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Financial Planning > Behavioral Finance

How financial planning saves advisors from themselves

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I read Bob Seawright’s story in October’s Research magazine, “When History and Finance Go Wrong,” with great interest for two reasons.

First, he leads off with a brief analysis of the start of the World War I which, to amateur historians like me, is one of the most fascinating and horrific inflection points in modern history. (Although whether the assassination of Archduke Ferdinand was really an “accident,” is a point of contention among professional historians. Barbara Tuchman’s “The March of Folly” offers an insightful analysis of the incident and its ramifications.) 

Second, and probably more important to most readers, Bob’s main concern is the primary challenge for all financial advisors: decision-making in an unpredictable world. While he does a masterful job of identifying advisors’ common mistakes and pitfalls, he seems rather quick to jump to annuities as a solution, while ignoring the many benefits of financial planning—which is specifically designed to address the problems of uncertainty. 

Here’s how Seawright describes the problem that advisors face “The planning fallacy is related to optimism bias (think Lake Wobegon—where all the children are above average), and self-serving bias (where the good stuff is deemed to be my doing while the bad stuff is always someone else’s fault). We routinely overrate our own capacities and exaggerate our abilities to shape the future. Thus the planning fallacy is our tendency to underestimate the time, costs and risks of future actions and at the same time to overestimate the benefits thereof.”

True enough. As Harvard psychologist Daniel Gilbert tells us in his book “Stumbling on Happiness,” our brains seem to be hardwired to make these mental errors. It’s even possible, he suggests, that these “mistakes” contributed to our survival in simpler times. In modern times, of course, these errors can hamper the success of investors and advisors.

Yet Seawright seems to ignore the fact that a group of “advisors” came to this conclusion in the wake of the stock market crash of 1968, and created a process that they felt would enable advisors and their clients to make better financial decisions. They called it “financial planning.”

Of course, that process has been improved by many individuals and organizations since then. Yet its purpose has remained the same: helping planners and clients to overcome their “instincts” to make dumb decisions, including underestimating the effects of “time, costs, and risks of future actions.” 

The very foundation of financial planning rests on the notion that “nobody knows what the future holds.” Consequently, investors will do better over time if they “avoid big mistakes,” keep costs low, manage their risk and continually monitor the results so they can make adjustments as needed.

To further control our harmful impulses, financial planning employs the following tools:

  • Diversification  To control our urge to “pick winners,” planners invest in baskets of stocks (usually mutual funds, including index funds and/or ETFs), baskets of asset classes and often multiple funds in each.    
  • Scheduled rebalancing To thwart our powerful impulses of greed and fear, which often compel us to buy high and sell low, regular rebalancing forces us to do the opposite: sell the winners and buy the losers.
  • Risk assessment To further help clients to avoid selling low, planners discuss their likely reactions to market drops, and create portfolios that their clients can live with, up or down.
  • Comprehensive planning People often fail to consider all their risks, obligations, and wants, both today and in coming years. By getting people to look at their whole financial picture, planners help them make better financial decisions through planning ahead.  
  • Regular reviews  Whether quarterly or annually, planners remind their clients—and themselves—that nobody has a crystal ball by assessing the client’s finances and making adjustments where predictions were off.
  • And finally, probably the biggest benefit that planners offer their clients is helping them to avoid “big” mistakes: unconventional investments (ostrich farms, gold mines, etc.), spur of the moment business “opportunities” and heavily loaded investments, etc.

Seawright is correct when he writes that advisors have motivations to skew reality: “Our plans and proposals must be approved by our clients and we have a stake in getting that approval. This dynamic leads to our tendency to understate risk and overstate potential. Perhaps we see it as easier to get forgiveness than permission or perhaps it’s just a sales pitch.”

The three lessons that he offers to control our tendencies are dead on as well: Stay humble; Avoid errors; and plan for the worst. But let’s not forget the financial planning process reins in advisors’ destructive inclinations as well as those of the clients.

Sure, planners still sometimes get it wrong. Take, for example, when they used “average life expectancies” for financial plans or when most asset classes fell in tandem in 2008. The feedback loop in financial plans forced planners to rethink their assumptions: spawning Monde Carlo simulations, and expanded asset classes.

While it’s always important to evaluate the flaws in our thinking, it’s also important not to overlook the available solutions. As George Santayana famously said: “Those who are ignorant of history are doomed to repeat it.”


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