As a child growing up in Huntsville, Alabama in the 1980s, I was surrounded by a number of friends whose parents were involved with the space program. Ever since, I have maintained a childlike wonder toward the shuttle program. However, I recently learned something about those early missions that offered a powerful analogy to some of my work in the world of behavioral finance.
At the time of the first shuttle missions, scientists in the program were facing a challenge. They were having trouble getting the shuttle off the ground because it was about 600 pounds too heavy. So, the NASA rocket scientists did what incredibly smart people do best—they tried to come up with a complicated solution to a pesky problem.
They experimented with space-age polymers and tried different forms of material, but none of these solutions could cut the appropriate amount of weight. Then—as the story goes—a line worker walked by one day and saw these scientists in the process of scratching their heads on how to reduce the weight. He stopped and asked why they didn’t just stop painting the fuel tank white. As it turned out, the paint weighed exactly 600 pounds. Hence why today we no longer see a gleaming white fuel tank on NASA’s shuttles. They solved the issue by simply not painting the tank, and instead began leaving it the familiar orange hue most of us know today.
The lesson here is this: a simple solution can often solve for what complexity cannot. For me, this insight served as a compelling metaphor for some of the problems advisors and their clients face every day. Though well intended, advisors can often engineer overly complicated solutions for our clients’ woes that, in reality, require a much simpler and direct approach.
The Investment Problem Vs. The Investor Problem
When it comes to the advisor-client relationship, we have largely solved the problem as it relates to managing investments. Looking back at the past 50 years, evidence suggests that we have figured out how to create funds and indices that maintain a consistent growth trajectory over time, serving as a largely reliable avenue for clients to realize profits with each passing year.
However, studies also show that investors are not capturing the full extent of the possible value of their investments—not by a long shot. A lot of investors get caught up in short-term approaches, like trying to time the market or chase after recent gains. This often points to a gap in their understanding, or a lack of discipline needed to benefit from what the market can offer over extended periods. Ultimately, they end up reacting to immediate market shifts, which reduces their potential for higher returns over time. For example, recent Morningstar research shows that over the past decade, investors in mutual funds and ETFs earned an average of 6.04% annually, which is 1.67 percentage points lower than the total returns of the funds themselves (7.71 percent). This gap in performance is especially pronounced in sector funds and nontraditional equity funds, where investors' attempts to time the market can lead to reduced average returns.
As founding Orion CEO Eric Clarke once said to me, though the investment problem has been solved, the investor problem still needs a lot of work. We need to figure out how to keep investors in their seats and address the behavior gap that leads to much lower returns than is possible. If we refer to our shuttle program example, the complex solutions that solved the investment problem may not be the most suitable approach for addressing the investor problem. For that, we need to revisit the basics of being human and what makes us tick.
The Case For Behavioral Finance
In 2016, Merrill Lynch completed a meta-analysis of several prominent studies related to the value delivered by various aspects of an advisor's daily work. The study looked at everything that comprises an advisor's day in the office and sought to find out which tasks were the biggest drivers of financial returns and improvements to a client’s life.
The good news is that more or less everything an advisor does adds value. From tax management to behavioral coaching, everything is prudent and additive to the lives of those who have entrusted their advisor with their financial (and personal) well-being. Notably, however, functions that touch on behavioral finance stand out as exceptionally valuable, with behavioral coaching possessing an average value of 244 basis points (bps). In comparison, a traditional task like asset allocation typically yields around 35 bps. Of the four areas tested (behavioral coaching, client assessment, goal optimization, and saving and withdrawal guidance), it's worth highlighting that even the least valuable behavioral function surpasses the most valuable “old school” advisor tactics, which include asset allocation, tax management, product allocation and portfolio rebalancing.
This drives home the idea that for advisors to serve their clients appropriately and to the best of their abilities, they need tools that allow them to better understand their clients’ needs as humans—not just as investors.