In Leonardo da Vinci’s “Treatise on Painting,” he argued passionately that painting could be improved through a deeper awareness of scientific principles. Lifelike representations of the human form require a grasp of mathematics and optical principles such as geometry, proportion, shape, motion, distance and light. The value of this knowledge is obvious to anyone who compares a lifeless two-dimensional 15th century painting to any one of da Vinci’s 16th century masterpieces.
Is financial planning an art or is it a science? According to Rachele Bouchand, a financial planner in Bellevue, Wash., “financial planning is an art that uses scientific tools. You have to have both. I love getting to know my clients as people—their hopes, dreams, and fears—and using advanced techniques to find the best solution for them.”
Most would agree that this sounds like a reasonable description of financial planning. It combines interpersonal skills and intuition with financial theory mixed in with a lot of applied knowledge. But what is the difference between science and art?
Art implies subjectivity. If financial advice is an art, then it is different from a science-based profession like medicine. Doctors vary in their ability to communicate effectively with patients, but the advice they give tends to be consistent because it is based on sound theory supported by evidence. What would happen if doctors stopped reading medical journals, didn’t receive training in science-based techniques and relied instead on their instinct? Plenty of holistic medical professionals practice healing techniques that have no proven effectiveness (and they also have many loyal customers).
The scientific method uses theories tested with data. A theory explains a relationship between A and B. If an investment has greater systematic risk, we expect it to, on average, have a higher return. This theory is tested using observed data. If evidence is consistent with the theory, we start incorporating it into our recommendations. If the theory doesn’t hold up, we cast it aside and look for a new theory. At its essence, the goal of science is to understand reality.
It’s hard to imagine an aspect of financial planning that is not based on a theory that can be tested. An advisor may try a new planning technique, observe whether it works with a client, and then adopt or reject the technique based on the client’s response. This mimics the scientific method, except the sample size of the empirical test is one. After advisors have dealt with hundreds of clients they get a much better idea of what works and what doesn’t. But that doesn’t mean that they’ve developed an art. They developed a set of techniques that were tested on their own limited sample of clients. And sometimes techniques that work, in the sense that they lead to satisfied clients, aren’t necessarily the best techniques a planner could have chosen. Cancer patients may get great satisfaction from their acupuncturist, but they may have gotten a lot more from an oncologist.
One of the strongest adherents to science-based financial planning is Rick Miller, a planner in Waltham, Mass. According to Miller, “There should be much more science. Planners need much more support from the scientific community, both in research and in communicating the results of the research. Planners need to actively seek out what science has to say, even when that is uncomfortable.” As for whether financial planning is an art, Miller notes that “in many cases planners use art either because they are unfamiliar with the science or because the science is not yet available.” Indeed, science has much to say about many aspects of client interaction that many practitioners (and financial economists) have yet to explore.
How do scientists approach financial planning? Economists base their models on utility theory. Utility theory makes a lot of sense on the surface. Human beings get more happiness when they spend more money (whenever a philosophy professor suggests otherwise, I simply ask him to write me a check to test the hypothesis—it hasn’t happened yet). Although spending more makes us happier, each additional dollar provides a little less marginal enjoyment. We start out buying the things that make us the happiest (food, shelter, healthcare), move to spending categories that are the cornerstone of a middle class life (transportation, cable/Internet, clothes) and ultimately to the categories that are arguably the most fun (travel, eating out, massages, a convertible). The fun stuff is undoubtedly a lot less fun if you are hungry, naked and forced to hitchhike back to your tent.
All economists ask is that you accept a continuum of decreasing marginal happiness from spending. If you do, then they have the tool they need to make all sorts of financial recommendations. Utility maximization becomes what’s known as the objective function or, ultimately, the purpose of life. We can plot out the utility function in a graph where utility goes up with spending but at a decreasing rate. We can even estimate how steep the curve is by measuring your risk aversion. More risk averse means that each additional dollar provides less happiness than it would to someone who was risk tolerant. That’s why risk tolerant investors are willing to take risks—they place a greater value on the possible increase in spending.
Utility theory says that if we spend $80,000 in one year and $20,000 the next year we’ll be less happy than if we’d spent a smooth $50,000 in both years. This makes sense, since uneven spending means you’ll be enjoying vacations and restaurants the first year, then moving into a smaller apartment, selling the car and cutting the cable the second year. If we know your risk tolerance, we can even estimate exactly how much less you’d be willing to spend each year in order to avoid having to spend $80k and $20k. If you’re risk tolerant, you might have been just as happy spending $45,000 each year. The risk averse might be just as happy spending $40,000. This amount, also known as the certainty equivalence, helps us understand why investors don’t like risk and why they’re rewarded for accepting it. Voilà, a risk premium.
So planners are already using utility theory when they make common sense recommendations like holding a diversified portfolio with an appropriate amount of investment risk. They’re also using utility theory when they recommend life insurance (to protect survivors against a sharp decline in spending), disability insurance, long-term care insurance, and even saving for retirement. After all, the reason saving for retirement makes sense is because we expect a possible decline in spending when we give up employment.
Utility theory is important to understand because it’s also the reason why many common planning practices drive economists crazy. I have a collection of favorite quotes by great economists about common planning practices. Boston University professors Laurence Kotlikoff and Zvi Bodie provide a seemingly unending source of gems. Kotlikoff has noted that planners “make outrageously bad saving and insurance recommendations,” that their retirement income replacement rate “methodology is just mind-boggling in how erroneous it is,” and that “traditional planning is geared toward product sales.” According to Bodie, “the standard models that are used to give investment advice to millions of Americans are fundamentally wrong.”
Being repeatedly called an idiot has created some resentment between planners and academics. It might be best to take a step back and examine why the recommendations of planners and academics differ. The first is a very legitimate reason. Clients aren’t always utility maximizing robots. They are emotional, they freak out when markets fall despite their supposed risk tolerance, they focus more on goals than on smoothing consumption, they have family dynamics that make optimal recommendations impractical, and they have trouble sticking with the plan.
The second reason practice doesn’t look like science isn’t quite so legitimate. Sometimes common practice becomes accepted because it is good enough or because it fits the objective function of the advisor. What’s the objective function of the advisor? It is to a) keep the client and b) maximize the amount of revenue received from that client. Recommending a fund with a 200 basis point expense ratio probably isn’t optimal. Even advisors who consider themselves fiduciaries are vulnerable to making recommendations that aren’t in the best interest of a client when it means they have to sacrifice income (research shows they often do this subconsciously). I have had fiduciary fee-only planners tell me they wouldn’t recommend longevity insurance to a client if its cost will reduce assets under management.
A more subtle problem with common practice is that it was adopted because it generally worked rather than because it was optimal. My favorite example is the 4% rule. William Bengen proposed the 4% rule after researching historical 30-year retirements based on an investment portfolio invested in U.S. stocks and bonds. He did it for a very good reason. Even though the average portfolio earned nearly 10% during this period, an advisor couldn’t necessarily assume that a retiree could safely withdraw 10% each year in retirement because returns are random. Sometimes these random bad returns early in retirement can have a big impact on retirement sustainability.
But if we use utility maximization as the objective, then other retirement spending strategies are more appealing. David Blanchett, head of retirement research at Morningstar, has found that the average retiree can live about 30% better in retirement if they don’t follow the 4% rule. According to Blanchett, “any true profession needs to be based on the same basic underlying principles or logic. The ideal application is much more ambiguous than other fields that hold themselves out as more academic-oriented professions such as law, accounting, medicine, etc.” Scientists like Bodie and Kotlikoff would prefer to see recommendations that were based on some underlying logic and verified by empirical data.
To many veteran planners, the recommendations of scientists don’t always seem that useful. Even if an advisor knows that a recommended strategy is theoretically optimal, that doesn’t necessarily mean a client is going to follow it. The right recommendation may be one that recognizes both the theoretical optimum and the behavioral idiosyncrasies of the client. Financial planner and Texas Tech University Adjunct Professor Harold Evensky developed the so-called two bucket strategy to help client’s maintain a scientifically optimal investment portfolio through the use of a behavioral trick—narrow framing.
If there is an art to financial advice, it may be through the assimilation of relevant scientific knowledge into practice. Nobel Prize winning scholar Daniel Kahneman (a client of Evensky) found that utility theory often didn’t do a very good job of explaining how people make financial choices. Instead, people seem to respond emotionally to risk and loss. If you can frame volatility in markets as something other than a loss, you can reduce the chance that clients will respond emotionally. Evensky introduced a framing strategy where clients could ignore the inevitable ups and downs in their investment portfolio by reassuring them that they had their next five years of spending covered with their so called “cash flow reserve.” Frame their near-term income as safe and they’ll act more rationally about their long-term investments.
A new software platform at Raymond James that focuses on implementing and monitoring goals draws from such behavioral approaches. Senior vice president Patrick O’Connor finds that focusing on goals has a profound effect on both advisors and clients. “The science of behavioral finance is shaping how we frame our analysis and recommendations to inform more effective client decision-making,” says O’Connor. The brokerage firm executive believes that focusing on goals “combats the negative investment biases identified in behavioral finance with the positive emotions of connecting financial decisions to those goals that are most important in our clients’ lives.” Seeing goals as the outcome moves the frame of reference toward long-run objectives and away from assessing advisor value through short-run portfolio performance.
Da Vinci considered the complete mind a mix of knowledge and inspiration. “Study the science of art. Study the art of science.” Good financial planning, like art, requires an understanding of science. It also requires the ability to imagine how scientific tools can be used to improve the quality of advice. There is no question that planning success takes a certain amount of intuition and communication skill. Ultimately, however, there is no substitute for knowledge.