Check Yourself Before You Wreck Yourself

Professional advising overcomes client biases and adds incremental value

 “The first principle is that you must not fool yourself – and you are the easiest person to fool.” 

 – Richard Feynman

We live in a world of misinformation.  We carry the world’s knowledge in our pockets on our smartphones, yet when we try to use this knowledge to our advantage, we often find misleading or biased answers instead of correct ones.  We consume a staggering amount of information daily, and it is up to us to interpret and use it to make well-informed decisions; however, so much of the information we digest is filtered and shaped through networks of influence that by the time we receive it, the meaning is often tainted.  There’s also an ever-growing body of psychological research which indicates that our minds are not so good at objectively analyzing information to arrive at the truth.  Instead we tend to make new information fit what we want to believe, with little regard given to evidence.  This tendency to misjudge facts, combined with the exposure to an overload of information in an increasingly complex world, puts us all at risk – especially when it comes to our financial lives.  Whether it’s intentional or unintentional; whether it comes from the outside world or from inside our own minds; whether we want to accept it or not, one thing is certain:  we’re all being fooled, many times every single day, and we’re terrible at detecting false information¹

Considering these facts, you might be asking yourself a very important question:  why are we so bad at this?  The reasons are numerous, and a bit complicated, but well worth understanding.  One reason we’re so easily tricked is because we use mental shortcuts, known as “heuristics”, to solve problems and make judgements in a quick and efficient manner.  Heuristics are “good enough” solutions to complicated problems, and from an evolutionary standpoint they helped us tremendously in our navigation and survival as a species.  We use heuristics all the time to this day because when we use them we don’t have to think too hard about every single decision we make.  For example, if I ask you what two plus two equals, the answer will come to you immediately.  This is because you’ve developed a heuristic for the problem of two plus two.

Heuristics are fantastically useful things; however, because our minds are hard-wired to use heuristics and other mental shortcuts so often, we are constantly exposed to errors of logic and irrationality.  These errors stem from cognitive biases, which are the roots of irrational behavior.  Some of the more well-known cognitive biases are:  Anchoring (the reliance on the first piece of information we receive, which informs the rest of the information we take in); Overconfidence (confidence in our own beliefs, which cause us to take greater risk); Survivorship Bias (the idea that just because we succeeded at something means anyone else can succeed at the same thing); and, my personal favorite, Confirmation Bias (wishful thinking that our preexisting beliefs are the most correct beliefs, so we should only listen to them)².

Another reason we’re so bad at detecting misinformation and subject to psychological misjudgments has to do with our egos.  The ego is valuable because it gives us an important sense of self-esteem, but it can also block the rational part of our minds and make us think we know more than we do.  This can lead to cognitive biases of all stripes.  We’re also susceptible to self-serving bias (distorting the truth for the sake of our self-esteem) and motivated reasoning (flawed decisions based on what we think we know), which are emotional reactions that protect us from feeling like nitwits.  Much like heuristics, these are survival tactics our minds use to keep us alive, which helped a lot during the Pleistocene Epoch when we were hunters and gatherers but they’re not as useful in the modern world as we sit in front of our computers.

If we want to cut through the clutter of our minds, we need to confront our own biases.  This is much easier said than done, as our biases make us feel safe, comfortable, and familiar.  In the classic sci-fi film, The Matrix, Neo (the central character) must choose to either take a blue pill – which will allow him to return to his blissful ignorance – or a red pill – which will show him what the real word truly is, which isn’t so pretty.  To confront our biases and admit we might be wrong about some of our cherished beliefs is not unlike taking the red pill.  It requires courage and the acceptance that we don’t have all the answers.  We need to follow the evidence wherever it leads us, and approach reality with a cold, objective lens.  But it’s hard to do this alone, because our minds will always err on the side of what we want to believe.  We need to depend on others who we can trust, who don’t share our egos, and who aren’t afraid to tell it like it is.  But how do we know who we can trust, especially with our life savings?

In the industry of finance, misinformation, deception, cognitive biases, information overload, and irrationality are everywhere.  The misinformation in the finance industry is often a result of the complexity of the finance industry, but sometimes there’s an intentional push to spread misinformation.  This misinformation (or, rather, disinformation) is not limited to consumers of the finance industry.  Finance professionals are often the victims of false information, which in turn can make them the perpetuators of it.  Yes, that’s right – finance professionals often perpetuate misinformation to their clients and others without even knowing they’re doing so!

Consider the example of a wealth management firm that receives compensation from a fund company for selling its products – something that occurs more than you might think.  The wealth management firm wants to sell the fund company’s mutual funds to their clients, and as a result might choose to provide cherry-picked research about the mutual funds to its own financial advisors.  If the advisors don’t question the research (or if they receive a higher commission for selling it), they might spread the gospel without realizing (or admitting) there are better alternatives for their clients.

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

– Upton Sinclair

An informed investor knows about the problem of trust in the business of financial advice, so it’s no surprise that many people choose to invest without the help of financial advisors ³.  In fact, self-directed investors made up nearly half of the entire investing community in 2015, and their numbers are rising quickly.  With so much nonsense and confusion permeating throughout professional investment advice, it’s understandable that people have issues trusting advisors.  However, self-directed investors – as well as investors who work with the wrong advisors – often miss out on additional value and higher overall returns. Vanguard released a white paper report, informed by more than a decade of research, which indicates that the right advising team can add roughly 3% in net returns more than self-directed investors can achieve.⁴  This 3% (or so) per year is after fees, including the advisor’s fee, expense ratios, and taxes.⁵  3% per year may not sound like a lot, but it is.  Consider a retirement nest egg of two million dollars, saved over the course of a lifetime of working.  3% of two million ($60,000) could represent an entire year’s worth of retirement expenses.

There are seven categories in which financial advisors could cumulatively add up to 3% more in returns, and of these seven categories the highest increase come from behavioral coaching ⁶.  Other studies found behavioral coaching alone can add anywhere from 0.1% to more than 5% in additional value.⁷  In other words, a good advising team can improve the returns of your portfolio, and potentially keep you from making huge behavioral mistakes, which are often caused by misinformation and psychological misjudgments.  Furthermore, a good advising team can add an abundance of value above and beyond mere investment returns.  For example, when’s the last time you updated your estate plan?  Are your beneficiaries up to date?  Do you have enough disability insurance?  What’s your plan for tax efficiency this year?  Do you rebalance your portfolio when it makes sense to do so?  Is your portfolio properly diversified?  How high are your expense ratios (the internal costs of your portfolio’s funds)?  Are you maximizing social security benefits?  Do you have a budget?  How about a financial plan?  Do you even have time to worry about any of these things?!?

Finding the right advising team can be difficult, but there are a few key indicators that can help investors make the right decision when shopping around for finance professionals:

• First and foremost, find finance professionals who are fiduciaries 100% of the time.
  • A fiduciary must act in your best interest, but some advisors are dually-registered, which means they can act as a fiduciary sometimes and as a broker at other times. Work with an advisor who is always required to act as a fiduciary.
• Find an advising team that has no investment conflicts of interest and is truly independent.
  • Conflicts of interest come in many shapes and forms, such as the example of a wealth management company who is incentivized by selling a specific mutual fund.
  • Truly independent firms can select financial solutions from across the entire financial landscape, not limited to their own proprietary products or the products of only a handful of companies.
• Find an advising team who focuses on keeping costs low, and who focuses on tax-efficiency.
  • Low-cost funds are those that have low expense ratios, but you’ll also want to work with an advising team that examines the entire industry for the “best in breed” funds that also have low costs. In other words, you don’t just want low-cost funds, you want the best low-cost funds.
  • Tax efficiency means holding the right type of securities in the right type of accounts and mitigating the influence of taxes. Some advisors use model portfolios that are not tax-efficient.
• Find an advising team who will create a customized, comprehensive financial plan with you.
  • This includes a retirement and investment plan; an estate plan; a plan for risk management; business planning; tax planning; debt management; and any concerns specific to your situation.
• Find an advising team who bases their philosophy on rationality, science, and academic research.
  • There’s plenty of data about the finance industry out there. Your advising team should take an academic approach and employ a philosophy that puts you in the best position for success.

Creative Planning is a truly independent firm; we are fiduciaries 100% of the time; we create customized, comprehensive plans for our clients; and we take a rational approach based on scientific and academic research.  We also look for improvements to our philosophy as changes to the industry and regulations occur.  We engage in a team effort and strive to do what’s best for our clients.  We also have the ability to create and update your estate plan and provide tax advice in-house.

The world is an uncertain place, internally and externally, especially in the world of finance.  Working with a trusted advising team that employs the criteria above can put you in the best position to achieve your goals, because objective number one of a trusted advising team is to help keep you from making costly mistakes.  If you have a plan in place you’re already ahead of the curve if the plan is robust, you stick to the plan, and trust the process in up markets and – especially – in down markets.  The research demonstrates that we all think we know more than we actually know, and it’s easier to recognize other people’s mistakes than our own ⁸.  Understanding that we all have our own biases and challenges is the first step toward building a better life for ourselves and each other, but we need to take meaningful action to make substantial improvements and to avoid disaster.  Put simply, you better check yourself before you wreck yourself.

Footnotes:

1. 1. There are scientific studies to demonstrate this: we’re lied to up to 200 times every day, we detect those lies with only 54% accuracy, and even the experts such as FBI interrogators and law enforcement officials can only discern deceptive behavior 54% of the time.  And that’s just an example of the external deception!  Our own brains deceive us every day as well.  For further reading on these subjects, check out Liespotting by Pamela Meyer and Predictably Irrational by Dan Ariely.
   2. PBS Frontline has a documentary about the problem of trust in the financial services industry.  It’s called The Retirement Gamble:  https://www.pbs.org/video/frontline-retirement-gamble/. 
   3. Here’s a pdf link to the Vanguard study: https://advisors.vanguard.com/iwe/pdf/ISGQVAA.pdf
   4. This increase doesn’t happen every year, because sometimes markets can be a bit choppy.  But over time the increased returns end up to be about 3% per year on average.
   5. See page 4 of the Vanguard study: https://advisors.vanguard.com/iwe/pdf/ISGQVAA.pdf
   6. Morningstar quantifies additional value from behavioral coaching by level of sophistication of the investor, and indicates a wide range of return deviation based on an individual investor’s knowledge of the investing world:  https://www.morningstar.com/content/dam/marketing/shared/research/foundational/831611-GammaEfficientPortfolio.pdf Russell Investments indicates behavioral mistakes added up to 2% on average:  https://russellinvestments.com/Publications/US/Document/2017_Value_of_Advisor_study.pdf
   7. If you really want to understand this, and the details of how people think, read Thinking, Fast and Slow by Daniel Kahneman.  This book will blow your mind.