What is (Good) Financial Advice?

i'd like to say that investing has been solved that's not completely true nobody can tell you what the perfect portfolio for the next 30 years looks like today but we do have a pretty good understanding of what works what doesn't and why based on this knowledge any investor can access a great portfolio on their own for almost no cost the late vanguard founder john bogle's vision is being realized based on this reality a question that i get asked often is ben if you're telling me that i should be investing in low-cost index funds why do you still have a job it's a good question and i think i have a good answer at least i hope so but it might not be what comes to mind when you think of investment management i'm ben felix portfolio manager at pwl capital in this episode of common sense investing i'm going to tell you why i can promote low-cost index funds as the most sensible investment for most people and still have a job as a portfolio manager [Music] before i describe what constitutes financial advice let me start with what doesn't when i say that investing has been solved i am of course talking about low-cost index funds beating most other investing strategies over most time periods academic literature going back to the 1960s has consistently found that trying to beat the market index is a losing game on average most investors are best served owning the market and keeping their costs low there was a time not long ago before the weight of evidence favoring index funds grew to its current stature when financial advice focused on wishfully selecting usually unsuccessfully investments hoped to beat the market today knowing what we know about financial economics and portfolio management financial advice that views investing as the primary problem to solve as opposed to one component in a broader solution should probably be ignored altogether attempting to pick winning funds stocks or other investment strategies is largely a losing game in investing as in any other field experts cannot predict the future as much as we may want to believe that they can in their book decisive how to make better choices in life and work chip and dan heath explained that experts are pretty bad at predictions but they are great at assessing base rates base rates are known probabilities for example i will never try to tell you which fund manager or stock is going to do well for the next 10 years but i can tell you that around 90 percent of active fund managers and 63 percent of individual stocks trail the market at the decade horizon base rates are crucial inputs in decision making it follows that advice on how to allocate to the best fund managers or pick the right stocks while ignoring the base rates on how poorly active funds and individual stocks tend to perform is more likely to do harm than good if this type of information is being sold to you as financial advice you should run in the other direction all right with what isn't financial advice out of the way let's answer the question at hand what is financial advice it's my view that expert financial advice can be categorized into five areas where knowledge of base rates technical competence in financial planning and an understanding of human psychology can be applied to help people arrive at high quality financial decisions those areas are goal formation and quantification asset allocation insurance needs analysis financial product allocation and tax awareness i'm going to touch on each of these areas starting with goal formation and quantification before investing you need to know why you're investing setting financial goals is one of the most important actions that we take in our lives financial goals influence how we spend our time who we spend our time with the jobs that we take how much we save how much we spend what we spend on and how we invest in other words our financial goals dictate how we allocate our temporal social human and financial capital this probably sounds obvious when you hear it but the problem is that humans are really bad at setting goals that align with a meaningful life in the 2005 paper affective forecasting knowing what to want timothy wilson and daniel gilbert found that we are really bad at predicting our future emotions imagine setting an ambitious financial goal like an early retirement making significant sacrifices or taking on excessive risk to achieve that goal today and then realizing when you get there in the future that you aren't any happier something called hedonic adaptation plays a meaningful role in this problem hedonic adaptation is humans ability to adapt quickly to their circumstances both good and bad the 1978 study lottery winners and accident victims is happiness relative found their recent paraplegics and lottery winners converged at their previous levels of happiness or sadness not long after their life-changing event that early retirement new car bigger house or lakeside cottage may not increase your well-being as much as you think at least not for long this has obvious implications for goal formation similar to portfolio management there is a large and growing body of literature on happiness and life satisfaction i think it's sensible to say that anyone being relied on for financial advice needs to understand the base rates on life satisfaction to offer perspective on the content of a meaningful life the ultimate goal of every human investor going down the analytical path to meet a financial goal without first scrutinizing the goal itself is a recipe for misallocations of capital it may seem strange to suggest that financial advice requires an understanding of psychology but money is where the rubber hits the road financial decisions are some of the most impactful and psychologically taxing decisions that we make in our lives once goals aligned with a meaningful life have been determined a necessity in financial advice is figuring out how much those goals cost these may be simple or complex calculations depending on the goal and the circumstances quantifying meaningful goals helps us to avoid one of the biggest and most dangerous hedonic traps the infinite pursuit of more in his book the psychology of money morgan housel states that the hardest financial skill is to get the goal posts to stop moving enough is realizing that an insatiable appetite for more will push you to the point of regret the pursuit of enough is far more psychologically demanding than the pursuit of more speculating in the stock market in pursuit of more feels a lot better than the cognitive load required to take a step back and reflect on what enough might look like with meaningful goals formed and quantified setting the goal posts for enough asset allocation is the next area to consider given a set of meaningful goals and their estimated costs how should you allocate your financial assets far before deciding whether it makes sense to use index funds investors need to determine their mix between stocks bonds and other asset classes it's even a possibility that long-term risky investments like stocks and bonds aren't the right choice given the goals at hand debt is also addressed in asset allocation asset allocation decisions can't be made in a vacuum either in addition to being anchored in meaningful goals the characteristics of human capital need to be considered for example a tenured professor has far more stable income than a commissioned salesperson in a volatile industry and these differences in human capital should be reflected in financial asset allocation a 2015 paper in the financial analyst journal titled no portfolio is an island found that incorporating non-financial assets like human capital region-specific home ownership and pension benefits into a portfolio optimization routine resulted in materially different solutions asset allocation is one of the most important determinants of expected investment outcomes a more aggressive portfolio with a higher expected return might allow you to achieve a goal more quickly or with less additional savings but it may also make the outcome more uncertain and be harder to stick with when markets are volatile picking an asset allocation that is too conservative can have an enormous implied cost due to lower expected returns taking meaningful quantified goals and non-financial capital into consideration to arrive at an appropriate asset allocation is a key piece of financial advice at this point things are shaping up there are meaningful goals in place those goals have been quantified and an asset allocation has been determined to meet the goals with further consideration for non-financial assets like human capital but there's still a gap unless you are financially independent now there's a good chance that you rely on your human capital your ability to earn income or the human capital of someone else in your household to move toward achieving your financial goals a premature death or much more likely and unexpected disability can easily derail the best laid investment plan life and disability insurance may be the least fun to think about but most important components of a financial plan similar to quantifying a goal determining insurance needs can be simple or complex depending on the circumstances understanding insurance needs and the cost of covering them is another crucial piece of financial advice with insurance needs addressed we can start thinking about financial products index funds finally get their mention evaluating the best financial products to implement an asset allocation and an insurance plan is an important area of technical competence but it cannot be done at least not done well without the context found in a broader plan in many cases financial advice i would call it bad financial advice starts with the product lastly looming over all of these areas are taxes tax awareness at every step has the potential to meaningfully improve expected outcomes without increasing risk this is another area where both technical competence and context are important in his book the geometry of wealth brian portnoy succinctly summarizes the process that i've described so far as defining your purpose setting your priorities and implementing your tactics tactics of which index funds are won are the last step this whole system exists as an iterative process people change over time meaning that their objectives preferences and values also change the process of managing wealth is one of continuous improvement not a one-time set it and forget it exercise a question that i have left unanswered is why you wouldn't just subscribe to my youtube channel listen to the podcast episodes that i'm going to recommend at the end of this video and do all of this yourself the information is out there often for free chip and dan heath again from decisive have some interesting insight they described four villains of decision making narrow framing the tendency to define choices too narrowly or see them as binary when they're not confirmation bias the human tendency to form a quick belief and then seek out information that confirms it short term emotions which can obviously get in the way of good decisions and over confidence the feeling that we know more about how the future will unfold than we actually do i'm not going to stand here and tell you that everyone needs professional financial advice i make these videos to empower people with the information needed to make great financial decisions on their own i even publish model portfolios to help people build their own etf portfolios in a way that i think is sensible but the four villains of decision making largely exist within what psychologists call the inside view the view that stems from the information directly in front of us including our own biases one of the best ways to overcome the inside of you is by reality testing your assumptions which in many cases especially in complex areas like managing wealth is best accomplished by consulting an expert making better decisions with an outside view is a pretty good argument for financial advice but it may also be useful to understand why people seek advice in her book advice that sticks dr moyer summers a neuropsychologist offers some of the reasons that consumers seek expert advice expert advice allows people to quickly optimize trade-offs going through the advice steps that i've described with an expert results in a relationship where there's a mutual understanding of goals preferences and values this mutual understanding combined with technical competence and a knowledge of the relevant base rates makes optimizing trade-offs far more efficient should you buy a bigger house with a bigger mortgage should you take a lower paying job to spend more time with your kids should you opt for the survivor benefit on your pension should you sell the shares that you own in your employer financial trade-offs come up every day expert advice reduces complexity there is a ton of information available online but it's not always easy to know how to weigh the relative value of that information for a given decision experts should be able to judge the credibility and utility of information quickly to reduce the number of inputs in a decision too much information and perceived complexity easily leads to time-consuming and stressful decision paralysis expert advice increases confidence in an intended plan of action people want to make sure that they've not overlooked anything a study from fp canada found that people who had consulted with a financial planner had increased financial and emotional well-being they had increased confidence in their ability to meet their goals and deal with setbacks without having to make financial sacrifices lastly expert advice saves time through obvious channels like minimizing the need for large amounts of upfront research and eliminating the ongoing tasks required to implement a financial plan but also through less obvious channels like reducing the time spent in inaction and the time spent dealing with stress related to the task of implementing the plan financial advice is not about which fund managers or stocks to pick the fact that index funds are the most sensible investment for most people does not negate the need for financial advice financial advice starts with setting meaningful goals and then quantifying them followed by determining an appropriate asset allocation and insurance plan only then specific financial products and strategies should be considered all while keeping taxes in mind these are all things that can be accomplished on your own with sufficient research but humans have a tendency to get stuck in the inside view where narrow framing confirmation bias short-term emotions and overconfidence contaminate the decision-making process consulting with an expert can help in overcoming the inside view an expert is also able to assist in optimizing trade-offs reducing complexity and saving time all within the context of your specific goals preferences and values i tell people to invest in index funds every day but i also tell them to do a lot of other things i hope that i've articulated the fact that there's a lot more to financial advice than telling someone to invest in index funds if you want to learn more about these topics you can find conversations on the rational reminder podcast with dr moira summers in episode 45 dr brian portnoy in episode 102 and morgan housel in episode 128. their books and my conversations with them were impactful to my views on money life and the important ways that they intersect thanks for watching i'm ben felix portfolio manager at pwl capital if you enjoyed this video please share it with someone who you think could benefit from the information and don't forget if you've run out of common sense investing videos to watch you can tune into weekly episodes of the rational reminder podcast wherever you listen to podcasts

Channel: Ben Felix

Views: 126,477

Keywords: benjamin felix, common sense investing, ben felix

Id: TI5p8vqdjTw

Length: 15min 55sec (955 seconds)

Published: Sat Apr 24 2021