5 Basic Finance Lessons Many Clients (and Some Advisors) Forgot This Year

The American College of Financial Services published a new podcast this week featuring Michael Finke, a senior leader at the college who directs the wealth management certified professional designation program, and David Blanchett, managing director and head of retirement research at Prudential Financial’s asset management business, PGIM.

During the discussion, Finke and Blanchett spotlighted the market challenges investors have experienced in 2022, with a particular focus on what they called the “spectacular decline” in the value of cryptocurrencies and related digital assets.

According to Finke and Blanchett, the crypto losses and the broader client pain suffered during 2022 offer some key lessons for financial advisors to carry into the next year. The pair emphasized how advisors must work hard to remind their clients that there is no free lunch in investing — and to combat their own feelings of “FOMO” when exciting new investment opportunities appear that seem too good to be true.

In the conversation highlights presented below, Blanchett and Finke offer up five basic finance lessons that clients (and many advisors) seem to have forgotten this year.

1. Hindsight Remains 20/20

As Blanchett pointed out, individuals are really good at spotting what they perceive to be attractive investments — but only after they go up and much of the potential profit has already been reaped by others. As it is commonly put, investors are prone to chase past performance and buy assets only after they have appreciated in value.

This hindsight bias applies to traditional assets, Blanchett said, but especially to new and emerging assets and specifically to cryptocurrencies. Prior to this year’s meltdown, investors of all stripes, from the most sophisticated to the most novice, were simply dazzled by the meteoric rise of the value of cryptocurrencies. They could not help but buy into the hype generated by celebrity endorsements and Super Bowl ads.

As Blanchett noted, many investors probably did feel some degree of uneasiness with respect to piling into cryptocurrencies that were hovering at or near record highs, but they couldn’t help chasing the possibility of magical returns.

2. Reward Only Comes From Taking Risk

“Another related lesson learned this year that will be carried into next year is the simple fact that, if you are trying to make a return above and beyond what is reasonable, you are going to be taking excessive risk in the attempt to accomplish that outcome,” Blanchett said.

As Finke and Blanchett pointed out, a huge amount of wealth has been destroyed in 2022 simply because people forgot the basic mantra of investing and life: If an opportunity seems too good to be true, it probably is.

“That’s true about crypto-type assets and also about any other asset type, for that matter,” Blanchett said. “This type of magical thinking has happened before, sadly, and it will happen again. What we have been reminded of is that opportunities for an outsized return are only possible because you are taking excess risk and because you could lose much more than you might anticipate.”

3. No Free Lunch Means No Free Lunch

Finke said that prior to the crypto crash, it was all too common to hear investors say they had found a no-risk investment opportunity that would deliver returns in the realm of 9% or 10% — for example, by investing funds in the FTX or Celsius platforms.

“When you hear something like this, your first thought should be, wait a minute: There is no free lunch in investing,” Finke said. “Another point to make is a little more subtle. You have to ask yourself, well, if this really were a true risk-free opportunity, what is stopping people from borrowing Treasurys and putting all their money in Celsius or FTX as an arbitrage opportunity?”

As Finke explains, such an investor could reliably pay back the 2% or 3% interest on the Treasurys while they are at the same time enjoying a 9% return. In other words, they could enjoy a free lunch!

“That is what we would think of as a classic arbitrage opportunity,” Finke said. “As such, there are plenty of sophisticated hedge funds and other sophisticated actors out there in the market who would have done this — but they wanted nothing to do with this approach. Why? Because they understood that you have to be taking risk in order to be compensated for risk.”

Finke said too many investors (and advisors, as well) failed to appreciate where the risk in these strategies was coming from. The basic answer is that the crypto platforms were holding themselves out to be operating like a bank, when really there was no collateral being collected and no guarantee being made on the value of deposits.

“With such an arrangement, a de facto bank run can occur at any moment and you can be left with literally nothing, because this is not a bank,” Finke said. “Sadly, that was the source of the risk that ended up burning so many people, and it was not adequately explained or understood.”

4. Healthy Skepticism Is Essential to Investing Success

In Finke’s view, the “crypto craze” also shows that many financial advisors let their own guard down and failed to be adequately skeptical and sober-minded.

“Many advisors kind of just sat by as their clients demanded that they move some assets into these ‘new opportunities’ that were promising returns well above the expected market rates with little to no risk,” Finke said. “As an industry, we failed to make the public at large aware of the risks and appreciative of the risks they were taking by investing in this emerging space. And frankly, some advisors even saw their practices benefiting from clients investing in crypto and holding crypto as the bubble grew and grew.”

Blanchett and Finke said the advisory industry has to reckon with this uncomfortable reality moving forward.

“As we move into 2023 and beyond, we need to address the insecurity that a lot of advisors feel about falling behind the curve,” Finke said. “Advisors fear that, if they don’t know about and utilize all the hot new investments coming online in the marketplace, then they aren’t serving their clients properly. Or, perhaps more accurately, they fear they are going to be seen as old and out of touch.”

Finke and Blanchett noted how common it has been to hear industry professionals suggest that, if a financial advisor isn’t talking about and including crypto assets, they are behind the times and they don’t understand how this hot new thing works.

“Frankly, I think that some pro-crypto actors were able to use advisors’ inherent insecurity to get them to at least tacitly agree with the idea of their clients moving into crypto investments,” Finke said. “As advisors, we must have courage in our convictions to continue to focus on the same ‘boring’ type of investments and only adding new things to the portfolio when we have a very strong and provable conviction that they are going to add value to the portfolio.”

5. Zero-Value Assets Are a Zero-Sum Game

According to Blanchett, many of the people who bought into the crypto bubble at its peak in early 2022 grossly overestimated the amount of wealth other people had actually generated by holding crypto assets.

People fail to realize that, if they were to have purchased bitcoin at $1 and it subsequently went up to $5 or $10, it is very likely they would have cashed out the value gain and then missed further increases.

“In reality, very few people actually enjoyed that crazy 1,000-times runup that the indices were showing,” Blanchett said. “Only the true believers rode the speculation bubble all the way from the bottom to the top — but they were also the likeliest to have ridden the decline all the way down.”

The best way to summarize the point moving forward, according to Finke and Blanchett, is as follows: If there is zero apparent fundamental value in an “asset,” then the creation of wealth through that asset is going to be a zero-sum game.

“If someone makes money on the asset, someone else has to lose money,” Blanchett said. “It has now become so apparent that this craze was really a reverse Robin Hood situation. The wealthier and more sophisticated investors got wealthier, while the less wealthy and less sophisticated investors got poorer.”

(Photo: lewkmiller/iStockphoto.com)