From the January 2005 issue of Investment Advisor • Subscribe!

January 1, 2005

Getting the Vitals

Just as MDs promote health and wellness, advisors can foster wealth and well-being

Many financial advisors are drawn to the profession by a sincere desire to help clients. They dedicate themselves to learning about investment products, financial markets, and portfolio construction. They strive to become expert investment managers so they can create optimal investment solutions and generate wealth for their clients. But in focusing narrowly on the art and science of investing, advisors are missing an opportunity to serve their clients in a deeper. more significant way. By developing a broader perspective and acting as financial physicians, rather than as investment managers, advisors can promote both the wealth and well-being of their clients. To do so, advisors may have to change their mindsets and acquire new skills. They must recognize that clients do not come to them to find the mostdesirable point on the efficient frontier or a benchmark-beating mutual fund. They come to find someone who can help them realize their dreams of becoming rich and protect them from their fear of becoming poor. Moreover, their definitions of "rich" and "poor" reflect their own unique perceptions and views of the world.

Advisors who see themselves primarily as investment managers run the risk of seeing each client relationship as an equation to be solved. The first step in solving the equation is determining the client's goals, like providing for a comfortable retirement and educating children. These goals are then translated into a set of long-term return objectives. Next the advisor attempts to establish the client's tolerance for risk measured in her ability to cope with market volatility. Then the advisor constructs a portfolio calculated to maximize the likelihood of achieving the client's return needs while minimizing her exposure to portfolio volatility. Periodically, the advisor reviews the portfolio's performance with the client relative to benchmark indexes and makes any needed adjustments. The process is a simple matter of balancing risk and return, objectively measured and mechanically applied.

Flaws in the Model

This model for servicing clients has a number of problems. The first is that client behavior is more complex and cannot be adequately represented by a simple two-dimensional risk/return model. Meir Statman, a Santa Clara University professor and both a pioneer in the emerging field of behavioral finance and the originator of the "financial physician" concept, believes that clients are driven by more than objective needs like providing for their children's education or securing a comfortable retirement. He suggests, in "Financial Physicians" (Investment Counseling for Private Clients IV, AIMR Conference Proceedings, March 11-12, 2002), that at a deeper level, they are driven by aspirations, emotions, and fears that go beyond meeting the basic needs of comfort and security for their families.

The second problem is the way the conventional model deals with risk. Standard questionnaires attempt to measure risk in terms of an investor's ability to withstand market volatility. But investors don't view risk that way. In fact, they usually don't even understand concepts like standard deviation that advisors use to measure risk. They think of risk in terms of fear of loss, becoming poor, or losing status in their communities. As Statman points out, a client's risk tolerance can change over time and may even vary depending on which pool of assets the client is considering at the moment (say, an IRA, a child's education fund, or a taxable investment account).

A third problem is the way the model measures investment results. Few clients naturally measure their own investment progress relative to index benchmarks. Most don't really have any idea what indexes are or how they might be relevant to their investments. They focus on indexes because they are taught to do so by their advisors, but that can lead clients to lose sight of the most important benchmark of all: their personal investment objectives. Since consistently beating index-oriented benchmarks is extremely hard to do on a quarter-to-quarter basis, clients are often left feeling that their investments are not doing well when, in fact, they are doing just fine.

A final problem is that the model positions the advisor narrowly as an investment manager and makes performance the basis for judging the advisor's value. If the advisor misses the target or the ride gets too bumpy, the advisor is seen as having failed in his or her mission.

Ultimately, the model falls short because it is based on faulty assumptions about how investors truly behave and see the world. How we invest today is influenced greatly by the theories of standard finance, modern portfolio theory, and the mean-variance framework associated with those theories. The developers of those theories were brilliant people who provided us with highly insightful ways to describe the investment world. In order to do so they made a number of assumptions about investor behavior. However, their focus was not on investor behavior at all, but rather on the mathematics of market movements and investment performance.

In adopting the mean-variance framework for investing, our industry has unwittingly incorporated its assumptions about investor behavior into our client service model. Proponents of standard finance may be correct in saying that markets behave over time as if investors were coldly calculating, rational creatures. But behavioral finance clearly shows us that individual investors do not operate that way on a day-to-day basis.

A Behavioral Perspective

Statman's concept of the advisor as financial physician offers us a more realistic model for servicing clients. As Statman sees it, investors are neither rational nor irrational. They are not always fully informed and they often make errors processing the information they have. They are not perfect decision-making machines, but they fall short in ways we can understand.

Consider the case of the man who visited an advisor shortly after receiving $30 million from the sale of his father's business. The advisor recommended a globally diversified portfolio of stocks and bonds, designed to minimize risk, protect the man's considerable wealth, and generate solid long-term returns. But the man was not happy. His brothers and sisters, each of whom had received the same amount from the sale of the business, had chosen highly concentrated portfolios, confident they could pick winning stocks. They ridiculed his conservative, well-diversified portfolio. He was sure they would laugh at him when their concentrated portfolios came out ahead. This story illustrates the difference between wealth and well-being.

Biologist Robert Sapolsky's book, Why Zebras Don't Get Ulcers (W.H. Freeman, 1998), compares the physiology of animals under stress to that of humans to further illustrate this point. Sapolsky notes that the heart rates and hormone secretions of two people playing chess resemble those of gazelles being chased by lions. In other words, we experience stress constantly in our daily lives. We worry about our next move on the chessboard, we worry about our relationships, we worry about our children, and we worry about our investments.

We experience stress most often in environments where there is little predictability, little control, and little social support. That describes the investment world pretty well. That heir with $30 million to invest is facing the unpredictability of the securities markets for many years to come. Rather than receiving support from his family in the process, he feels he is in competition with them, like a chess player trying to gain an advantage.

What reduces such stress? Statman points out that status helps. He notes that we compare ourselves to other people: Am I richer than my brothers and sisters? Or we compare our current position to our past position--Am I as rich as I was a year ago?--or to our hopes for the future--Am I as rich as I want to be? We are happy when our status is high relative to that of other people, our past position, and our dreams for the future. The problem for every investor is that while wealth is absolute, status is relative. The man with $30 million is certainly wealthy, but he has not achieved the status he seeks relative to his brothers and sisters.

Statman suggests that status seeking is a survival instinct, hard-wired into our brains. Centuries ago, status seeking motivated us to act in environments where food was scarce. Even now it is encouraged because it serves society by spurring economic growth and innovation. On an individual level, however, those vestigial urges that served us well in a bygone era can leave us feeling dissatisfied and unsettled.

Advisors can help their clients overcome these and other similar feelings by assuming the role of a financial physician. But how do you assume this role? The skills of a financial physician parallel the skills of a good medical doctor: asking, listening, empathizing, diagnosing, educating, and reassuring. Through those skills, physicians promote health and well-being while financial physicians promote wealth and well-being. Let's review these skills:

Asking. Financial physicians need to ask the right questions if they are to discover the hopes, fears, and emotions that drive their clients' behavior. The questions on the standard risk tolerance questionnaire will not do the trick. Advisors must go beyond those questions and probe into areas they may not be used to discussing with their clients. This may include general attitudes about money and wealth, family history, and certainly a discussion of the client's deepest hopes and fears about the future. The good financial physician must follow this conversation wherever it may lead.

Listening. This requires patience. Clients often have not thought through the relationships that exist between their money and their hopes and fears about the future. Helping the client discover these can take time. But if you are an active listener and respond in an interested and meaningful way to what the client tells you, the client will be encouraged to tell you more. Listen for and follow up on the messages between the lines.

Empathizing. Empathy means participating in or identifying with the feelings or ideas of another. True empathy builds trust, which is essential if you expect your clients to share their innermost feelings with you. As you listen to your clients, try to project yourself into their world and experience what they tell you from their perspective. If you do, your clients' protective barriers will begin to come down. Suspend judgment when listening to your clients. You do not have to agree with your clients' perspectives, but try to identify with them. Truly try to put yourself in their shoes.

Diagnosing. Physicians, whether medical or financial, must walk a fine line when diagnosing their patients. They must use all their professional skills to identify the problem and determine the alternative courses of action. Then they must decide how much information to share with the client and how best to present it so the client can make an informed decision. Too much information may confuse or unduly frighten the patient. Too little leaves the client unable to make well-founded decisions.

Educating. Consider the story of the man who complained to his rabbi that his house was too small for his family. "Bring your goat inside your house," instructed the rabbi. The instructions made no sense, but the man followed the rabbi's advice. A week later the man returned complaining that the situation was intolerable. "Take the goat out of your house," instructed the rabbi. To the man, the house now felt bigger. Helping clients put things in perspective is one of a financial physician's most important roles.

Reassuring. No matter how well you prepare your clients, there will be times when they experience anxiety or even outright fear about their investments. Reminding them of the long-term return expectations of the U.S. equity markets or pointing out that all their funds are beating their benchmarks even though they are losing money is not likely to provide the necessary reassurance. You can't control your clients' emotions any more than you can control the markets, but you can identify and deal directly and honestly with them.

Balancing Act

Part of the job of a financial physician is to help clients find the balance between wealth and well-being. When an entrepreneur sells her business for $50 million, she experiences an increase in wealth, but does not necessarily experience an increase in well-being. Indeed, cashing in may bring great pride and joy or it may bring a sense of sadness and lack of purpose. An advisor should be tuned in to the impact of major financial events on the well-being of the client. By being sensitive to such things, the advisor has greater opportunity to add value to the client relationship.

Now let's say our entrepreneur decides to give part of her $50 million to charity. Her sense of well-being may increase as she experiences the positive feelings associated with donating a significant amount to charity. Yet her wealth will surely decline. A skilled physician must be prepared to identify and help the client deal with these trade-offs.

Do your clients view you as a financial physician? Consider the following. "I have $500,000 in my portfolio," says the client. "I don't mind paying you a fee for the management of my stocks. Stocks are complicated. But managing bonds is easy and cash doesn't take any management at all. Why am I paying a fee for these?" If that conversation sounds familiar, your clients do not view you as a financial physician.

You can change their perception. Imagine that you go to your doctor with a stomach ailment. Your doctor asks many questions, listens to your answers, and probes to find the source of your pain. Then he makes you feel better by empathizing with your pain and the fear you experience from the uncertainty of not knowing what is wrong with your stomach. The doctor next tells you what is wrong, explains how to avoid the problem in the future, and reassures you about your prospects for recovery. The doctor then prescribes a pill and says, "All my other services were free, but this pill will cost you $200." All too often that is how advisors position themselves with their clients. The portfolio is the pill and the advice, guidance, and counsel that clients value is treated as if it had little or no value. Advisors must position themselves as investor managers rather than investment managers.

Investing is about more than money. It is about hopes and dreams, fears and anxieties. Your clients' perceptions of you will be determined, in large part, by how you see yourself. Advisors who want to serve the deepest needs of their clients and establish strong, lasting client relationships should consider taking Professor Statman's advice and thinking of, and presenting themselves as, financial physicians.

Scott MacKillop is president of USF Services, a U.S. Fiduciary company based in Sugar Land, Texas, that provides managed account and investment consulting services to financial advisors. He acknowledges the sponsorship of OppenheimerFunds in the preparation of this article. MacKillop can be reached at scott.mackillop@usfiduciary.com

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