Author Archives: John Ndege

About John Ndege

Founder of Risk profiling software for financial advisers.

3 Trends To Watch In 2015 From 351 Financial Advisors

2015 NotesSo what’s going to happen in 2015? Over the year I’ve seen three clear trends from discussions with 351 financial advisors. I have two books full of notes as you can see in the image and I am going to share what I am seeing. Getting insight into what other advisors are thinking and doing can better prepare you for 2015. Not just in terms of competition but getting new ideas to propel your business forward. Let’s get started.

Trend #1 – New Client Acquisition Methods

A consistent theme throughout the year, which will continue to gather pace next year, is the need to acquire clients through new methods. Historically, advisors have been very reliant on referrals and seminars. This is changing. Increasingly the advisors I speak to are keen to acquire clients through content marketing (e.g. blogging, podcasting), online risk questionnaires (to lead capture drive by website visitors) and bespoke client retirement tools and calculators like

Client acquisition doesn’t need to be as “local” as it once was and a sizeable number of advisors want to use online marketing to gather clients nationally. My experience tells me advisors have been threatened and inspired into action by the online investment firms (e.g. robo-advisors) and are looking for more competitive tools and approaches.

Trend #2 – More 401k Business

As you already know fee-only RIAs are increasingly interested in advising on retirement plans (401ks) for plan sponsors. This interest has not waned. Perhaps it is the increased publicity of “marketplace conflicts” that exist in commission-based models or growing self-confidence that continues to push RIAs in this area but don’t expect it to let up. The opportunity for RIAs to diversify and strengthen their business is very tempting. Unfortunately the tools and platforms that help advisors deal with high-net worth clients are more advanced than those for RIAs managing retirement plans. This is an opportunity for technologists within the industry. If you have any tools or ideas you’d like to see in this area let us know within the comments.

Trend #3 – Risk Needs, Risk Tolerance, Risk Capacity

As you would expect many advisors speak to me about assessing client risk. There has been one great trend in this area, which I welcome. This is the need to correctly balance a client’s needs, risk tolerance and risk capacity.

Historically advisors were only focused on risk tolerance but quickly realized overly conservative clients would never meet their retirement goals. They then swung towards investing based on a client’s needs, which resulted in stock heavy portfolios to make up for a lack of savings. When 2008 happened clients couldn’t stomach the declines, bailed and missed the run up in stocks from 2009 to today.

Advisors have learned that each portfolio needs to consider a client’s risk needs (goals), risk tolerance (willingness to risk) and risk capacity (risk capability). That is why at Pocket Risk we released a new feature earlier in the year allowing advisors to add questions to our questionnaire to ensure they capture this necessary information.

Final Thoughts

I expect my conversations in 2015 to continue just where we left off in 2014. How do we tackle the robo-advisor threat? In what new ways can we grow our business and how can we better serve our clients? That is what the trends in 2015 will be all about. I am excited to see how they evolve!

#Bonus Trend – One additional trend I expect to hear more about is the concern about bonds and whether they are a sufficient diversifier from stocks in the near term. Time will tell.

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Do Knowledgeable Investors Need A Financial Advisor? [A Mathematical Approach]

BrainA never-ending challenge for the financial advisory industry is quantifying the value it produces for its clients. We know advisors help people set goals, choose investments and sleep well at night but what about the dollars and cents impact? As clients get smarter they’ll be able to construct their own passive, well-diversified and regularly rebalanced portfolio. They’ll become Knowledgeable.

As Michael Kitces mentioned a few months back “a well-diversified passive strategic portfolio is on its way to being totally commoditized”. Instead of catering to the average investor, advisors will have to work for the client of tomorrow. The Knowledgeable investor.

So the question is, what is the quantifiable value of a financial advisor for the Knowledgeable investor?

First, let’s define the knowledgeable investor. In my eyes the knowledgeable investor understands the following, which an average investor may not…

  • They understand they should have a financial plan. It may not be complicated or consider all the variables but they should have something.
  • A passive diversified portfolio is likely to meet their investment needs over the long term. Most active investment strategies don’t beat the index over sustained (10 year plus) periods.
  • They should rebalance regularly.
  • They should minimize fees (fund fees, transaction fees etc).
  • Investor psychology (i.e. overconfidence, loss aversion, mental accounting etc.) can lead to actions that limit investment returns.
  • Getting started with investing today means they will benefit more from compounding.

Importantly, the knowledgeable investor may understand the points above but never act on them and this gives an advisor the opportunity to force good behavior.

Quantifiable Benefits of a Financial Advisor

 1.    A Financial Plan

Knowledgeable investors understand they should have a plan and probably have something in their head but it is not a formalized IPS, a strict budget or a retirement number. It’s more like “max out my 401k and hope for the best”. This puts them ahead of most people but may not be enough for them to live the life they want. Even for those who have used retirement calculators or read the books the variables can be overwhelming. A financial advisor will give a knowledgeable investor a specific actionable plan. In my opinion this is the most valuable contribution an advisor can make to a person’s future.

 So what is the quantifiable benefit of a financial plan? Likely several years even a decade or more of retirement. That means you can spend less time working and more time with your loved ones. Put a price on that!

 2.    Managing Investor Behavior

The DALBAR studies (which compared dollar weighted investor returns with index returns) popularized the idea that the average investor jumps in and out of investments, buying high and selling low resulting in poor performance. Their conclusion was that “The average equity investor underperformed the S&P 500 by 4.32% for the past 20 years on an annualized basis.”

Further investigation led by Harry Sit and Michael Edesess showed these numbers were exaggerated and possibly even completely false. The DALBAR methodology failed to account for the fact that poor equity market performance during the 2000’s accounted for poor dollar weighted investment performance not investors jumping in and out of the market. Furthermore, earlier this year another DALBAR study showed that 55% of the reason investors fail to meet the index is because they didn’t have the capital to invest and buy at the lows. Therefore we must conclude that the importance financial advisors have in managing behavior has been overstated.

Despite the apparent failing of the DALBAR studies others have attempted to quantify average investor behavior. Russell Investments recently showed that if you had invested in the Russell 3000 index in 1984 and done nothing you would have performed 2.2% better than the average investor (using ICI’s monthly fund flow data to mimic the average investor). I had difficulty getting all the methodological details of this study so I’ll take it with a grain of salt.

What we can say is that the importance of managing investor behavior has probably been exaggerated but it is still significant. If an advisor can save an investor 1-2% a year through managing behavior this more than covers their advisory fee.

But what happens if you are a knowledgeable investor who needs little behavioral management? Then you’ll end up paying for something you do not need.

That’s the question knowledgeable investors have to ask themselves. Without an advisor how good will my behavior be throughout my investing lifespan? If you have serious doubts about your behavior an advisor could well be smart investment.

 3.    Fund Selection and Rebalancing

Another area where having an advisor could have a quantifiable benefit on the bottom line is in fund selection and rebalancing. Russell Investments have shown that a regular (monthly, quarterly annually) rebalancing policy can juice your returns from 0.51-0.93% annually.

However, knowledgeable investors are now well versed in passive fund selection and the importance of rebalancing. Any knowledgeable investor who has done a modicum of research knows Vanguard is highly recommended when it comes to minimizing fees and with their Life Strategy Funds you don’t have to worry about the rebalancing.

Frankly the knowledgeable investor doesn’t choose an advisor to help pick funds and rebalance unless they believe in active investing.

 4.    Tax Planning

A further quantifiable benefit of working with an advisor is the tax planning. Unfortunately, it’s difficult to find any statistics on the tax savings people accumulate from working with a financial advisor. Anecdotally it’s not uncommon to hear of advisors saving their clients 10’s of thousands of dollars. If these savings are invested, grow and compound the benefit of working with an advisor could be worth a lot more than managing behavior or selecting the right funds.

What investors have to ask themselves is whether their tax situation is complicated enough to realize significant savings. A regular W2 employee with a fixed salary is unlikely to benefit as much as business owner, with stock options and investment real estate. If I were to hazard a guess I’d estimate someone with a tax situation that is more complicated than a regularly salaried employee could save several percentage points on an annualized basis over their lifetime through working with an advisor.

 Dollar and Cents Return

So let’s put this into an example. Let’s assume you are a knowledgeable investor who is considering working with a financial advisor. Is it worth it? Well based on the details above the answer would be an emphatic yes….

Advisor Makes You Advisor Costs You
Proper Financial Plan – You end up saving an extra 5% a year Annual Advisory Fee – 1.5%
Managing Behavior – 1.5%
Fund Selection and Rebalancing – 0%
Tax Planning – 2%

Using the numbers above if we assume you have a $100,000 salary and have $250,000 in savings/investments.

Financial Plan  = +$5,000

Managing Behavior = +$1,500

Fund Selection and Rebalancing = +$0

Tax Planning = +$2,000

Advisory Fee = -$3,750

Net Benefit per Year = $4,750

 A knowledgeable investor working with a competent financial advisor is likely see a positive ROI over the long term so long as the expense is not too high.

I find it unlikely that for 20 years even knowledgeable investors can create a viable financial plan, which they can stick to, while simultaneously managing their behavior, keeping up with changes in the industry and optimizing their tax situation. It’s just a very difficult thing to do over a long period of time. Not impossible but very difficult.

The greatest achievers in any field have always needed coaches, advisors and people to keep them accountable. When it comes to investing doing it alone is as tough as it comes.

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3 Important Academic Studies About Risk Tolerance

Risk DiceUnderstanding risk tolerance should not be a guessing game especially when dozens of academic studies can point us in the right direction. Below is a list of important academic studies in the field of risk tolerance.

Financial risk tolerance revisited: the development of a risk assessment instrument  - John Grable and Ruth Lytton – 1999

Perhaps the most important paper on devising a risk tolerance questionnaire. Dr Grable and Dr Lytton bring scientific validation to the risk questionnaire through the use of validity and reliability testing. 

Link to paper

Measuring the Perception of Financial Risk Tolerance: A Tale of Two Measures - John Gilliam, Swarn Chatterjee and John Grable – 2010

This study compares the explanatory power of a simple question about risk versus a multi-dimensional 13-item questionnaire when trying to understand someone’s risk tolerance. Unsurprisingly the multi-dimensional questionnaire showed better results. The research helps explain why advisors should not be using boilerplate questionnaires.

Link to paper

Insights from Psychology and Psychometrics on Measuring Risk Tolerance – Michael Roszkowski, Geoff Davey, John Grable – 2005

This paper re-enforces previous studies that show risk tolerance can be measured as long as the questionnaire is long enough and asks good questions (doesn’t mix in questions about risk capacity and risk needs).

Link to paper

If you want to know more about the academic study of risk tolerance please add a comment.

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What Tony Robbins REALLY Says About Financial Advisors

Tony RobbinsTony Robbins needs little introduction. The personal development guru has touched millions of lives around the world through his ability to “awaken the giant within”. He released his first book in 20 years – Money: Master The Game which tackles the issue of financial advice.  To summarize the book in a sentence Robbins advocates becoming an investor instead of a consumer, paying yourself first, having winnable goal, avoiding fees, choosing the right advisor, knowing your risk tolerance and learning from experts money makers (e.g. Icahn, Buffet, Bogle, Templeton, and others).

You can find a great summary of opinions on the book here.

So why does this matter to you? Robbins’ 600+ page tome is already an Amazon Bestseller and NY Times Bestseller. It will be a favored holiday gift and some of your clients will undoubtedly come across it.

Isn’t it useful to know what one of the most respected life and business coaches is saying about you? Here is a short summary.

1. Don’t Trust Brokers – If there is one rallying cry from the book regarding financial advice it is that you should not trust brokers. They often funnel you into expensive actively managed mutual funds, that don’t beat the market (over a sustained period), don’t perform as advertised and favour their own interests.  Robbins’ goes on to say the suitability standard is “pre-engineered to be in the best interests of the “house”” and what individuals need is the fiduciary standard.

2. You Can Trust A Fiduciary or Can You?  -  Robbins’ says the best way to “solidify yourself as an insider” is to “align yourself with a fiduciary”. However, he goes on to say, “not all advice is good advice” and a fiduciary may not be “fairly priced”.

 He recommends individuals find advisors from NAPFA and ensure they are…

a)    Registered with the SEC.

b)   Compensated as a percentage of your assets under management.

c)    Not compensated for trading stocks and bonds.

d)   Not affiliated with a broker-dealer. Robbins says “This is sometimes the worst offense when a fiduciary also sells products and gets investment commission as well!”

e)    Ensure your investments are custodied with a third-party like Fidelity, Schwab, or TD Ameritrade.

Robbins then goes on to make a final point….

“The added cost of a fiduciary may only be justifiable if they are adding value such as tax-efficient management, retirement income planning, and greater access to alternative investments beyond index funds.”

This aligns with a consistent theme throughout the book that individuals should avoid fees at all costs unless they are justifiable and most fees are not justifiable. However, Robbins falls short of calculating the value of a fiduciary.  After all it’s not a simple calculation and depends on the skill of the advisor. To wrap up, Robbins somewhat disappointingly champions his own financial advisor’s robo-advice platform Stronghold Financial in which he is in talks to become a partner.

3. Conclusion – Overall Tony Robbins is a supporter of fiduciary financial advisors. He believes they can make investors insiders and give them the advice they need to meet their goals. However, more than a supporter of fiduciary financial advisors, Robbins hates fees including expense ratios, transaction fees, cash drag, soft dollar costs, redemption fees, and countless others.

The book gives a lot of mathematical examples of how fees can eat into your returns but it does little to show how a fiduciary’s fees can help you. If you are fee-only financial advisor this book is generally supportive of your work. If you are not, I’d be wary.

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4 Ways To Deal With Clients During Market Volatility

Volatility RollercoasterHow do you deal with your clients during market volatility? I was recently reading a post on the anonymous advisor forum Advisorheads, where the community was trading ideas.  The question is, do you lay low and wait for the storm to pass or reach out to your clients and risk the chance of waking the “angry bear” as one advisor noted. Below are four strategies based on the discussion of about a dozen advisors.

1. “Leave them alone” and don’t do anything – The upside of this approach is clear. You minimize the threat of waking the “angry bear”. Pointing out volatility could lead to a client leaving your practice. On the other hand keeping quiet could result in your clients feeling you aren’t communicating properly. A Financial Advisor magazine study cited “failure to communicate on a timely basis” as the number one reason advisors loose clients.

I don’t believe any advisor wants to hide from their clients but they may want to hide from their past mistakes. Maybe you recruited a client who wasn’t an ideal fit for your business or possibly you failed to sufficiently educate them about the possibility of market declines. Reaching out now, will expose your past mistakes and could result in lost business. However, how can you build a successful business by burying your head in the sand? Leaving your clients alone is unlikely to be the best long-term approach but communicating differently with different clients could have the dual benefit of recovering from past mistakes and minimizing any market fears in your client base.

2. “Send out frequent emails when things get hairy” – It’s generally better to say something than nothing but this approach seems very reactive. The advisor on the forum says, “Clients and prospects love it. They know you are watching and have a plan”. I expect this is the least an advisor should do to deal with clients during market volatility. However, as another advisor says the “past year I have told pretty [much] everyone we will see a market correction soon, curious who will remember”. The bottom line is that you should be regularly making your clients aware that the market can go up and it can go down. At the moment it appears “going down” is more likely.

3. “I called/emailed most of my clients over the past two days. All were happy to hear from me, and I used it as my quarterly touch”.  For this advisor reaching out to all of his clients worked well (it also resulted in more AUM) but it was clearly part of his regular quarterly pattern. His clients were not getting a call out of the blue. However, his approach is very time consuming. Another advisor says “I used to get on the phone and call everyone, but found it to be counterproductive since many would then want to make unwise changes.” I wonder if the desire to make changes is the result of a lack of trust in the advisor’s advice or poorly recruited clients.  A client that is well educated, well recruited and trusts you would probably not demand to make “unwise changes”.

4. “You have to know your clients” – Here is a great quote from one of the forum advisors…. “You have to know your clients. I know which one’s need a phone call, and those are the one’s I call proactively to talk about the market when things get crazy. I have been preparing for a client appreciation dinner, which was tonight, but I did call 4-5 “sensitive” clients today. I only got one incoming call today, and it wasn’t a panic call, it was just a question, the conversation was…

Him: Should we be doing anything?

Me: No, this is just noise and while it might not feel good while it’s happening, it will pass, and you will be better off doing nothing. Less is more.

Him: Ok, thanks, that’s all I needed to hear.”


Throughout the post the general conclusion is that you should know your clients and phone the ones most likely to react to the volatility.  At the same time you should have some sort of newsletter or quarterly touch point with all your clients so they know you are watching and have a plan.  Lastly, you need to make a bigger effort to recruit the right sort of clients. Either clients that our willing to be educated about markets and risk or clients that trust your judgment.

What other good ways are there to deal with clients during market volatility? Give me your thoughts in the comments below.

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Morningstar Risk Tolerance Questionnaire – The Good and the Bad

Morningstar LogoThere are many risk questionnaires used by financial advisors and the most common appear to be bundled in with software an advisor is already using. Morningstar is a popular tool used by financial advisors for investment research and financial planning. I often get asked my opinion on the Morningstar risk tolerance questionnaire. So today, I am taking a deeper look at the good and the bad.

Click here to get the Morningstar Risk Questionnaire pdf

Morningstar Risk Questionnaire – Time Horizon

Morningstar 1

The Good

  • The good thing about the time horizon section is that the questionnaire is attempting to establish some sort of goal for the client by asking about their age and when they expect to start drawing income. That being said this is supposed to be a risk tolerance questionnaire not a collection of goals. How much risk someone is willing to take is not the only factor in determining someone’s goals. You also have to look at their needs and risk capacity.

The Bad

  • Age in itself is not a clear indicator of risk tolerance. It’s possible that someone who is older than 75 has a higher risk tolerance than someone who is less than 45.  There is dangerous assumption in the question that to be older is to be more conservative. This is not necessarily true and can result in younger people having overly aggressive portfolios and older people having portfolios that are too conservative.
  • The second question assumes the client wants to draw income. Again this is an assumption that may not be true for all clients. That being said most clients of financial advisors are looking to draw income at some stage so I think this question is fair.

Morningstar Risk Questionnaire – Long Term Goals and Expectations

Screen Shot 2014-11-19 at 10.34.12 AM

The Good

  • Again there is an emphasis on the client’s goals, which is good to know but I am left wondering if this is the right place to ask such a question. Are we trying to establish someone’s risk tolerance or their goals? These two factors often conflict.
  • Question five is interesting and speaks well to understanding a client’s expectations.

The Bad

  • Question three is ok but I wonder if the question covers all the goals a client could have. For example, a client could have different goals for different buckets of money. Or maybe they just want to meet their retirement needs but they have no idea if this requires aggressive growth or “to grow with caution”.
  • Question four is challenging because of the use of “normal market conditions”. What is normal? Is this the last year? 10 years? 50 years. Other than that, I like the answer options.

Morningstar Risk Questionnaire – Short Term Risk Attitudes

Screen Shot 2014-11-19 at 10.34.24 AM

The Good

  • I like question 7. Again, seeing how a client feels in the short run helps an advisor manage expectations.  The specificity of the third answer option (10%) makes it clear what type of loss we are talking about.

The Bad

  • Question six starts off good. I like the question. However, the answer options are too vague.  Someone may be comfortable with a “small loss” but what is a “small loss”? 1% 10%, 15% or more? It is unclear from the options resulting in the advisor having to make an assumption.


The Good

  • The questionnaire makes a decent effort at understanding client expectations and there is a fair attempt at understanding their goals.

The Bad

  • Frankly, this doesn’t appear to be a risk tolerance questionnaire it’s more of a hodgepodge of questions designed to understand the very basics about a client and it struggles to do that conclusively.
  • Too few questions. It’s unlikely that someone’s investing future can be determined by 7 questions.  There’s just not enough detail to make the final result reliable.
  • Where have these questions come from? Was there any science or academic research behind its development? Without this its accuracy can and will be questioned.

For those advisors who wish to go deeper with their clients and have a thorough understanding of their risk tolerance I would be a little cautious about the Morningstar risk questionnaire.  It’s basic and you would most likely need to ask many face-to-face questions on top to learn more about your client.

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[CLIENT GUIDE] Explaining The Difference Between Average Annual Return and Compounded Annual Growth Rate (CAGR).


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I was on the phone with an advisor two weeks ago and he was bemoaning the lack of client education surrounding the difference between average annual return and compounded annual growth rate (CAGR).

His argument was that the leading measure used to evaluate financial products was “completely broken”.  The result being sub-optimal investment selection at its best and fraud at its worst.  I decided to investigate.

There is no denying that by using an average annual return statistic, investments tend to have a higher performance percentage (as you will see below). Yet its also true few clients fully understand CAGR and its implications.

If everyone understood CAGR then I believe it would be a better measure than average annual growth rate and you will see this in the examples. But first I want to you copy, print or download the guide below that will simply explain the difference between average annual return and compounded annual growth rate.

Average Annual Return

The average annual return for a set of investment years is calculated by summing the results of each year and dividing by the total number of years. Below is an example based on the returns of Vanguard’s Total Stock Market ETF (VTI) from 2004-2013.























The average annual return calculation would be….

12.73% + 6.15% + 15.70 + 5.36% + -36.81% + 28.73% + 17.28%  + 1.00% + 16.45% + 33.48% Divided by 10 years  = 10.01%


Compounded Annual Growth Rate

The compounded annual growth rate (CAGR) measures performance over a series of years and represents what you actually get from your investments at the end of the investing period. It accounts for compounding and volatility (unlike the simpler average annual return calculation). This is best explained with an example.

If you invest $100,000 dollars over two years and the returns are 10% and -10% the average annual return is 0% (10% + -10% / 2 = 0%). However, this doesn’t represent what you actually get at the end of the two year investing period.

At the end of the first period you will have $110,000 dollars but after a 10% decline at the end of the second year, which is $11,000, you will have a loss ending on 99,000.

Year End of Year 1 End of Year 2
Return 10% -10%
Investment $110,000 $99,000

The average annual return statistic would have you believe that you ended the two period on $100,000 (because of the 0% average annual return) but this isn’t the case.  The compounded annual growth rate formula would have picked this up and given you an annual return of -0.5%. So if you returned -0.5% in the first year and -0.5% in the second year you would have $99,000.  Which is exactly what you got at the end of the period.

Investment $100,000
CAGR -0.05% – End of Year 1 $99,500
CAGR -0.05% – End of Year 1 $99,000

The formula for CAGR is outlined below. It is a little complicated so you can use an online calculator at websites such as Investopedia.

 CAGR = (B/A) 1/n – 1

A = Original investment amount

B = Value of your investment at the end of the period

n = number of periods (e.g. years).

Implications for Investors

In the example above we only used a two year period however the difference between the average annual return and the CAGR tends to grow larger over longer time periods and periods of volatility. Using the example of the Vanguard Total Stock Market ETF quoted earlier the average annual return is 10.01% but the CAGR is 8.13%. Put simply, average annual return ignores compounding, which is critical factor in an investor’s returns. So what should an investor do?

  • Where possible calculate the CAGR before selecting any investment product.
  • Expect your return to be a little less than any quoted average annual return statistic.
  • When evaluating investments do your best to evaluate like with like.

Download our free client guide to help you explain the difference between annual average return and compounded annual growth rate to your clients.

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Avoiding 16 Psychological Biases That Could Kill Your Business

 Right or WrongYou’ve probably read about some of the psychological biases that impact investment decisions every day and shake your head. Whether it is the herd mentality that causes investors to sell low and buy high or the inability for people to cut their losers. The human mind is so self-manipulating and malleable that it can be impossible to come to any reasoned decision.

But have you taken the time to think how these biases impact the decisions you make in your business?

Take some advice from Charlie Munger who has developed a psychological checklist for making major company decisions. We’ve adapted them to the financial advisory community so you don’t make one of these common mistakes.

Print these out and start making better decisions today.

1.  Reward and Punishment Bias – Probably the most powerful bias of all. People are often biased towards what is in their best interest. At times you may find your interest conflicting with a client. Have you ever thought your interest was the best for everyone involved? Maybe this was because it was in your interest. Think about it.

2.  Liking/Disliking Bias – People are likely to favour those they like. The result being you only see good in their actions and dismiss their faults. For example you might like a particular equity research analyst and as a result accept her ideas without proper due diligence.

3. Doubt Avoidance Bias – People like to quickly dismiss doubt and make a decision. Doubt paralyzes action and has a heavy cognitive load. Hence people like to avoid situations where there can be doubt. Have you recently made a quick decision because you couldn’t live with the doubt?

4.  Inconsistency Avoidance Bias – A person’s desire to avoid inconsistency with what they have already decided, agreed or believe makes them continue living with a bad decision. It just takes too much energy to change. So they are biased against any inconsistencies. Perhaps you hired someone who hasn’t performed well but you don’t want to admit everything you thought about why he was a good hire was wrong.

5.  Fairness/Reciprocation Tendency – A desire in people to do what is fair and reciprocate good and bad behavior. For example if someone pays your business a compliment you are more likely hear their sales pitch even if you have absolutely no interest in what they are saying. This is a waste of your time and their time.

6.  Envy/Jealousy Tendency – People are generally envious of those (who are close) to them and have more of what they want. This leads to making decisions that are not in their best interest. For example, a competitor may have a brand new fancy office but do you need one? A client may want to copy their friends and move to a 80/20 equity allocation when 60/40 is more appropriate do you allow them?

7.  Influence From Mere Association Tendency – Did you read this article because I associated myself with Charlie Munger in the early paragraphs? Have you recently chosen an investment product, service or tool because it had some sort of celebrity endorsement? That is influence from mere association. That alone does not tell you anything useful about what you are about invest your time in or purchase.

8. Pain Avoiding Psychological Denial – A common bias employed by entrepreneurs. The truth is too painful so you distort reality to make it bearable. A classic example is blaming the client instead of yourself for anything that goes wrong.

9. Deprival Tendency – You’ve probably experienced this with clients. The pain of loosing 10% is higher than the joy of winning it. Being deprived something you already have is more painful than what you gain.

10. Social Proof – People value things higher because others admire it. This cuts across everything from investments, to cars, to houses, to clothes etc.

11. Contrast Bias – Something or someone looks better or worse because of a contrast next to another item. For example a $499 item looks cheap next to a $1,499 item but expensive next to a $9 item. The value may be completely unrelated to the price.

12. Stress Bias - When people are stressed e.g. under time pressure they can often act in extreme ways. For example limited time offers (e.g. buying into an IPO) can lead to making decisions they would normally never make.

13. Availability Bias – People are biased towards what is easily available (physically and mentally) because to think or do something else is too much work/stress. For example investors often choose financial products they know because the time and effort to do research into other areas is deemed too taxing.

14.  Senescence Tendency – Biologically speaking it becomes difficult to learn new things as you enter old age. This can bias decision making towards what is already known and understood.

15.  Authority Tendency - Tendency to believe and follow those deemed as authorities in a certain area. Each person’s work should be evaluated on a case-by-case basis.  For example many people believe in the efficient market hypothesis because its main proponent won a Nobel prize. This alone should be an insufficient measure of whether the Efficient Market Hypothesis is a good investment theory.

16.  Reason Respecting Tendency – People tend to accept certain paths because a reason is given, even if that reason is unfounded. For example a client may say he wants to invest in fine art because he believes the market is going up. That may be true but you don’t accept this course of action simply because he has a reason.

That’s it. Sixteen psychological biases to avoid when making decisions in your firm. Print these out and take a look whenever you are making major business decisions.

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Lessons from FPA conference: Increase equities in retirement

I recently returned home from the annual Financial Planning Association conference in Seattle. There were lots of great breakout sessions but the one that got me thinking the most was Michael Kitces’s presentation about the “Rising Equity Glidepath”. If you have a chance to see him speak, please do. He delivers his points intelligently with lots of energy and great humor. Simply put, increasing the amount of equity a client has in retirement will improve outcomes and reduce the chance that they will run out of money.

This is because of the threat of sequence risk (retiring as the market collapses). If the first years of retirement happen to be during a downturn then by slowly increasing the equity exposure over time the client will be dollar cost averaging into markets at “cheaper and cheaper valuations” and if markets are good then they have little to worry about. Below is a diagram I put together to illustrate this point.


Obviously, this approach flies in the face of conventional wisdom. Luminaries like Jack Bogle, the founder of Vanguard have long preached you should have your age in bonds.

What Kitces has observed however, is that many advisors are already unwittingly increasing their client’s equity exposure over time by having a bucket strategy. By having a portion of the portfolio in cash for near time spending, another block in bonds for spending in the next 5-7 years and then the rest in equities the exposure to the stock market will increase over time as the cash and/or bond interest is spent.

If we are already “secretly” increasing equities in retirement why not be open about it with clients and optimize for better results? I spoke to one financial advisor at the conference who said they had floated the idea with clients but they were met with consternation. Openly and directly increasing equities in retirement is far too contrarian for most clients. Perhaps the bucket strategy is the only way to get this past client psychology.

During his session Kitces also talked about the impact of market valuations on choosing the right equity glidepath in retirement. Using the Shiller PE Kitces explained that retiring in “overvalued” periods tends to lead to a lower safe withdrawal rate. Unsurprisingly, the best way to recover is to increase equity exposure during the downturn.

Lastly, Kitces said he would be doing research on the best way to reduce equity exposure, as one gets closer to retirement. I’ll be writing about that, as soon as it is published.

3 Lessons on Growing your Financial Advisory Practice from Warren Buffett

Warren BuffettI recently finished reading Warren Buffett’s Letters To Berkshire Hathaway Shareholders 1965-2013 as well as Michael Kitces’s recent blog posts about the threat of robo-advisors.  Having read these pieces it made me think….

What would Warren Buffet do if he were the owner of a financial advisory practice?

Many of the stories about Warren Buffet’s success focus on his investing prowess but little is dedicated to him as a business owner.  After reading his shareholder letters I’ve come to believe there is a lot the advisory community can learn because let’s face it – things are going to get tougher.

Competition from traditional advisors is rife. According to Cerulli Associates there are about 310,000 financial advisors of one type or another. In the U.S. there are about 5.2 million millionaires.  That makes about 17 millionaires for every advisor. Not exactly a lot when you factor in salaries for support staff, marketing and technology expenses. If we add robo-advisors on top it gets even more competitive.

So how can you grow your business using the wisdom of one of the greatest business owners of the 20th century? Let’s find out.

Lesson 1: “…producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage.” – 1978

When Buffett wrote these words he was talking about the textile industry and you are probably thinking financial advisory is not a “capital intensive” business but work with me for a second. Think about the cost to find, hire, train and support a new advisor. It’s certainly not cheap. Then think how long it takes for them to develop a book of business that supports them and generates profits? Is it a year or longer?

If we compare financial advisory to other service businesses such as software development consultancy, accounting, advertising you will find these other businesses tend to hire when they have too much work (meaning a new employee can usually earn their keep within 90 days). It’s a lot more transactional and easier to scale.

But with advisors hiring a new employee is more of an upfront investment, which pays off over a longer timeframe.  This is because advisors must build trust to win clients and that typically takes longer than completing a tax return or managing an ad campaign. Thus I believe within the service economy financial advisory is capital intensive.

If you agree with my logic then the only conclusion (given the large supply of advisors) is that differentiation is the key to growth.  As Kitces says “building a well diversified passive strategic portfolio is on it’s way to being totally commoditized”.  So if you fall into that group you must differentiate. This would require something that goes beyond portfolio-only solutions and is a lot more comprehensive or specific/niche.

So lesson number one from Buffett is differentiation.

Lesson 2: “The primary test of managerial economic performance is the achievement of a high earnings rate of equity capital employed.” – 1979

One of the most remarkable things about Buffett is that he chose one metric that matters for his business and stuck with it for years. In his case ROE/ROCE. Other metrics matter too but they are of secondary importance.

What’s the one metric that matters in your business and do you watch it on a weekly or monthly basis?

Let me give you another example. For Pocket Risk our one metric that matters is the % of customers who complete a questionnaire each month. This is because the value of Pocket Risk is in completed questionnaires advisors can assess and use to determine a financial plan. Customers who complete many questionnaires are happy and do not churn. We could have used a vanity metric like logins (which is higher) but value is not derived from logging in, it is derived from client engagement.

At first thought you may think AUM is your one metric that matters but we know that all AUM is not created equally. You will need to determine the metric or metrics that matter to your business. If I were an advisor I imagine it would be a formula that calculates the profit per customer (accounting for acquisition and support costs) on the front end and client churn on the backend.

So lesson number two from Buffett is find the metric or metrics (I doubt you need more than three) that are most important in your business and measure constantly. As Peter Drucker says “what gets measured gets managed”.

Lesson 3: “It is impossible to overstate the how valuable Ajit [Jain] is to Berkshire. Don’t worry about my health: worry about his.” – 2000

“If Charlie [Munger], I and Ajit [Jain] are ever in a sinking boat – and you can only save one of us – swim to Ajit.” – 2008

How many of your employees do you speak of in such terms? Buffett’s brilliance is also in his ability to find and nourish great people. Sure he wants them to be hard working, smart and honest but he also wants them to be self-directed. He wants them to have the mindset of a business owner. Micromanaging your team means you cannot scale therefore you cannot grow without adding layers of management. To avoid this you need your employees to have the mindset of a business owner.

Judging from his letters Buffett didn’t spend much time trying to train people to think this way, he found people who already had this mindset.  However, I think you can train people to think this way if you give them the power to make important decisions. You have to trust them. Trust however, has to be earned and you will probably need to do this over time.  Just remember there has never been a great organization without great people.

So lesson number three from Buffett is find employees with a business owner mindset who can be almost totally self-directing.

Concluding Thoughts 

Given Warren Buffett has been one of the most successful business owners in the 20th and early 21st century it pays to listen to his advice. As a financial advisor I encourage you to think more about differentiation, the one metric that matters in your business and improving your team.

I’d love to get your thoughts in the comments below. What do you think advisors can do to grow efficiently, effectively and sustainably in the years to come?

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