Written by Clive Fernandes | National Capital
Robo-advice may not disrupt the whole financial industry, but it is certainly poised to disrupt financial advice.
Soon every advisory business will be a robo-advice firm, or, to use a more appropriate term, a digitally enabled advice firm. Of course, there will always be the one percent of advisories serving a diminishing cohort of clients who don't want a bar of digital, but for economic reasons at least, it makes sense to look to the future. For now, there is still one major service robo-advisers cannot provide - behavioral coaching. Indeed, general opinion on the topic holds that the adviser’s main value to the client is behavioral coaching, not portfolio management. Robo-advice will only increase that gap. Very few advisers will be able to design a portfolio better than a robo-adviser with AI and machine-learning capabilities. However, every good adviser has an opportunity to give service their clients in a way that robo-advisers cannot (yet). Behavioral coaching focuses on increasing investor returns rather than investment returns. Investment returns are the stated returns of any investment or portfolio; essentially, the long- term return numbers we see for a particular fund or index. Investor returns, on the other hand, reflect how an investor’s specific portfolio performs over a set period, taking into account all the investor’s actions. These ‘dissonance actions’ – for example, moving in and out of their investments at inappropriate times – are responsible for the difference between the two figures. The Dalbar's Investor Returns study, which was started in 1994, records the difference between the returns of the market index and the actual results of investors. The 2017 report showed that the 20-year annualized S&P return was 7.68 percent while the 20-year annualized return for the Average Equity Fund Investor was only 4.79 percent, a gap of -2.89% annualized.
The famous example of Peter Lynch's Magellan fund drives home the point. Lynch is considered one of the world's greatest investors, running Fidelity Investments’ Magellan fund from 1977 to 1990. During his tenure, the Magellan fund's average annual return was 29 percent. You would think the average investor in the fund made a lot of money.
No. The average investor in the Magellan fund actually lost money. So even when investors can find good investments, they consistently perform poorly with their investments.
Why do investors take these dissonance actions, which clearly do not benefit them? We know investing for the long term is a good idea, and we should not be chasing returns; despite this knowledge, very few people stay the course during the ups and downs of a specific fund or market in which they are invested. Buying high and selling low is not something we can only do with individual securities, but also while investing in managed funds and ETFs. The primary reasons for these dissonance actions are investors’ behavioral and cognitive biases, such as loss aversion and hyperbolic discounting.
So what is behavioral finance? Building over the past four decades on Daniel Kahneman and Amos Tversky's original thesis on rational (or irrational) client behavior in their ground- breaking 1979 paper 'Prospect Theory', there have been some interesting developments in the field.
A few examples of behavioral biases which we have developed as part of our evolution are anchoring, mental accounting and the aforementioned loss aversion.
Anchoring is a cognitive bias where an individual relies too heavily on an initial piece of information offered (considered to be the "anchor") when making decisions. This leads to clients letting their cost basis dictate future investment decisions.
Mental accounting refers to the tendency people have to separate their money into different accounts based on miscellaneous subjective criteria, including the source of the money and the intended use for each account. This is especially relevant to Kiwi clients who have the bulk of their assets in property, and then view their share investment portfolio as a separate bucket, thereby ignoring deviation of their overall investment portfolio towards property and New Zealand-based assets.
Of all the behavioral biases, perhaps loss aversion is the most well-known. This bias refers to people's tendency to prefer avoiding losses to acquiring equivalent gains; that is, losing
$10 hurts much more than gaining $10 feels good. It is one of the reasons investors will hold on to losing trades with the hope of 'breaking even'.
Helping them recognize and mitigate these biases are what investors should be expecting from their financial advisers. A study by Vanguard, one of the world's largest investment management companies, has shown that advisers can potentially add about three percent in net returns to clients’ portfolios, half of which is attributed to behavioral coaching. Advisers can use empirically proven behavioral finance principles to build their understanding of clients and design interventions to help them achieve their goals.
Robo-advisors today can estimate a client’s risk tolerance and design a suitable portfolio as well as, if not better than a human adviser. Delving into the study of behavioral finance can help advisers gain greater lifetime returns for their clients, and that is what every Kiwi investor should be asking and expecting from their advisors.
Related: Robo-Advice Is Here … What Comes Next?