Preventing Emotional Investing: An Added Value of an Investment Advisor
This is a recap of a research paper by Gregg S. Fisher and Phillip Z. Maymin (Assistant Professor of Finance and Risk Engineering, NYU-Polytechnic School of Engineering) which was published in the Journal of Wealth Management, Spring 2011.
According to traditional financial theory, investors should pay a financial advisor for one of two things: an expected higher return or a lower anticipated risk. While much recent research suggests that statistically significant risk-adjusted outperformance is a rare achievement, there is one specific kind of risk that financial advisors can help to reduce: the risk that investors will, on their own, make bad decisions about buying or selling securities. Perhaps investors retain advisors to help them navigate near-term emotions like fear, regret and greed so they can make healthier, more-objective choices. In other words, they hire advisors to keep them on track, as dieters might put a lock on the refrigerator to regulate their own behavior.
Research studies suggest that this could be a rational choice. More-aggressive individual trading does tend to lead to poorer investment results. One study that analyzed a comprehensive dataset of Taiwanese investors determined that aggressive trades by individuals resulted in substantial economic losses for them—on the order of four percentage points a year. In other words, according to the study, it appears that enlightened investors ought to prefer to pay about one percentage point to an investment manager who will at least impede aggressive orders than to pay nearly four times as much for the privilege of excessively and detrimentally trading their own account.
If, indeed, investors hire advisors to keep themselves from making emotion-driven choices, we thought this theme should be visible in historical data tracking our own firm’s interactions with clients—specifically, in the number of “touches,” or attempts by clients to argue for reallocation or other aggressive trades. We formulated five testable predictions:
- First, there should be a considerable number of touches as the client adjusts to the relationship with the financial advisor.
- Second, the number of touches should diminish but never vanish; it should reach some sort of steady state average.
- Third, periods of high market volatility should lead to a higher volume of touches.
- Fourth, the incidence of substantial changes in asset allocation should be quite low number; i.e., aggressive trading should be rare.
- Fifth, when aggressive trading does occur, it will coincide with a higher number of touches.
For purposes of this study, we used notes from 1993 through mid-2010 in the Gerstein Fisher database, covering a total of 1,427 households. A note is created when an email is sent or received from the contact, or a telephone call or meeting takes place, or there is any other client-related activity.
Analyzing the contacts actually recorded between clients and the manager in our dataset allowed us to test each of these predictions. The first prediction clearly holds: new clients do, indeed, have significantly higher touches in their first few months. The second prediction holds as well: over time, touches appear to converge on a relatively low level. The third prediction of higher touches following higher market volatility also seems to be confirmed: Investors become agitated by what they have already experienced, rather than by market forecasts of their future volatility, and they are likely to call their advisor to make a change or at least receive reassurance about the continued merits of their current strategy. The fourth prediction, that aggressive trading will be rare, also holds, and so does the fifth, regarding increased touches around aggressive trades. Clients usually have around 3.5 touches a month, but those who have changed their equity allocation by more than 10% have an average of 6 touches a month. Furthermore, the more aggressive the trading, the higher the number of touches.
We conclude that the advisor plays a very valuable role in helping investors stay disciplined and on plan in the face of market volatility, including dissuading them from excessive trading.
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