Choosing an advisor with the care you choose a good doctor will increase the odds of achieving your financial and life goals.
[This article was co-authored by Andrew Berkin.]
At a recent National Association of Professional Financial Advisors (NAPFA) conference in Salt Lake City, finance professor Meir Statman told advisors that, to do their jobs well, they need to think of themselves as “financial physicians.” This role requires advisors to pay attention both to the wealth objectives and the overall financial well-being of their clients.
Statman, who teaches at Santa Clara University’s Leavey School of Business, focuses on behavioral finance research. His goal is to understand how investors and managers make financial decisions, and how these decisions are reflected in financial markets.
At the conference, Statman counseled advisors to provide their clients not only with a financial education and a prescription for the right investments, but also to treat the human emotions and tendencies that lead to behavioral mistakes.
Behavioral mistakes, such as overconfidence and confusing “familiar” with “safe,” can lead investors down the wrong financial path. Statman recommended that advisors teach investors “the science of investment markets, but also the science of human behavior.”
His comparison between the medical profession and financial advice is a good one for many reasons. For example, when you visit a physician for the first time, you’re required to fill out many pages of medical forms so that the doctor has all the information necessary to make the proper recommendations.
The same thing should be true of an advisor. Before giving any advice, the advisor should carry out a thorough process of “discovery” to determine everything that is important to you about money.
To develop the right financial plan, the advisor needs to learn not only your financial goals, but also your life goals. So, like a good doctor, I believe your financial advisor should do the following.
Be An Educator
Doctors know that the best patients are the ones educated about their conditions and treatment plans. Similarly, the best investors are the ones who understand why they have adopted a strategy, or investment plan, and why they have chosen specific investment vehicles.
That’s why Statman urged advisors to be educators. It’s obviously also good advice for investors. Education is the armor that can protect you from both bad advice and your own mistakes.
Be The Quarterback On Your Team
Just as your doctor needs to know about all of your other medical relationships in order to effectively coordinate treatment and make sure each professional on the team is aware of what’s going on, a financial advisor should know your CPA or other tax professional, your attorney and your insurance agent.
This is important because even the “perfect” investment plan can fail for reasons that have nothing to do with investing. Just as an internist will act as the quarterback on your medical team, a good financial advisor will act as the quarterback on your financial team, coordinating all activities.
As one example, many business owners experienced losses in 2008, which provided an opportunity for your advisor to coordinate the conversion from a traditional IRA to a Roth IRA while minimizing the tax consequences.
Develop Alternative ‘Treatment’ Plans
Doctors don’t have crystal balls. They often need to perform a series of tests to make a proper diagnosis and to determine which course of action will likely lead to the desired outcome. Similarly, financial advisors don’t have crystal balls that permit them to forecast stock and bond returns.
In most cases, the only way to determine the asset allocation and spending plan that will provide the best odds of success, while still allowing you to achieve your financial goals without taking too much risk, is to run a Monte Carlo simulation.
Monte Carlo simulations require a set of assumptions regarding time horizon, initial investment, asset allocation, withdrawals, rate of inflation and, very importantly, the distribution of annual returns for different asset classes.
In Monte Carlo simulation programs, the expected final wealth distributions are determined by such factors as the average annual return, the standard deviation of the average annual return, the investment horizon and the withdrawal rate.
The Monte Carlo simulator will randomly select a return for each year and calculate the wealth values over the expected horizon. This process is repeated thousands of times in order to calculate the likelihood of possible outcomes. This allows the advisor to estimate the odds of success of various strategies.
Having A Plan B
Good doctors also recognize that sometimes they just don’t know which treatment path will deliver the best results. They educate the patient on why they are following a specific plan. But they also let their patients know ahead of time what Plan B—and even Plan C—might be if the first course of treatment doesn’t deliver the desired results.
The same thing should be true of a financial advisor, because no financial advisor can predict the future. At best, like the doctor, advisors can only estimate the odds of a plan’s success. And just like the doctor, advisors should have a Plan B ready ahead of time.
You should put into writing what actions you will take if the “left tail”—the bad outcomes in the potential distribution of returns—occurs, as it did in 1973-1974, 2000-2002 and again in 2008.
Act In Your Best Interest
Doctors are required to follow the Hippocratic oath, in which they swear to practice medicine honestly. The original version required the doctor to always do what is best for the patient, rather than what is best for the physician. You would never consider using a doctor who didn’t act solely in your best interests.
Similarly, you should only work with a financial advisor who provides a fiduciary standard of care. The fiduciary standard is the highest standard of care under the law, requiring the advisor to give only advice that is in your best interest.
Most financial advisors, however, provide only a suitability standard of care, which merely requires them to give advice that is “suitably” consistent with your investing objectives. There’s simply no reason ever to work with an advisor who will not offer the fiduciary standard.
Acting in your best interest requires the doctor to avoid conflicts of interest. That is why physician groups cannot be publicly traded securities—there would be a potential conflict between duty to patients and duty to shareholders.
Similarly, doctors in the U.S., unlike in some other countries, cannot own pharmacies—there would be a potential conflict between a patient’s best interest and a doctor’s financial interest in overprescribing to line their own pocket.
The parallel between a doctor pushing medication for her own profit and a broker pushing his firm’s financial product, also for their own profit, is striking. Yet such “advice” is allowed under the suitability standard.
The Hippocratic oath also requires physicians to abstain from doing harm. The analogy to investing is that financial advisors should avoid recommending speculation that can lead to irreparable damage.
Rely On Science, Not Opinion
The original Hippocratic oath also required the doctor to use appropriate means of care, most often the established and accepted medical practice.
Consider the following situation. You aren’t feeling well. You make an appointment to visit a doctor your friend has recommended. After a thorough exam, he turns around to his bookshelf and reaches for the latest copy of Prevention magazine. Even before hearing his advice, you’re already thinking it’s time to get a second opinion. So, you make an appointment with another doctor.
After her examination, she reaches for a copy of The New England Journal of Medicine. At this point, you are feeling much better about the advice you’re about to receive. The financial equivalent of The New England Journal of Medicine is a publication such as The Journal of Finance.
Advisors should be able to cite evidence from peer-reviewed journals supporting their recommendations. Just as you should prefer a doctor whose care is evidence-based, not intuition-based, you should prefer a financial advisor who provides evidence-based advice.
In both cases, the advice should be easily understandable and transparent. One of the things I’m most proud of is that so many readers of my books have told me about what might be called their “aha!” moment. That’s the moment they finally understood how markets work, how prices are set and what the winning strategy is.
Tell You When The Evidence Isn’t Always Available
While the ability to provide evidenced-based advice is always preferable, it’s important to understand that, in medicine, there are times when the science just isn’t there—for example, studies regarding the specific problem have either not yet been done or are not of good quality.
In those instances, an ethical physician is obliged to inform the patient that her recommendation is based on prior experience. Otherwise, the whole relationship is undermined. Patients should not assume that physicians have all the answers simply by virtue of their position, because that’s certainly not the case. Decisions can’t always be as data-driven as we would like, especially when dealing with unusual diseases.
The same thing is true with investing.
It’s especially true when it comes to events often referred to as “black swans.” Those are market occurrences that come as a surprise, have a major effect and are often inappropriately rationalized after the fact with the benefit of hindsight. There will be times when financial advisors won’t have all the answers, and they shouldn’t pretend that they do. So what should the financial advisor, or doctor, do in such a situation?
Discuss Likely Outcomes
When faced with uncertainty, both the physician and financial advisor should discuss the range of likely outcomes, the uncertainty associated with them, the possible next steps and their consequences.
Whether you are a patient or a client, you should not let a smooth talker who pretends to have all the answers fool you. The following example, related by a friend, demonstrates the right way to address uncertainty.
My friend was getting a blood test, and the doctor asked if he wanted to include the subtest for prostate cancer indicators. The doctor asked this question because the latest evidence shows that many positive cancer indications, while true, end up developing into tumors so slowly that there is no point in performing the surgery to remove them.
As a result, some in the medical field don’t believe in even bothering with taking the measurement. My friend had a discussion with his doctor. In the end, he had the test done because a negative result would give him peace of mind, while a positive result would still give him the opportunity to discuss the situation with his doctor and decide what to do. He told me he was grateful for the discussion, as well as the fact that the test was no longer digital (and he didn’t mean the opposite of analog).
Understand That The Unexpected Can And Will Happen
Some diseases have a natural—although not exactly predictable—variability. They will improve or worsen at times, even with the appropriate medical care. This can be frustrating to patients, and can lead them to use unproven advice or remedies from other sources, such as the Internet, cable TV or their brother-in-law.
If taken at a certain time in an illness’ cycle, these agents may be credited with producing improvement (to the same extent as would other placebos, such as chewing gum, changing toothpaste brands and so on) however short-lasting it may be.
Outcomes can be random in nature. Luck can be good or bad. Believing there is a causal relationship where none really exists can undermine confidence in the physician’s advice and be a source of difficulty for the doctor. This is usually seen when dealing with patients who don’t allow themselves to be educated about their illness.
The same thing happens with investing. The right strategy can have either a good or a bad outcome, because outcomes are often determined by random or unpredictable events. This can cause investors to confuse strategy with outcome, an important error to avoid. In a world where there are no crystal balls, the correctness of a strategy should only be judged before we know the outcome.
Education, before the outcomes are known, is the way to prevent patients and investors from confusing strategy with outcome. Nassim Nicholas Taleb, author of Fooled by Randomness, put it this way: “Lucky fools do not bear the slightest suspicion that they may be lucky fools—by definition, they do not know that they belong to such a category. They will act as if they deserve the money. The lucky fool [is] defined as a person who benefited from a disproportionate share of luck but attributes his success to some other, generally very precise, reason.”
The problem is that a lucky fool will repeat the behavior that led to a successful outcome. But if there was no causal relationship, it’s unlikely that the outcome will be the same. The costs can be significant, or even fatal, in terms of either physical health or financial health.
Treat The Whole Patient
Doctors know that they need to treat the “whole” patient. Often treating just the physical symptoms isn’t enough. You may also have to address lifestyle, habits and psychological problems that can cause physical ones.
A good financial advisor also “treats” the whole “patient,” educating his clients about behavioral errors that investors are prone to make simply because they are human beings. My book, “Investment Mistakes Even Smart People Make and How to Avoid Them,” addresses 77 such mistakes. Good advisors educate their clients on the science of investing, but also the science of investor behavior. Forewarned is forearmed.
Eat Their Own Cooking
I always find it comforting when a doctor tells me that she is following the same regimen that she’s prescribing for me. Similarly, financial advisors should eat their own cooking. They should be investing in exactly the same investment vehicles they’re recommending to you.
The advisor should be willing to show you his own statement from the custodian holding his assets so that you can verify his claim. For privacy reasons, an advisor might want to redact the dollar amounts, but he should be willing to show you his personal investments.
He should also be able to show you that his company’s 401(k) or other retirement plans offer the same vehicles he is suggesting to you. That doesn’t mean that his asset allocations will be the same as he recommends to you—because each person has a unique ability, willingness and need to take risk—but the vehicles offered should be identical. If they aren’t, don’t hire him.
Have A Good Bedside Manner
In 1892, The Journal of the American Medical Association published an article about the importance of health-care professionals having a good bedside manner. The article stated: “The true basis of the good bedside manner is a large heart. Some expansiveness of the intellect is undoubtedly an advantage but a humane and sympathizing nature outweighs all other qualities.”
Many hospitals now recognize the importance of bedside manner, and have made it a standard practice to include a health care professional’s soft skills—such as respect, courtesy, listening and ability to anticipate a patient’s needs—as key performance appraisal components.
A good bedside manner can be equally important when providing financial advice that might be hard for an investor to hear. For example, delivering the message that you’re far behind on your financial plan is not unlike delivering the message that your weight will lead to diabetes. You want to work with a financial advisor who, while being able to deliver a tough message when it’s needed, will do it with respect and empathy.
Know That An Ounce of Prevention …
There is a reason doctors often say that an ounce of prevention is worth a pound of cure. It’s easier to try to keep a bad thing from happening than it is to fix the bad thing after it has occurred.
Despite the wisdom of this statement, many people don’t schedule regular checkups, be it with their doctor or dentist. Skipping regular checkups can prevent the chance of catching diseases early. Skipping those can lead to an increased risk of landing in the emergency room, or worse.
The same thing can be true of your financial health. Regular checkups with a financial advisor are important if only because the simple passage of time can change your ability and need to take risk. If any of the assumptions underlying your financial plan change, your investment policy statement (IPS) should be altered to adapt.
Life-altering events—such as a birth or death in the family, a marriage or divorce, a large inheritance or a promotion or job loss—can affect the plan in dramatic ways. The impact is frequently seen in your ability, willingness or need to take risk. Thus, your IPS should be reviewed whenever a major life event occurs.
And it’s not just life events that can impact a plan’s assumptions. Even major market movements can lead to significant changes.
For example, if you’ve already accumulated significant financial assets, bull markets—such as the ones we saw in the 1980s and from 1995-1999—that produce greater-than-expected returns mean that you will be ahead of your goals, allowing you to take less risk.
However, bull markets also lower expected future returns, meaning those still far from their goals may have to take more risk. This doesn’t necessarily mean you should take more risk. Alternatives might be to lower your goal, save more or plan on working longer. The reverse is true of bear markets—such as from 2000-2002 and 2008. A good policy is to review your IPS and its assumptions on an annual basis.
Provide Regular Care And Maintenance
If you want to keep your teeth healthy, you know regular checkups that include X-rays and a cleaning are required. Similarly, a portfolio requires regular care and maintenance in the form of rebalancing and tax management.
To make sure that the market’s movements don’t cause your asset allocation to drift too far away from its targeted levels, you should check for the need to rebalance on a regular basis. It is just as important to check for the opportunity to “harvest” losses for tax purposes.
Like rebalancing, tax management is a year-round job. Far too many investors wait until the end of the calendar year to look for opportunities to harvest losses. Opportunities should be checked for throughout the year, because losses that might exist in January could disappear by December. In addition, it can be important to realize any short-term losses before they become long term.
Just as the regular care and maintenance of your body gives you the best chance of living a long life, regular care and maintenance of your portfolio gives you the best chance of not outliving your portfolio. Quality medical advice can be indispensable, and so can quality financial advice.
In summary, choosing a financial advisor with the same level of care you would choose a good doctor will greatly increase the odds of achieving your financial and life goals. If you decide to hire a financial advisor, be sure that:
- They are educators.
- The only thing they are selling is advice, not a product.
- They provide a fiduciary standard of care.
- Their advice is based on science—evidence from peer-reviewed journals—not opinion. Relying on science and evidence will prevent mistakes that occur when decisions are based on anecdotal evidence. For example, “George smoked cigars all his life and never got cancer” or, similarly, “My brother-in-law made a 100 percent return buying Internet stocks.” That doesn’t mean it’s a good idea for you to smoke cigars or buy only Internet stocks.
- Their investment plan has been integrated into an overall financial plan that includes estate and tax strategies.
For those further interested in this subject, I recommend reading Meir Statman’s “What Investors Really Want.” It’s one of the best books I’ve read on the subject of behavioral finance.
I would like to thank my internist, Dr. David Walden, for his many contributions to this article.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.