. Trying to assist these investors by providing advice and products that are not necessarily appropriate and geared more towards compensation has failed. Increased fiduciary standards for advisers product providers would be a welcomed start.
The only problem with investors firing their financial advisors and relying on an algorithm is, “garbage in garbage out.” The output of even the most sophisticated mathematical equation is only as good as the data it’s supposed to interpret. Many investors feel their own knowledge is inadequate when answering questions about investing. With so many financial planning tools like http://www.riskalyze.com for allocating portfolios based on risk tolerance, http://www.mint.com for budgeting, or the many sites like http://www.bankrate.com for financial planning, fewer investors will need financial advisors; but there will always be a need.
A couple of comments, based on my own experience.
1. No matter how much you say you will live on, you *will* spend more than that in the first few years after retirement, as you do all (or most) of the things you’ve been saving all that money for. After that period – which will vary from person to person – things will level out. The question is how to plot something like that. I have no idea.
2. I believe that many people could manage their own money, especially if they’re retired when they have more time to do so. Or, they could put the money they would normally put in stocks and put them in index funds instead.
But they put don’t. Why?
Because if everything goes haywire and they take big losses (like we’ve had periodically over the last few years), they can blame their financial planner.
I’m not defending planners here. I’m just saying people know the market is unpredictable, and are afraid of losing money based on the decisions they themselves have made.
They shouldn’t call it a 1% fee. They should call it a 1% blame tax.
And I’m as guilty of it as everyone else
What’s interesting in this topic is that despite the shortcomings you highlight, financial planners are so in demand. There should be plenty of data out there showing that customers never actually met their plan, given how much income they think they need to live the life that they think they want…so how could the profession still exist? Does reality set during that first meeting that they can’t meet the savings obligations, and so throttle back? If so, then hasn’t the planner done his/her job? Or does this happen more over time? Perhaps the person loses energy / drive as they get older, and simply does less because they are older, and so can live within what they were able to save? Or perhaps it’s much more simple, that they paid off their mortgage, and so they can live at 75%, which would be equivalent to 100+% salary with mortgage?
It would be interesting to study the behavioral economics principles that planners use to shift new customers’ thinking from “yep, i want to retire in france” to reality…
Dan, have you considered the tradeoffs involved in getting to the point where a 135% replacement rate is feasible? I wrote up a blog entry about this, referring to a paper I will have in the October 2011 Journal of Financial Planning, “Getting on Track for a Sustainable Retirement: A Reality Check on Savings and Work.”
Assuming Social Security will add another 20%, so that 70% vs. 135% corresponds to 50% vs. 115%, the table in my blog post shows, for instance, that a 40-year old with wealth equal to 4 multiples of salary could retire at 58 with a 50% replacement rate, and retire at 69 with a 115% replacement rate. That is an 11 years difference. I think a good financial planner should help their clients to evaluate these sorts tradeoffs and decide on a happiness-maximizing solution.
Wade Pfau
http://wpfau.blogspot.com/2011/09/dan-ariely-on-spending-in-retirement.html
rough draft of paper: http://ideas.repec.org/p/pra/mprapa/31900.html
Disclosure: I am a financial advisor with 36 years experience.
My first comment is that both sets of questions are wrong. The first is needs focused and too narrow and doesn’t focus on what is really involved in having a successful retirement.
It really is a question in the accumulation phase of retirement and not enough questions are being asked to help monetize the accumulation objective.
Your questions are want focused and of course will add up to 135% of last year’s income. The reality is that most people won’t even be close to meeting their needs let alone wants.
Also proper retirement planning looks at what happens post retirement too as there are significant risks there as well.
My role as an advisor is to help people create long term plans based upon their goals and stick with it, to help prevent them from making the big mistake. The reason more people don’t have the resources they will need is because they make big investing mistakes.
http://garygorr.wordpress.com/2011/07/03/are-we-our-biggest-investing-enemy/
You are correct, money is about opportunity cost. People however have to make the tough choice themselves. I can only do so much.
It is not the financial advisory class that is the issue as your post suggests, we are just an easy target, but it is Boomers, the people who have had so much that are so in denial. They must wake up.
Here is a blog post that can help people address the retirement reality in a realistic way. http://gbgorr.wordpress.com/2011/03/08/what-is-your-number/
Dan, the field of behavioral economics has a lot to contribute to the field of professional financial services, and this article falls short of what you and the field can contribute. While accusing the financial advisory industry of asking over-simplistic questions, you caricature the industry as a whole in an over-simplified manner. This may be provocative, but it seems to me to be an ineffective way of encouraging the profession to reinvent itself to service the need people have with making financial decisions.
On another note, do you have a reference for the study where you asked people how they want to live in retirement, including where they want to live and the activities they want to engage in? My first thought when reading about this is that these questions are likely to elicit an unrealistically high figure. If you asked someone how they want to live now in these same respects, they would probably need more than their current income to do so!
Dan, have you considered the tradeoffs involved in getting to the point where a 135% replacement rate is feasible? I wrote up a blog entry about this, referring to a paper I will have in the October 2011 Journal of Financial Planning, “Getting on Track for a Sustainable Retirement: A Reality Check on Savings and Work.”
Assuming Social Security will add another 20%, so that 70% vs. 135% corresponds to 50% vs. 115%, the table in my blog post shows, for instance, that a 40-year old with wealth equal to 4 multiples of salary could retire at 58 with a 50% replacement rate, and retire at 69 with a 115% replacement rate. That is an 11 years difference. I think a good financial planner should help their clients to evaluate these sorts tradeoffs and decide on a happiness-maximizing solution.
Wade Pfau
(Typing on a real keyboard is a lot more accurate than on a tablet.)
Let me set the record straight. I am NOT a fan of Dave Ramsey. Some of his advice is unsound for anyone. However, both you and Mr. Ramsey offer ‘cookie cutter’ advice. When I made reference to Mr. Ramsey’s advice, I was alluding only to his primary mantra regarding people avoiding debt as much as possible and to be cautious when entering debt agreements. This would prove beneficial to the 90% of folks who are struggling with financial issues.
As to your advice, anyone with an ounce of financial planning experience will tell you that we do not live in a ‘one size fits all world’. There are a plethora of dynamics which differ from person to person. Some are caring for elderly parents, some may have the concerns of a special needs child. In addition, there are an abundance of risk variables to consider.
So in stating that clients need ’135% of their pre-retirement income’ you’re making an assessment which is completely unrealistic for most people.
Add to this the fact that this past decade has been one of, if not the very worst economic cycles this country has ever seen, and your advice to someone already struggling on the edge as they enter retirement will make them feel like they’ll need to commit suicide.
Another major factor your arguement totally ignores is that healthcare finance costs have been scheduled through legislation to skyrocket even faster which will further exacerbate the inadequacy of retirement investment.
(PPACA: a deliberately defined oxymoron specified as Patient Protection and Affordable Care Act, but which in nature should be defined as the Personal Property Appropriations Commandeering Act).
I can tell from the comments from the other FPs here that most of us do agree with you in that the first two questions asked are not sufficient enough to provide advisors with nearly enough insight to benefit their clients. However, few of us are naive enough to believe that algorythms will provide everyone with financial security.
If this were true, everyone who ever bought a book espousing the benefits of algorythmic investing would be wealthy and everyone else would be joining them.
Intriguing post! It makes me wonder if the financial (personal) services industry should in-fact be based on getting their customer to understand the dynamics of these two (or any other) fundamental questions regarding their investment for retirement and enable them to find pragmatic answers to the same. I agree with the finding that people are not aware of their risk profile and have (in crude terms) no sense of money, but I scarcely believe that the answer to these (and other) questions would be same for a lot. Thus without generalizations, the research (in my view), at the financial-services end, should focus on getting people to asses themselves and their risk profile. This, to my utter dissonance, reverberates back to financial-literacy.
And financial literacy is equally nebulous as no amount of maths nicked from physics stopped the world economies going into meltdown. No economist can make accurate predictions – although it doesn’t stop them trying. I find most financial experts haven’t figured out that we are in a Pirsig world where economic truths only hold until the next one comes along.
Expectations in the UK are skewed by a brief period when it was possible to retire at 50 with a guaranteed pension, the reality is that the majority will have a larger state provision than private pension. Conversely I am told that in Australia where compulsory pension saving was introduced non pension saving has almost dried up because your future is perceived to be secured.
People have to engage with money and have a proper relationship with it rather than seek the impossible and abdicate responsibility.
The question is not “How much do you need in retirement?” but “what are you going to do with what you’ve got.”
If I calculate that I ‘need’ 135% of my salary and I can’t come up with that, then I have to scale down my spending plans. I’ve had to do that all my working life – why should it be different in retirement?
Once you find your comfort zone for risk and develop a savings plan, the final result is more or less up to the market.
And, even in retirement, I think it prudent to spend less than you make.
“but I think that a simple algorithm can do this, and probably with fewer errors”
Isn’t this how most people already do it (and still take a cut for it). The people I know in finance use very simple algorithms and constantly beating themselves for not simply following them (when they get big losses they exit even if the algorithm says otherwise)
Great Artical! But I have some comments
First. You do not need a complex algorithms to find out the answers to those questions. A simple Time value of money calculation will do.
Second, The Financial Advising business has nothing to do with rebalancing and help someone pick which car loan to get. Its all sales! Financial advisor’s ( who work for the big firms) main job is to sell you a product ( high fee mutual funds, insurance, etc.) Gather your money and collect fees. They are not money mangers. They are paid to HIRE money managers .
You are absolutely correct that “Financial advisors should be helping their clients with these tough decisions!” However, The people who needs help with tough financial decisions don’t pay the advisors enough to get that type of treatment. For example, lets say someone invests $50,000 with an advisors. 1% of $50,000 is $500. The advisor needs to give 50% or more to the company they work for. To keep it simple, lets say the advisor keeps 50% $250. The advisor will not get the $250 up front. They get it throughout the year monthly or quarterly. So, the Advisor asks to him or herself is $20 (monthly) worth spending an hour or 2 with someone understanding and teaching someone about the market and helping them with tough financial decision? OR Should they spend their time finding a bigger client? Its sucks but that’s how the business is.
Money is attached to emotions. A good reason to hire a investments manager is if your emotions get in the way of important decisions.( if you sold in 2008-2009 because of panic, hire someone to do it for you!) If you are disciplined enough to manage your investment yourself. I say go for it! But its your are not, you will make lots of bad decision. For example, Selling and buying at wrong times.
If you are looking for help with your financial decision you have to do your research and find the right person that has your best interested at heart. Independent advisors ( RIA ) CFP and or CFA certified are your best bet.
Last, Risk tolerance is set questions the regulators ( SEC and FINRA ) force the advisors to ask. Its used to cover the firm and the advisors butt in a lawsuit. For example. If a client sues their advisor because they lost money. The first evidence they will show is the risk tolerance questions the client answered. If they answered any question that involve any type of risk, they will lose the case. In the notion that they accept risk, and that was a possibility they will lose money.
Last Last, Not even the best financial advisor, money manager, investments coach, etc. can teach someone character. Malcolm Galdwell said it best in his book outliners, Its all about where you came from.
I think people need to distinguish between “adisors” and “planners”. I am a Fee based planner and give unbiased advice regarding all aspects of my clients financial well-being. Investment advice is only one area that I cover. Others include tax, mortgage & estate planning, cover risk management strategies , I talk about credit issues and budgeting and help clients set realistic expectations regarding their retirement income needs. I have told more than one client to place paying down your debt or mortgage a head of retirement savings because they will accumulate more wealth in the long term.
People need to do dome due diligence when seeking financial advice. The “nice guy” at the bank is making profit for the bank by pushing their mutual funds. The advisor from the well known investment firm with the fancy office is also making a lot of money selling mutual funds, not giving “free advice”. Find a proper, accredited Financial Planner and ask for referrals and/or a sample Financial Plan.
I’m tired of everyone in this industry bashing everyone on the other side of the fence. You’re fee-based. Fine. Unbiased? Hardly. You just told me that I’m unprofessional and that all I do is make money for the bank where my office resides. I have been involved in virtually every aspect of this business and I’ve seen the very best and worst. It boils down to the individual advisor or planner, not their fee structure. Your mantra reads like a typical political attack ad based on absolutely no knowledge of me whatsoever. You want people to come to you, not me. You want them to pay you a fee to do what I do for free. If they take your plan and buy a no-load fund at a bank they’ve paid extra for no reason. And please don’t tell me that never happens. I believe that you are likely good at what you do, and that your plans are absolutely worth what you charge. But I have no way to know that for sure. You don’t know me, so please shut your yap and stop pretending that everyone who isn’t you is a money grubbing criminal that’s out to screw the public. Promote yourself, but not at my expense.
First you don’t do anything for free. Stop lying to yourself and to your clients. Sounds like you are new to the game or you are completely brain washed by your company.
The only “easy” part of this discussion is knowing that there are no easy solutions. People are irrational, markets are unpredictable and if you put one hundred top economists in a room with the same data, you’ll get 100 opinions on not only what WILL happen, but also what HAS happened. Everyone is different. Everyone has to find their own way through the maze. And VERY FEW HAVE ENOUGH KNOWLEDGE to wade through the muck all by themselves. That’s why the professional investment advisory insdustry is supposed to exist. Unfortunately about 80% of all the recommendations made daily have to do with selling a product and are made without enough knowledge of the client to make any sense at all. I am a professional advisor and I work hard every day to help people feel comfortable with money and investments. I find the more they know the more comfort they have and the better decisions I can help them make. Everything else is just details, opinion and supposition. To suggest that implementing a “simple algorithm” can solve anyone’s problems is simply ridiculous. Keep studying away there Dan, and the rest of us will deal with real people and real issues face to face, day after day.
Your points are well taken. People have no idea.
I stopped using both questions years ago in my practice for that very reason. Risk tolerance questionnaires should be called, “How much can I lose before you sue or leave me?” As far as income, you’re right there too. We use our models to determine how much income we can generate. Are folks unrealistic? Yes. But the investment industry is the one pushing the dream in all their lit. I tell my clients up front, ignore the pictures. Retirement is not walking on the beach, and biking through the country side every day.
While I can’t necessarily speak for other financial advisors or investment professionals, I run a website that has hundreds of advisors from all different channels (Banks, Wirehouses, Regional firms, Independents and RIAs) and one thing I have noticed is that you can’t generalize how they practice. These people have two things in common among them: 1) They want to earn a good living and 2) They have a strong desire to help people. As for questions being asked, you would be quite surprised how people run their businesses differently.
You are quite correct that in that particular case, an algorithm would probably be suitable. However, there are many other things advisors bring to the table.
Also, as far as risk tolerance is concerned, the first question shouldn’t be “What is it?”, but “How are we defining risk?”.
Interesting post, however I believe the conclusions possess a similar weakness in the “75% rule” you are using as the baseline. Budget is a key aspect of how one lives know and in retirement.
If you were to ask most people how they wanted to live and did not put parameters on the question I am faily confident that the answers you will get will exceed reality. Were the folks indicating a spend of 135% of current income told that they would be spending more in retirement than they are spending at the current point in time? Most likely would change their perspective once finding this out. As often is the case the value of a concusion is highly correlated to the quality of the questions being asked and study design…
I would hope that Finanacial Advisors do more than ask what percent of income is needed in retirement when talking with their clients–I myself would actualy start with a current budget as a baseline and project spend from that. I manage my own money (along with several individuals) and can tell you that any future projections that do not start with current spent and account for several likely large expenses later in life are most likely flawed. However, I can say that I really have a difficult time seeing how one can expect to spend more in retirement than they spend in their earning years (unless of course they have a high degree of certainty they retirement years will be short-lived).
I think you should at least spend some time with real financial planners before drawing these broad, unsubstantiated conclusions. This sort of “advisory pornography” is precisely what makes it difficult for consumers to get good advice. It causes them to conclude that either there is no good advice out there or, if there is, finding it will be virtually impossible. The financial planning profession has evidence-based methodologies for addressing both of the issues you identify (how much will be needed and what is the consumer’s risk tolerance, including how to assist the consumer with their risk perception and how to artfully include the concept of their risk capacity into the analysis). Take you own advice, sir, and reinvent yourself into a journalist who actually does research for his articles.
I am a holistic, no-commission financial advisor. Essentially, I’m a paid consultant. I sell no products of any kind. If a client comes to me wanting to know whether or not they can afford retire, it typically costs them far less than 1% of their assets (about 0.40% is common). And if I needed to ask only two questions, we would do that in far less than the three 90-minute meetings we routinely schedule for this task. Not to mention to 15 to 20 hours of additional work involved.
This is what it takes to do a retirement financial analysis in the right way. There may be financial advisors who take 1% for asking two questions. But that doesn’t describe me, my colleagues, or thousands of fiduciary, fee-only advisors around the country.
Mr. Ariely, you do a grave disservice to many advisors and those clients they may assist when you say, quite incorrectly, “For the most part, professional financial services rely on clients’ answers to two questions…”
We, sir, are already reinventing the profession, as we’ve been doing for decades. It’s a shame you’ve never met any of us. We could teach you a thing or two, Professor, about what really happens in fiduciary financial planning.
I’ve always thought it important to find a financial advisor who shares basic lifestyle values with your. One thing my wife always jokes about is that we want to see our next financial advisor’s portfolio before we do any business with him or her! You really want someonwe who has been successful managing your assets – and not someone with no experience – or assets.
I’m a little shocked at how little people consider the idea of their retirement at all. I used to save diligently until after I got divorced, then with expenses the same, but income cut in half, saving and investing a few thousand every month became less possible, but it’s a scary thought to think that I’d need 135% of my current income in retirement. Clearly, I’ll need to invest in some inexpensive hobbies!
Is this for real? Dan assumes that all Financial Advisors do is calculate numbers. I am involved in so many aspects of my clients lives that, while numbers are important, they are only a small part of what we do.
“Not to be offensive, but I think that a simple algorithm can do this, and probably with fewer errors.” I agree with this statement, but that is just the point. That is the smallest part of what I do for my clients. It is highly offensive to me to imply that the 1% fee is just about calculating a formula. If this is all your advisor is doing for you then find another advisor!
To all advisors in this discussion, Please answer the following questions ( be honest)
Will you do a full financial plan and manage the assets of a client that has less then $25,000
Will you help someone who doesn’t have any money but wants to start saving?
Will you pick a high cost mutual fund for your client instead of a low cost ETF because it pays you more?
How many of your actually keep a emergency funds for your clients? For the Fee based advisors Do you charge for non managed cash?
If you come to the conclusion that paying off a client’s home will be better for them, will you advise that or will you convince then to invest with you instead?
Personally I will do a financial plan for anyone. I charge a modest fee, $250-500 in most cases. If I think they will do better by paying of their mortgage faster I tell them that. I give them a plan, if they choose to have me implement some of it I charge up to 1% for AUM, depending on the size of the account, using commission/trailer free investments. Recommendations are made assuming the client is going to implement the plan themselves.
What about technological advice? This is a great post and I really liked following the discussion. I think what you are saying applies to assessment of the effect of technologies as well. People doing technology assessment assume that they can estimate what result a new technology and its use might have. They build many scenarios and think of the possible outcomes. I think that in many cases, small-scale experiments might be more useful that this abstract activity. What are your thoughts about this?
hello,
As I have read the above post, I learned that how investment advisor really helps us in the business. And it encourages me to be more sufficient in managing money in the business. I just wanna thank you guys for posting this one.
I think this blog entry is as simplistic as the approach that many financial advisors take. We ask our clients to try to calculate their post-retirement financial needs by itemizing their anticipated expenses. Some are higher than their current income needs, some are lower. 135% is certainly not the magic number. As for risk, this is a challenge to quantify via any methodology. What we do is to take their total in savings and try to find where their point of pain is in terms of loss. Still a limited and limiting approach, but one would have to be able to accurately define risk in the first place to do any better, and that hasn’t been done yet to my knowledge.
Dan,
Your books irritate me! Thank you. (But when I watch you on video I can’t get away from your pain and suffering.)
As to this post: we – especially those annoyed by behavioral economics – want some of you clever experiments!
I want to hear about hyperbolic discounting and the alternative person approach when dealing with temptations, etc.
By the way, I just started reading Startup Nation. This should be good.
Finally, two points – (One) when did people start planning for retirement? Recent norm I suspect. (Two) for a lot of us: there isn’t going to be any retirement!
You know, when my 16 years old daughter is facing a dilemma, she calls me. Usually I give her a good review of all the ups and downs of the effective options. Knowing what is going to happen next – I tell her “it is your life, and you will have to decide what to do”. And – guess what? Her reaction is – “So many points to consider maybe you will tell me what I should do” (since she is 16 years old I tell her, and overrules it, but that’s a different story).
Isn’t that what we want the “expert” to do for us? The world is complex, retirement is far, we can’t calculate all the complexities, so here comes a person with a title of expert and he makes the decision. It is expert advice and we do not have to think about it ever again. We pay for this peace of mind, fake or not. So – in fact, while YOU are overruling the decision making process, you are hearting our inherent peace of mind (resulted from the “experts” advice). (-:
The problem with the financial service industry is that they receive commissions and kickbacks from pushing various financial products, so you never know what’s in your best interest. Its really difficult to know who to trust.
Seems like the best way to go is to pay someone by performance, but those are usually the top dogs with proven results and don’t manage money for the average Joe.
I find a financial adviser asking me how much risk I’m willing to take (i.e., how much do I mind losing a lot of money) no more ridiculous than having a waitress ask me how much I mind getting food poisoning.
I barely manage to squeak by, living paycheck to paycheck. So things like stocks, investments, funds simply sound too remote. I agree that one should plan ahead for the retirement, but when you live on a modest budget it’s hard to make plans for the future.
Hi-Dan
I have a client who is very interested in purchasing link advertising from your website.
I would like to place a seamless text link of a couple of words within an existing sentence on a sub-page of your website?
Does Dan Ariely.com accept link advertising?
Thanks I look Forward to Hearing From You-
Ed Bassett
These questions are examples of something very widespread in economics and finance, both among academics and practitioners: a remarkably amateurish understanding of people, what they are good at and bad at, and how to ask questions that makes sense to the other guy. Asking people, “What is your attitude toward risk,” assumes that 1) They understand just what you mean by “risk,” 2) Whatever they understand is the same everywhere in their lives, 3) People are good at recognizing their own attitudes, and 4) A persons’ self-presentation is to be taken at face value. Your data nicely demonstrates how wrong these assumptions are, as clinical psychologists, public opinion pollsters, and your everyday bartender know — especially the last two. Famous work, including the foundational work on biases and heuristics, exhibits the same disastrous error: the experimenters assumed, with no justification, that when an experimental psychologist uses the word “probability,” a “lay” person understands it to mean the same thing the experimenter does.
I will right away grasp your rss feed as I can’t find your email subscription link or e-newsletter service. Do you’ve any?
Kindly let me realize so that I may subscribe. Thanks.
Here’s the problem. The future is unpredictable. Too often I read financial industry articles and such about about how “hard” it can be to predict the future. I prefer “impossible.” Though we have shown that we are fairly good linear extrapolators. The industry likes probabilities but in our one-instance, one-life world, one really can’t (well, “oughtn’t) plan that way. The future, especially the distant future (and that is something that even a 65 year has to “plan” for) is, in fact, so unpredictable that all we really know if that we have to set aside some of today’s earnings for a tomorrow we can’t measure. We have to hope to maintain general purchasing power and, ideally, grow it. Though that may be the wrong way to talk about it because there is nothing we can really DO to grow it. We can simply put our money in places that have maintained or have grown purchasing power in the past, but still there is no financial law that demands that such a strategy or allocation will work again.
Some say that you cannot just throw your hands up and say that nothing can be assumed or predicted, but that may be the absolutely best strategy. After establishing as sound an insurance and cash defense (depending upon your amount, this could include cash diversification such as a basket of foreign currencies and gold) as possible, place 25% in Vanguard total bond market, 25% in the Vanguard TIPS fund, and 25% in the Total Stock Market and 25% in the Total International Stock market — and then re-balance. Total cost, a few basis points for the funds. This is just as good or even better than the pointless, misleading, and fantastic (as in fantasy) of the quadratic programming of most asset allocation means-variance optimizers. As Nassim Taleb wrote in “Black Swan” and his other books, having the wrong map is worse than having no map at all.
By the way, there is not just a measurement problem with “risk tolerance” (can it be measured? Is is reliable? is is static?) but one of assumptions, as well. That is, if someone is an 8-10, they will be put into a position that definitionally will likely have them experience the maximum pain they say they are prepared to accept. Further, the knee jerk reaction is to increase the percentage of stocks versus bonds but that actually assume that stocks will have a better return over the period and thought that has happened most of the time, it is not always true nor does it have to be. Let’s just say that the 2 fared a heck of a lot better from 1999-2009 (ten years) than the 8, both in terms of return and a lot smoother ride along the way. That same scenario could be true for 20 years or more. This is not gravity.
Risk tolerance is really just a charade to have the client feel as though they are “known” and that the portfolio is being customized to them. It is a way for the client to feel as though the asset allocation output matches up to their unique fears. It is a bonding moment to make the financial advisor’s job a little easier. It’s behavioral theater.
Hey Dan – Enjoyed the article. Made me smile since I used to be in finance.I wondered if you had a specific strategy of how to actually develop/write out the right questions?
Not sure about Dan’s response, but Zvi Bode, Finance Professor from Boston University, has a good answer to question one in “Worry Free Investing” and “Risk Less and Prosper.” As for Risk Tolerance, Bode also does a good job, I think, in moving that question to that of “Risk Capacity,” something more measurable and useful. I would argue that the entire risk tolerance exercise is useless theater to create the illusion of a doctor/patient relationship — which a very broken analogy. But even assuming you could measure it accurately, even assuming it mattered what an investor felt, even assuming that risk tolerance was static.. then how do you apply it without making expected return assumptions that simply cannot be made?