Our brain is to blame. Why your advisor is a BFA.
You may notice at the end of our business cards a three-letter designation, BFA. While we greatly appreciate jazz and modernist painters in our office, it certainly does not refer to a ‘bachelor of fine arts.’
Instead, it refers to the fact Tony Bucci and Divyesh Sharma have attained the ‘Behavioral Financial Advisor’ designation. When there are financial planning designations like the CFP and CFA – both more common financial planning designations – you might ask why chose to focus on something called the BFA?
What is a BFA? And what is Behavioral Finance?
BFA stands for Behavioral Financial Advisor and the study of Behavioral Finance integrates three disciplines: Traditional Finance, Neuroscience, and Psychology.
The purpose of Behavioral Finance is to provide a greater understanding of the role that emotions and human biology play in the decision-making process and to provide tools and techniques to help utilize that knowledge to make better decisions. A financial advisor with a BFA implements behavioral coaching and principles alongside the more traditional aspects of investing and financial planning.
Why is BFA so important?
We believe that the insights gained through sounds behavioral financial coaching is the single biggest reason for investing success or failure.
And there isn’t even a close second.
Vanguard backs us up. In their annual Advisors Alpha Study* they contend that advisors can add about 3% net of fees to a client’s portfolio.
If you are like most people, you would assume that most of that 3% would come from such things like advanced technical knowledge, great investment research or some ability to predict the direction of the market.
However, ½ of that extra return advisors can add to your portfolio comes from behavioral coaching.
What is the problem.
We all know that a cardinal rule of investing is to ‘buy low and sell high.’ Easy to understand. However, most investors actually do the opposite, they buy high and sell low!
DALBAR’s 2021 Quantitative Analysis of Investor Behavior report found that over 20-year period investors earned an average of 5.96% per year, while the S&P 500® returned an average of 7.47% per year over the same period. That means the average investor has earned only about 80% of what they could have earned by simply buying and holding an S&P Index fund. **
Why is there such a gap between what the market returns and what investors receive? Could it be poor advice? Bad timing? Bad investments? Maybe.
We think there is better answer.
Our brain is to blame.
Our brain is to blame . Old and built for another time. Our brains are tens of thousands of years old.
By comparison, financial markets are only hundreds of years old. We are essentially using hardware created thousands of years ago to address problems hundreds of years old.
An easy example of this misaligned hardware problem is our biological aversion to loss. Loss Aversion is the tendency to value safety and security over gain and risk. In fact, we emotionally feel loss two to three times greater than an equivalent gain. Loss aversion by itself is not actually bad and has proven quite useful. Psychologists feel this evolutionary trait enabled humans that were more risk aware to survive in a world of constant threats to survival.
Selling low.
Although loss aversion helped humas survive and get to the top of the food chain it can hurt us with investing. We might not be hunting and gathering any longer but our aversion to loss and is still very much with us.
This aversion goes sideways when investors automatically fly to safety when they feel threatened. We are at most threatened when the stock markets fall.
When markets drop we default into protect mode. How do we protect ourselves? We sell our investments and then hunker down until the threat is gone and the market steadies. As our ancestors on the plains of the Serengeti knew, when there was a lion nearby, keep your head down and don’t move a muscle. Best to wait.
Buying high.
The perverse nature of risk in investing is actually at its safest when it feels the most dangerous. A market drop means that stocks just became cheaper. Stocks bought on sale have higher expected future return than stocks purchased at high prices! If we measure risk in terms of expected future loss, the best time to buy is stocks have already dropped!
Yet, investors don’t act like shoppers on Black Friday. They procrastinate and wait. ‘Let’s let things calm down a bit” I’ve heard. They only jump back in after the market rises, once the threat is over. After the lion as long left the area. Repeat this enough and you get the investor vs investment gap scene in the Dalbar study.
It doesn’t matter if you own a portfolio picked by Warren Buffett if you don’t manage it correctly. I can (and do) spend hours researching funds, stocks and bonds. I build investment models built on time tested principles. I diligently monitor the market looking for trends and changes.
Even after all that work, I know my recommendations won’t matter one bit unless behavioral advice comes along with it.
So, is our brain is to blame, what do we do?
You don’t need courage. You need a plan.
How do we do it? What does Behavioral Financial Advice look like?
At its core, behavioral financial advice starts with helping our clients discover and understand their core values, priorities and objectives. We then teach them about their own minds, biases, and fears and how those could hurt sound investment decisions. We then craft a plan and portfolio aligned with their objectives that accounts for possible emotional roadblocks.
The BFA approach adds something that a simple spreadsheet cannot show. Rather than trying to forecast the market, we try to forecast our reaction to the investment losses and gains. For example, through our risk identification software Riskalyze, our clients imagine real losses and attempt to accurately understand their reactions. If a retirement account dropped 20%, or $200,000, how will the client feel and react? If their loss aversion is too great and we could potentially sell low during crisis, we take that into account in advance and build a portfolio that contains less volatility.
Everyone wants to buy low and sell high? We want you to do that as well! But doing so on a consistent basis means removing the thousands of years on ingrained biases and replacing that mental model with something even more powerful.
After all, it is the largest factor investing confidence.
Don’t take our word for it, just ask Vanguard.
The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Past performance does not guarantee future results.”
LPL Financial and its representatives, Mission Point Planning and Retirement do not provide tax or estate planning advice. These are services are provided in conjunction with a qualified tax and/or estate planning professional.
Sources
* https://advisors.vanguard.com/iwe/pdf/ISGQVAA.pdf
* https://advisors.vanguard.com/insights/article/IWE_ResPuttingAValueOnValue
** https://www.schwabassetmanagement.com/content/investor-guide