The Vanguard “Adviser’s Alpha®” study estimates the financial value for investors at 150 basis points, based on observed investor behavior with target-date funds.
But in a recently published Journal of Financial Planning article, I take a deeper dive into the dollars and cents of behavioral coaching—and how exactly it can help investors succeed. Here, we’ll jump straight into the results and what they mean for advisers.
Why do investors need behavioral techniques in panic-selling moments?
One of the benefits of behavioral coaching is obvious: to help investors not panic. Some investors can and do panic during market volatility. And this can lead to panic selling and missing out on the subsequent upswing. To the extent that advisers can avoid this negative outcome, investors (and advisers) are better off.
Advisers need tools to help investors not panic because—while well-intentioned—the industry’s current approach to matching investors to appropriate investments is incomplete. We are putting two competing demands on the investing process by trying to select investments that will both: a) deliver the returns that investors need to reach their goals, and b) avoid volatility that might lead investors to panic and abandon their investment plan.
Existing approaches do not meet the needs of risk-averse investors
To manage these competing demands, advisers generally apply two approaches: a risk-capacity approach that focuses on goals and generating the required returns; and/or a risk-preference approach that seeks to avoid panic by decreasing volatility exposure for risk-averse investors. In isolation or in combination, these two approaches may fail both to help clients reach their goals and forestall panic.
That’s because for many investors, these two demands simply cannot be met at the same time using asset allocation alone. The returns they need to reach their goals may require risk exposures that they would prefer not to have. Mixing the two approaches—for example, by calculating a stock/bond glide path based on the investor’s time horizon and then shifting it up or down based on the investor’s risk preferences—seems reasonable in principle. Unfortunately, it does not resolve the fundamental tension between these two competing demands. Splitting the difference simply means fulfilling each need less well. The way out of this problem is to address the two issues using tools designed for each purpose.
Conquering financial market volatility with new behavioral tools
Asset allocation is an appropriate and powerful tool to help investors reach their goals without taking on unnecessary risk. But on its own, it may not be enough to help investors manage the risk they do take on. Instead, behavioral tools—that help investors prepare for and respond to financial market volatility when it comes—are more appropriate.
Behavioral tools can address the discomfort directly or find other ways to manage volatility beyond changing asset allocations. For example, potential techniques include the following:
Measuring the impact of panic and a combined approach
To better quantify the financial impact of investor panic and the potential value of using behavioral tools alongside asset allocation, my Journal of Financial Planning paperpresents results from a novel simulation model of investor behavior. In short, the model simulates various scenarios under which investors might panic and determines what that means for their long-term financial outcomes.
The model demonstrates how investor panic results in a loss of between 8% and 15% of assets over a 10-year period when standard approaches are used—such as, risk-capacity-based asset allocations or risk-preference-adjusted glide paths. The results are robust to a range of model specifications and assumptions: No matter how you slice it, panic can be highly destructive.
By moving from these standard approaches to the proposed behavioral approach, investors receive a net increase of 17% to 23% in assets over 10 years, or roughly 170 to 225 basis points per year in returns. Some of that return comes from avoiding panic—supporting the analyses by Vanguard and others. The rest comes from freeing up asset allocation to better serve the financial needs of investors and remove the tension between the two competing demands outlined above: achieving an investor’s financial goals while avoiding uncomfortable volatility at the same time.
Advisers and planners know that their clients, especially risk-averse investors, struggle during times of market volatility. My Journal of Financial Planning paper points the industry towards a new set of tools being developed in the behavioral science community to help investors better manage volatility and reach their goals.
This post by Stephen Wendel first appeared on Morningstar Blog.
