Five Good Questions with Terry Odean

5 Good QuestionsTerrance Odean is the Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley. He is a member of the Journal of Investment Consulting editorial advisory board, of the Russell Sage Behavioral Economics Roundtable, and of the WU Gutmann Center Academic Advisory Board at the Vienna University of Economics and Business. He has been an editor and an associate editor of the Review of Financial Studies, an associate editor of the Journal of Finance, a co-editor of a special issue of Management Science, an associate editor at the Journal of Behavioral Finance, a director of UC Berkeley’s Experimental Social Science Laboratory, a visiting professor at the University of Stavanger, Norway, and the Willis H. Booth Professor of Finance and Banking and Chair of the Finance Group at the Haas School of Business. As an undergraduate at Berkeley, Odean studied Judgment and Decision Making with the 2002 Nobel Laureate in Economics, Daniel Kahneman. This led to his current research focus on how psychologically motivated decisions affect investor welfare and securities prices.

Today I ask (in bold) and Terry answers what I hope are Five Good Questions as part of my longstanding series by that name (see links below). Continue reading

Five Good Questions for Carl Richards

Carl Richards is a Certified Financial Planner™ and the founder of Prasada Capital Management, a fee-only firm he created to help clients with two objectives:  to avoid losing money and to enjoy their lives. He also explores how our relationships with money impact the quality of our lives at BehaviorGap.com. Carl is perhaps best known for his helpful illustrations of financial concepts, a sample of which may be seen below.  His sketches may be seen at BehaviorGap.com, as part of his weekly writing for The New York Times, and at Morningstar’s Advisor blog. He is also the author of a best-selling book, entitled The Behavior Gap. Carl earned a Bachelor of Science degree in Finance from the University of Utah.  What follow are what I hope are Five Good Questions for Carl Richards. 

Source: BehaviorGap.com

  1.  Your drawings help people understand what may be difficult concepts.  What do you think are the keys to an effective drawing?

Being an amateur! As is very apparent, I have no art background, but for some reason I found I learned things I didn’t know when I went through the process of trying to explain things using a Sharpie and a piece of paper. Limiting yourself to simple tools, like a whiteboard, pen and paper, or the back of a napkin forces you to get to the stuff that really matters. Having no artistic talent helps as well. Because I can’t draw a horse or a bird, I have to use simple lines, a box or a circle.

  2.  What have you found to be the most effective tool(s) for dealing with the “behavior gap” (the difference between what we should do and what we actually do)?

Asking questions. In our industry we have an obsession with having all the answers, but we spend very little time making sure we are asking the right questions to start with. If we can help people get clear about why they are doing the things they are doing, then, maybe we can help them make change.

  3.  You’re a powerful advocate for meaningful conversations about money.  How do you suggest people get started and go about having those conversations?

First recognize that is it okay to talk about money. Most of us were taught that money, sex, politics and religion were things you didn’t talk about in polite company. Of course we have gone way too far when it comes to sex, but we still have not learned to talk about money. Another key is to do what Stephen Covey suggested and learn to listen to understand and not judge. People want to know that we understand them before we give them advice. How can we prescribe before we take the time to diagnose?

   4.  You are careful to advocate life planning rather than just financial planning.  What does that mean?

I am not sure that life planning is the right term, but the reality is that the process of planning for our financial futures is about life. Almost every goal we have is funded by dollars. Security, health, safety, education, retirement are all make possible to some extent using money. So if we think that financial planning is a process of spreadsheets and calculators we are kidding ourselves. These things are about life. We are talking about people most important goals and dream and the things that keep them up at night.

  5.  As you emphasize, we need and may even want simplicity but we are attracted to complexity.  How do you suggest that people go about simplifying their financial lives?

Start by getting clear about where you are today and where you want to go, then give yourself permission to peruse the simplest path to make it happen. So often we think that because the problem feels complex to us, the solution must be complex, when more often it is the simplest solution that has the staying power to get us moving forward.

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The AdvisorOne version of this article is here.  The Five Good Questions series: 

Five Good Questions for Moshe Milevsky

Moshe A. Milevsky in an Associate Professor of Finance at the Schulich School of Business and a member of the Graduate Faculty in the Department of Mathematics and Statistics, at York University in Toronto. He has an M.A. (1992) in Mathematics and a Ph.D. (1996) in Finance, both from York University. He is currently the executive director of the non-profit IFID Centre at the Fields Institute, and has published 10 books and over 60 peer-reviewed articles on all aspects of retirement planning and the valuation of mortality-contingent claims. He is currently working on his next book manuscript entitled: TONTINES for the 21st CENTURY: The Fascinating Past and Future of a Product that Can Help Save Retirement. 

But that’s only the more formal biography.  As my friend Wade Pfau quips, when it comes to retirement planning research, “Moshe Milevsky has already done everything.”  He is, without question, “the world’s leading researcher and authority on retirement income strategies.” So, without further ado, let’s get started with what I hope are Five Good Questions for Moshe Milevsky. 

1.       How do you think the “annuity puzzle” can best be solved? 

I think the consensus at this point is that there really isn’t an annuity puzzle anymore. The puzzle is solved. Economists fully understand why people aren’t buying annuities. There is a long list of reasons that have been proposed over the last two decades to help explain the low levels of voluntary annuitization relative to the (famous) Yaari Theorem. Honestly. Very few researchers are running-around trying to find the answer to the annuity puzzle as if it was the Higgs Boson. I think the issue of the day is how to get more retirees to see the value of annuities and overcome some of their legitimate objections. This is especially important for those with 401(k) plans, or those who lack a DB pension. This is not a puzzle — in the traditional economic sense — as much as a challenge. Note the difference between: “Why do people eat unhealthily?” vs. “How do we get people to eat more healthily?” To me the answer to this challenge is a combination of education, product design, accommodating regulations and proper incentives. A week doesn’t go by without another policy-oriented paper that crosses my desk on “how to encourage” this business.

2.       What is your view about the continuation and pricing of retirement income/annuity products going forward, especially in light of the current interest rate environment and QE3? 

At these very low levels of long-term interest rates, the present value of any future cash-flow increases in value which means that retirement guarantees are becoming much more expensive than ever before. If this persists — and it looks like it will for the next few years — insurance companies will be hard pressed to offer new and innovative products. In fact, even the VA products that some companies are still offering these days are pushing-it in terms of pricing. If consumers and advisors were to smarten-up and “optimize” their utilization and allocation strategies, current pricing wouldn’t be sustainable. Here is the bottom line. Enjoy the irrational behavior of the masses — which allows you to get a good deal — while it lasts.

3.       How should advisors position annuity products (deferred and immediate) with consumers and the media? 

The behavioral economics literature is teaching us (old classical folks) that framing and language have a much bigger impact than we previously thought. These complex products have to be explained in terms of what they can do for a retiree’s spending power and standard of living, as opposed to being positioned as an investment product with IRR and yields. I think the concept of mortality (or longevity) credits has to be better explained by the industry, first to the media and then advisors. This is a very unique source of “alpha” that is only available to older individuals, etc. My next book is about the TONTINE Products and I’m hoping that it helps generate a debate about the economics, ethics and regulation of mortality credits.

4.       Your thought on GLWBs has generally moved from “anti” to “pro.”  Why? 

I was never really “anti” and I’m not currently “pro.” Rather, the best way to summarize my “Road to Damascus” conversion is that I can understand the value and role of guaranteed WITHDRAWAL benefits, more than guaranteed DEATH benefits. The existence and role of the GLWB in the optimal portfolio can be justified within a classical life-cycle model, but is more difficult to do with a GMDB, especially when you consider the historical pricing of both riders. Of course, you can probably find a behavioral story to justify almost any insurance product — EIA with a GLWB, anyone? — but you have to be able to spin quite the yarn. Here is the bottom line. Today I own a VA and I paid extra for a GLWB. I didn’t pay for any extra GMDB. Hopefully my grandkids won’t complain.

5.       It makes sense that we decrease spending as we age due to decreasing survival probabilities, but most people seem to reject that notion.  Why? 

This whole area has become quite jumbled. Normative economics — how should people behave? — is being confused with positive economics, which is concerned with how people actually behave. To make things more confusing, there are discretionary expenses vs. required expenses vs. medical expenses, which have completely different dynamics over time and as we age. Everyone is talking across each other here. The point I’m trying to make about longevity risk aversion (LoRA) is quite simple, really. For a new retiree, there is a 5% chance he will reach 100, and there is a 95% chance he will reach 70. Think of it as a roulette wheel that your genes — God? — will be spinning. Well. How much money do you want to put on the 100 slot vs. the 70 slot? Remember. You have a limited nest-egg budget! Well, I would rather put more chips on the 70 vs. the 100. Enjoy it while I’m younger and likely to be alive, because I am longevity risk tolerant. I know there is a 5% chance I’ll become a centenarian, and I’m willing to take a chance and reduce my standard living. Ergo, my spending will decline if-and-when I hit 100, because I didn’t rationally put many chips on that roulette slot. Of course, taking the leap from my simple longevity roulette wheel to actual real-life behavior is a big stretch. But, it should make you stop and think. Do I really want a constant real standard of living for the rest of my entire life? What is your — or your client’s — longevity risk aversion?

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The Five Good Questions series: 

This article is also available at AdvisorOne.

Five Good Questions for Michael Kitces

Michael Kitces, MSFS, MTAX, CFP, CLU, ChFC, is the director of research for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Maryland that oversees approximately $1 billion of client assets. He is the publisher of the e-newsletter The Kitces Report and the blog Nerd’s Eye View through his website www.Kitces.com. Kitces is also one of the 2010 recipients of the Financial Planning Association’s “Heart of Financial Planning” awards for his dedication to advancing the financial planning profession. Follow Kitces on Twitter at @MichaelKitces.  Today I ask (in bold) and Michael answers what I hope are Five Good Questions.

 1.  In your view, what are the difference and the significance, if any, in terms like wealth manager, investment manager and financial planner?

While the exact meaning of these terms is somewhat debated, I do believe that they describe substantively different services, and require different knowledge and skills to execute effectively. And while some of it is semantics, I believe the distinctions are important – how we describe ourselves and hold ourselves out to the public matters.

I would characterize an investment manager as someone who is focused solely on investment management – the service delivered is managing the pot (or pots) of money, and the expectation is to create value in the investment management process.

A financial planner and a wealth manager, however, provide a broader range of services, typically incorporating advice regarding a broad range of financial issues, which may or may not include the hands-on investment management aspects as a part. As I wrote recently on my blog, the emerging factor that is distinguishing a financial planner from a wealth manager is the wealth level of the target client. This is more than just using lofty terms; the reality is that the body of knowledge needed to serve the ultra high net worth market – as a private wealth manager – is different than the knowledge needed to serve the rest of the public. Over time, I expect that we will increasingly differentiate between the two; an early glimpse of this is the curriculum being developed by IMCA (Investment Management Consultants Association) for their new CPWA (Certified Private Wealth Advisor) certification, which has only a limited overlap to the CFP certification curriculum.

2.  Is the “4 percent rule” still an appropriate rule of thumb?

I find the “4 percent rule” continues to remain relevant today. The reality, as I recently wrote, is that such safe withdrawal rates are based not on average returns, but the worst return sequences we’ve seen in history – environments where balanced portfolios don’t even generate 1% real returns for 15 years (the entire first half of retirement!). Accordingly, if real returns on bonds stay low and the S&P 500 merely makes it back to its old high by the middle of next decade – truly a horrible return environment – we’re merely looking at results that are similar to the exact returns the 4% rule is based upon in the first place.

Ultimately, I am a little skeptical about whether those who retired in the year 2000 will ultimately violate the 4% rule, as market valuations back then truly reached levels of distortion never seen in our market history, even leading into the Crash of 1929 and the Great Depression. However, today’s market environment, while still overvalued, looks relatively similar to numerous other overvalued market environments throughout history, so while  the year 2000 retiree may be at risk (although recent follow-up research by Bill Bengen has shown that actually the year 2000 is still reasonably on track!), this does not raise the same concerns for today’s retirees, as market valuations today are far less egregious. On the other hand, market valuations are still high on a long-term basis, so I wouldn’t necessarily recommend clients significantly raise spending above that benchmark, unless they have a higher tolerance for risk and a potential need to reduce spending in the future.

3.  Do you think the barriers to entry to and/or the education and training components of our profession are too low?

I do believe that the educational and training requirements for financial planning need to rise, for it to become a bona fide true profession – and I don’t believe financial planning has reached the status of true profession yet, because of this. It should require more than what is essentially “just” half a dozen undergraduate-level courses in personal finance, and should have a more formalized training process than just unleashing newly educated practitioners on the public to earn their experience without necessarily being supervised (and coached and trained) in the advice being delivered. Although it will be a long time before we get there, I expect financial planning in the future, as a profession, to have both a deeper body of knowledge, and also a great deal of additional focus in trust, communication, and how to help clients actually change their behavior (to implement the advice).

Ultimately, significant training and educational requirements do effectively become a barrier to entry as well, which some have been critical of, but that’s part of the natural progression in the development of a profession. If the public doesn’t have a clear way to distinguish between the trained and untrained professional practitioner, it’s not a profession, and more importantly you can’t protect the public.

4.  Appropriate regulation (whether by the SEC, the states or FINRA) is actively being questioned and considered today (obviously).  How would you set things up if you were in charge?

In my ideal world, no one would be allowed to hold themselves out as a financial planner, advisor, consultant, or analogous term, unless he/she actually had the education, training, and experience to serve as a professional advisor. A national regulatory body would oversee this (although in reality state regulation may be the most likely solution), ensuring that only those meeting the appropriate minimum standards can represent themselves as advisors to the public. Anyone who delivers advice would be subject to a fiduciary standard, as almost by definition there’s no such thing as advice that isn’t delivered in the interests of the person receiving the advice! Notably, this is also why the public continues to be confused by our discussion of fiduciary and non-fiduciary standards for advice – because in the eyes of the public, there simply is no such thing as non-fiduciary advice.

That being said, I continue to see a role for people who sell and help clients to implement specific financial services product solutions. I don’t believe we need to eliminate the suitability standard or the existence of commission-based salespeople. However, such individuals should be required to hold themselves out to the public as salespeople, with a return to the labels “stockbroker” and “insurance agent” that were once used in the past. If that individual gives any advice to the client, that person becomes subject to a (fiduciary) advice standard. While I understand the origins of the exemption from the fiduciary standard for brokers and dealers who give advice that is “solely incidental” to their services as a broker/dealer, the reality in today’s world is that the exemption has become far too wide. As a result, there is significant confusion for the public as people routinely provide extensive advice while claiming they shouldn’t be subject to advisor regulation or standards and that the advice is “solely incidental” when it clearly is not.

The bottom line is that the real choice for the public shouldn’t be between fiduciary and suitability standards at all; it’s about the choice between being sold a product from a salesperson, or getting advice from an advisor. That is a valid choice for consumers – as long as the people on each side of the line are held to appropriate standards, and use titles and provide services that make it clear where the line is.

5.  A recent study from the National Bureau of Economic Research found that nearly half of all Americans die with virtually no financial assets. Clearly, many people are not getting good financial advice.  How can we go about improving the quality of financial advice being given overall and making it more available to those without the assets to make them attractive clients?

I think the first key to improving the financial circumstances of the average American is to understand that this is not merely a “financial literacy” problem, as though people would make the right and best decision for themselves if only they had a little more education. Yes, education helps – you certainly can’t make the right decisions if you have no idea what’s best in the first place – but it is only a necessary condition for success, not a sufficient one. If knowledge alone were sufficient, we would long since have conquered our country’s obesity problem, as there’s no lack of information regarding the harmful effects of obesity, and how “easy” it is to avoid it by simply eating less (and healthier), and exercising more. Instead, the reality is that improving financial health, like improving physical health, is about behavior change, and taking the steps necessary to help people change habits and implement changes in their lives.

Thus, to me the starting point is actually better education and training for advisors about how to effectively help clients find real success – and understand that it’s about more than just giving them information and having the technically accurate answers (although that’s also necessary). The greater the positive impact we have on changing people’s behavior and leading them to a sustained improvement in their lives, the more people understand the value of financial planning and seek it out, and the easier it is to serve a wider base of people.

In the end, the real reason that financial planners fail to serve the majority of Americans is simply that the public in the aggregate does not yet see enough value in what we do to demand our services en masse, and consequently firms and advisors seeking to serve the average American struggle with the marketing necessary to sustain enough clients for the business to be successful. To some extent, the lack of demand is simply because we haven’t done a very good job communicating the value of financial planning, so people don’t understand what we bring to the table; but I think the reality is that we could also get better at delivering real results for the average American that would make us more relevant and sought after, too.

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The Five Good Questions series:

Five Good Questions for Tadas Viskanta

Tadas Viskanta is the founder and editor of the indispensable investment blog, Abnormal Returns. Over its six-year life, Abnormal Returns has become a fixture in the financial blogosphere. Over thousands of posts Tadas has brought the best of the financial blogosphere to readers.  He is a private investor with over 20 years of experience in the financial markets. He is the co-author of over a dozen investment-related papers that have appeared in publications like the Financial Analysts Journal and Journal of Portfolio Management, among others. Tadas is also the author of the terrific new book: Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere, which culls lessons learned from his time blogging.

Tadas (pictured right) holds a MBA from the University of Chicago and a BA from Indiana University. He lives with his family in the heartland of America. He has graciously agreed to answer what I hope are Five Good Questions

     1.  Your book – rightly I think – describes investing as the “last liberal art” since what is interesting in investing isn’t really captured by the data.  How then do you suggest using the data we have and integrating it into the liberal art of investing?

We are awash in data. You could even say we are in a bull market for economic and financial indicators. It seems like every week there is a brand new indicator that will purportedly help us better understand the economic world around us. Despite all of this information I would argue that the vast majority of investors are not rigorous enough in their use of data.

Most investors rather than using a structured approach to stock selection and portfolio construction are really flying by the seat of their pants. This ad hoc approach leads to all manner of bad behaviors including overtrading and underdiversifcation. That is why client portfolios often look like a mish mash of stocks and funds than a consciously chosen strategy.

Unfortunately the data don’t often tell us the whole story. Every investor whether their approach be fundamental, technical or quantitative is going to have a period in which they underperform. The question is then asked: Is it different this time? Is my model/worldview broken? Most of the time with a well-constructed strategy it makes sense to stay the course.

However, sometimes the world really does change, oftentimes abruptly. If anything you could argue that these trend breaks are more likely now than ever before due to technology. Identifying these disruptive periods require a grounding not only in finance, accounting and economics but also in history, technology, politics and psychology to name but a few.

      2.  The book focuses on an investor’s need for humility since we can so easily go “off the rails.”  What techniques or devices do you use to try to guard against errors?

Most investors would claim that their time horizons are in the decades if not years, let alone months, weeks or years. If that is the case then are they spending their time watching CNBC and trying to trade during the day?

Their time would be much better spent reading, doing analysis and thinking than worrying about the minute-to-minute gyrations of the market. There are very few people are able to make money in that time frame especially as high frequency trading now dominates intraday trading.

What matters often is not the news itself, but the market’s reaction to the news. That requires more perspective than you are going to get from the financial media. If there really is no good way to limit your consumption of the media then you really have to block it out entirely and focus on what matters.  Your intraday decisions are more likely to hurt than help over the long run.

     3.  Following John Bogle and holding a portfolio of exceedingly broadly diversified index funds essentially forever would fit with your suggestion that investors avoid the active management game and keep things simple.  Are you a total buyer of the concept?

Up to a point. I think for the vast majority of investors a broadly diversified portfolio of index funds, rebalanced regularly with an eye on taxes and expenses should be their default approach. Two things are important to note.

Active strategies whether they are stock selection, market timing or manager selection are costly. Whether you do it yourself or hire a manger these strategies increase your expenses with no guarantee that they will necessarily increase your returns for the risk taken.

Not only is there an explicit cost there is also an opportunity cost. The time and effort put into trying to generate additional returns could be spent in other ways. These don’t necessarily have to do with investing. Most investors don’t have the burning desire to be active portfolio managers. Their time would be better spent on their careers or family rather than in the pursuit of a few more basis points of returns.

     4.  You extol the virtue of “investment mediocrity” in your book.  When, if ever, should we strive to do better than that?

I say in that book that investment mediocrity or competence is not too low a hurdle. John Bogle has written extensively about how it is that a low cost indexed approach to investing will actually lead to above average returns. This occurs by simply avoiding the high cost, active game that most everyone else is playing.

This doesn’t exclude the possibility of finding managers that can outperform. The challenge is identifying them ahead of time and hoping that their alpha will outweigh whatever fees they charge. I talk about in the book the difference between luck and skill in investing. Unfortunately there is no easy way of teasing out these two effects.

Investing is one of those rare endeavors where amateurs can compete directly with professionals. That is an enticing prospect. Investors just need to be aware that the odds are against them and that there are real costs, both explicit and implicit, in taking on an active approach.

All that being said I don’t think I or anyone else should dissuade a highly motivated investor from undertaking active strategies. No one can say ahead of time who will or will not be successful. It requires actually doing it and getting your hands dirty. However, investors need to undertake active strategies, like they would any other business endeavor, with rigor and above all a focus on risk.

     5.  What is the best piece of investment advice you ever received?

“There is no must-own stock/fund/asset class, etc.” 

This kind of thinking leads investors to load up on Internet stocks in 1999 and second homes in 2006. Investors are easily caught up the waves of sentiment that drive markets. We are driven to own a certain asset lest we feel like we are missing out some once in a lifetime opportunity. This peer pressure leads us to make decisions that ultimately work against our own best interests.

Every investor is ultimately his or her own client. You have only to answer to yourself and your own goals. You have to feel comfortable and confident with your decisions and you shouldn’t feel that you have to do something because everyone else is doing it. This ultimately leads to a real disconnect between the risk we think we can take and actual risks we are taking.

This dissonance in risk perception in theory and in practice is what leads to investors reducing risk at market bottoms and increasing risk at market tops. This so-called “behavior gap” drives a wedge between the returns we can earn and what we ultimately earn. In today’s markets there just isn’t that much in the way of nominal returns where we can afford to lose much to our own unforced errors.

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Also in the Five Good Questions series: