Advisors not only care about helping their clients achieve financial success, but it’s also a job that they take very seriously.
As the financial industry has evolved, advisors have begun to understand that it’s not valuable to focus exclusively on theories or mathematical models to identify the correct investment portfolio strategy for each individual investor.
In conjunction, advisors must keep in mind an investor’s financial risk tolerance (FRT), which can be a tough nut to crack, especially for retirement plans.
Is the investor’s main focus to maximize returns? Or is it to protect their current assets?
Despite the common assumption, these decisions don’t always directly relate to the investor’s demographics, like age. Instead, this has much – if not everything – to do with the Behavioral Finance Theory (BFT), which “attempts to understand and explain actual investor and market behaviors versus theories of investor behavior” (Wiley, 2015).
Let’s take a deeper dive…
Why is it Important to Understand Behavioral Finance Theory (BFT)?
Surprisingly, poor investment results are not the main reason that advisors lose clients. The predominant reason is that clients “don’t feel as though their advisors understand, or attempt to understand, the clients’ financial objectives— resulting in poor relationships” (Wiley, 2015).
Correctly understanding the way an individual client thinks about investing requires the advisor to ask their clients psychological or behavioral questions to establish biases, especially at the beginning of the advisory relationship (Wiley, 2015).
While it can often feel uncomfortable, it’s a very important process that will provide the context advisors need to better inform their decision-making. Once the advisor gets into a rhythm and remains consistent with this process, it can work like muscle memory.
Additionally, an advisor should set expectations for themselves, as well as allow the client to address their expectations. When the client feels heard and understood, it’s less challenging for the advisor to explain why the portfolio is designed the way it is and why it is the “right” portfolio for the client—no matter what happens with the market trends.
As a result of these efforts, both the client and advisor can work together as a team, and it may be easier to reach the client’s goals.
Let’s recap. There are few who could deny that every thriving client-to-advisor relationship contains these primary characteristics:
- The advisor fully understands the client’s financial goals.
- The advisor maintains a systematic (consistent) approach to advising the client.
- The advisor delivers what the client expects.
- The relationship benefits both client and advisor
How Does BFT Come into Play?
Let’s talk about a real example from a 1979 article by cognitive psychologists, Amos Tversky and Daniel Kahneman. This study was conducted with group of subjects who were presented unique scenarios.
The first group was presented with this problem:
- In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
A. A sure gain of $500.
B. A 50 percent chance to gain $1,000 and a 50 percent chance to gain nothing.
The second group was presented with a different problem:
- In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
A. A sure loss of $500.
B. A 50 percent chance to lose $1,000 and a 50 percent chance to lose nothing.
In the first group, 84% of participants chose A. While in the second group, the majority, 69%, opted for B.
However, in each instance, the net expected value of the two prospective prizes was the same. Having said that, the phrasing of the questions was altered slightly, which lead the subjects to interpret the problems differently.
As an advisor, do these findings surprise you? Our guess is probably not. And this next section probably won’t either.
What Are Some Common Investment Mistakes Having To Do With BFT?
Now that we have had a refresher on behavioral finance theory, we can talk about its results in common investment mistakes.
There are dozens of investment mistakes we could talk about here. Instead, let’s focus on the primary four that we see at Artesys the most frequently, holding investors back and leading to poor performance.
We’re sure you’ve heard of these before:
Copying the behavior of others, even in the face of unfavorable outcomes.
2. Media Response
The tendency to react to news without reasonable examination.
Relating to familiar experiences, even when inappropriate.
4. Loss aversion
The tendency to strongly prefer avoiding losses more than acquiring gains.
Historically, common investing mistakes are more detrimental to investor performance than the investments themselves.
So, How Do Retirement Plan Clients Often Get Left Behind?
As we’ve established above, there are many behavioral reasons to take the participants’ risk tolerance into consideration, even for retirement plans. When assessing a 401k client’s risk tolerance, advisors should consider both the ability of the individual to take risk and the desire to take risk.
The optimal portfolio should be the lesser of the two risk tolerances. This can be done through conversation, questionnaires, and financial projections.
Despite this being an important process, retirement plan participants don’t always receive tailored advice from an expert when choosing investments.
Why? Because advisors often lack the time.
Imagine if advisors sat down with each retirement plan participant for just one hour per quarter to provide a personalized solution. Would they have time to do anything else? Most likely not.
And we get it!
But as a result, advisors are left with two primary options: target date funds and managed accounts. Which one is the better and more customized investment solution?
How Do We Incorporate Risk Tolerance & Behavior with Retirement Plans?
Target Date Funds – Focus on the Retirement Date
In deferred compensation plans, the main driver for portfolio risk is the years to retirement. This is how a target date fund (TDF) works. An individual would simply select the fund that most closely aligns with their expected retirement date. It is important to note, only one data point is being considered on the participants behalf – years to retirement.
TDF’s do an excellent job for investors, but they do have limitations, including:
1. They don’t take investors risk tolerance into consideration.
Not every 50-year-old has the same tolerance for risk. Compare a 50-year-old warehouse manager vs. an executive. In a TDF, they are treated as the same client.
2. There’s a lack of transparency.
When investors view their statement, it’s just a line item instead of the diversification of the fund and changes to the asset allocation. In short, they simply don’t know what’s happening underneath the hood.
3. There’s a lack of options for diversification.
Some TDF invest in all proprietary funds.
4. Common investor behavior can add more risk.
There are a few common investor mistakes that often lead to poor performance, such as holding multiple TDF’s or holding other assets with the TDF, etc.
In our experience, most investors who use TDF’s incorrectly actually know they are intended to be used for the entire account. But, they diversify anyways for a few reasons:
- They may not feel diversified enough.
- They are trying to adjust for THEIR risk tolerance.
Is there a better way? Of course, there is – managed accounts, in addition to target date funds.
Managed Accounts – Focus on the Investor Behavior
On the other hand, managed account providers, like Artesys, seamlessly integrate with recordkeepers, such as OneAmerica, in providing investment management at the participant level. We work exclusively through financial professionals and do not go directly to plan sponsors.
Again, it’s not reasonable to assume that an advisor has the time to do sit down with every plan participant on a frequent basis. That’s where managed accounts come in. Together, we work with advisors to help ensure their plan sponsors and participants are meeting their retirement and wealth management goals.
Here’s what to expect with a managed account:
1. There’s full transparency.
Investors can see the underlying holdings, all changes made to the account, and how much they are being charged, which brings them peace of mind.
2. Portfolios are managed to investors’ personal risk tolerance.
It should never be a one-size-fits-all thing. Everyone takes a different approach, has unique goals, and varied risk tolerance with retirement investing.
3. Ongoing support and advice are available when investors need it.
The managed account provider is available to answer real investment questions about investors’ portfolios.
4. Managed accounts serve as a fiduciary.
Advisors appreciate the fiduciary protection from managed account providers. This allows them to focus on building and nurturing their client relationships.
Why Advisors Should Partner with Artesys Managed Accounts
We know how much time and attention it takes participants to manage their retirement accounts. Even if they can find the time to do it themselves, achieving satisfactory results while avoiding common mistakes remains an obstacle.
Artesys can help take the frustration out of investing for advisors’ retirement clients. We help advisors operate their business more efficiently by offering the type of investment service that attracts, educates, and retains clients.
In addition to the list above about managed accounts, Artesys offers:
1. Variety of Plans
We work exclusively through financial professionals on a variety of plans, including 401(k), 403(b), 401(a), 457, Defined Benefit, and Cash Balance. Contact us to learn more.
2. Active Management
As active managers, we monitor models daily, making adjustments as dictated by market conditions and asset class performance. We aim to outperform the market over market cycles on a risk-adjusted basis.
3. Diverse Investment Options
We offer seven models with two distinct approaches: Offensive vs. Defensive. Our proprietary approach gives advisors the insight and support needed to focus on their clients and help them meet their long-term goals.
Artesys is offered to participants at a competitive price. As the use of Artesys increases, the price decreases. There’s no plan-level cost, no opt-out penalty, and no termination fee. It’s a no brainer.
5. Participant Education
We’ve developed a unique set of materials to simplify the process for plan participants. Through the use of videos, handouts, and presentations, we keep clients up to date on how Artesys is working for them.
6. Risk Tolerance Assessment
As we emphasized above, correctly understanding an individual’s risk tolerance and behavior is crucial to providing a tailored solution that’s designed for success. We’ve built an easy-to-use online questionnaire that helps us determine what kind of investor they are and what Artesys investment model fits their retirement goals.
The moral of the story is– investors are not always rational, due to heuristics and biases. And we shouldn’t expect them to be. It’s our job as financial professionals to take the time to understand an investor’s risk tolerance and behavior around finances.
But when time isn’t available, don’t simply neglect those efforts; look to an alternative.
While target date funds can be good, a managed account provider, in addition, is the best because participants are looking for helpful advice from professionals, like us, who have dedicated time to talk about it.
Artesys is happy to conduct the research needed through conversation, questionnaires, and financial projections to effectively place individuals in the right investment portfolios, so you don’t have to. And did we mention—there NO COST to participants who don’t use us. Our goal is to help increase client attraction and retention. Always.
If you have any questions about a partnership with Artesys, we’re happy to talk more about it with you. It’s what we’re here for!
Phone: (877) 880-2543
We look forward to connecting with you. 🙂
“Behavioral Finance Theory.” The Investment Advisor Body of Knowledge: Readings for the CIMA Certification, by Jim Dobbs, John Wiley & Sons, Inc., 2015.
Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291. doi:10.2307/1914185
Raiffa, Howard. The Art and Science of Negotiation. Balknap Press of Harvard University Press, 2003.