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May 28, 2013 at 08:00 PM
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.
