Tim Maurer in Forbes on why life planning is a vital part of financial planning.
Tim Maurer, Director of Personal Finance, The BAM Alliance
“The whole financial planning process is wrong,” says George Kinder, widely recognized as one of the chief educators and influencers in the financial planning profession.
But what exactly does he mean, and how does he justify this bold statement?
First, let’s separate the work of financial planning into two different elements--let’s call the first quantitative analysis and the second qualitative analysis.
Quantitative analysis is the more tangible, numerical and objective. It’s where planners tell clients what they need to do and, perhaps, how to do it. For example:
The qualitative work of financial planning is the intangible, non-numerical pursuit of uncovering a client’s more subjective values and goals, and, hopefully, attaching recommendations like those above to the client’s motivational core--their why.
Qualitative planning often has been dubbed “financial life planning”--or simply “life planning.” It is defined in Michael Kay’s book, The Business of Life, as the process of:
I think it’s fair to label the quantitative work as “traditional financial planning” because it’s what has long been seen as the outcome of a client and advisor working together. It’s also where virtually all of the training in the industry has been focused to date.
The central source of this training is likely the Certified Financial Planner™ Board of Standards, whose CFP® credential is the most visible sign that one has been educated and trained as a financial planner. No entity has defined the financial planning process to which Kinder alludes more clearly than the CFP® Board.
But while the CFP® training mentions the importance of “determining a client’s personal and financial goals, needs and priorities”--even prioritizing it over “obtaining quantitative information and documents” in its practice standards--it requires little to no additional life planning training for one to be called a Certified Financial Planner™ practitioner.
And this is why Kinder argues that the process is fundamentally flawed, because, he says, “the client should come first in the curriculum, then the financial skills. As it stands now, the client doesn’t really exist except as narrowly defined financial problems requiring financial solutions.”
But beyond Kinder’s preference, is there evidence that life planning should be prioritized in the practice of financial planning? Yes, there absolutely is.
Consider, for example, the field of behavioral economics, as best articulated in Daniel Kahneman’s book, Thinking, Fast and Slow, although perhaps most approachably in Richard Thaler’s Misbehaving and most entertaining in Michael Lewis’ The Undoing Project.
Traditional economics presumes that we are rational beings, while Kahneman and his longtime research partner, Amos Tversky, proved what we knew all along--that we are actually human beings, quite prone to less rational, emotionally driven decisions. Indeed, most of our financial decisions are driven by our emotional processing center--the Elephant, if you will--not the rational Rider we might prefer to make those calls.
Similarly, traditional financial planning presumes that “the client already has a clear and objective understanding of all their goals and priorities and will readily communicate all necessary and relevant information when asked,” says Amy Mullen, the vice president of Money Quotient, a nonprofit helping financial advisors integrate their traditional financial planning knowledge with emotional intelligence.
But any of us who’ve been financial planners for any length of time know that clients don’t often have a clear and objective understanding of their goals and priorities. We know that personal finance is more personal than it is finance. Many of us, however, don’t have the training, experience or even the language to skillfully guide our clients down this path of self-awareness.
Instead, traditional financial planning presents a set of recommendations that in too many cases barely changes for each individual client. Worse yet, financial planners may even impose values and goals that are designed to lead clients to financial products and processes for which they are compensated rather than reflect the primary motivational drivers in their lives.
If we even mention emotions, we label them as the enemy, something to be avoided in financial decision-making. Unfortunately, as behavioral economics demonstrates, that’s impossible. And sadly, we may be missing out on an opportunity to help our clients process and enlist those emotions in support of a new resolve that would improve their probability of achieving goals of their own discernment.
After all, as George Kinder said, “You cannot solve a problem when someone is expressing an emotion. Empathy is the only way forward.”
Or think about it this way: You can’t solve a qualitative problem with a quantitative solution.
(And oh, by the way, for those financial advisors concerned about the increasing commoditization of financial planning through automation, I have some good news: it’s also very hard--if not impossible--to automate the qualitative elements of our work.)
So, Kinder might be onto something: The financial planning process is jacked up. But how do we fix it?
First, let’s recognize what is working in financial planning curricula. All of the experts mentioned in this article are Certified Financial Planner™ designees and supporters of the vital role the CFP® Board plays in the profession. (As am I.) And the CFP® Board’s traditional financial planning curriculum is excellent.
But second, we must recognize that life planning is an essential part of financial planning. It’s not a niche or a club. It’s “the essential process that must be done before a financial plan can begin,” says George Kinder. Or, more simply, it’s financial planning done right. “Either incorporate it or acknowledge it as an essential prerequisite,” he argues.
University of Chicago behavioral economics professor Richard Thaler told me plainly that we’re not doing our job if we don’t know this stuff, and I believe the CFP® Board can do a lot to enhance their requisite training in this arena.
Fortunately, until we get there, financial advisors aren’t left out in the cold. There are several pockets of life planning expertise throughout the country you can tap, but I’ll only highlight those with which I’ve had direct experience:
“We need excellence in our standards, not mediocrity, not dabbling. Life Planning is the essence of great financial planning,” George Kinder told me. I agree, but I also wanted to know what he, Amy Mullen and Michael Kay would recommend for the financial planner who’s inspired to do something to improve the qualitative element in his or her practice today.
Interestingly, the recommendation each of them mentioned as a primary skill was as much something not to do as it was a directive:
Listen. Stop talking. And listen.
This commentary originally appeared July 28 on Forbes.com
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Larry Swedroe on a study showing the better strategy may be a factor that pairs fundamental and price momentum.
Larry Swedroe, Director of Research, The BAM Alliance
Momentum is the tendency for assets that have performed well (poorly) in the recent past to continue to perform well (poorly) in the future, at least for a short period of time.
The momentum effect is one of the most pervasive asset pricing anomalies documented in the financial literature: Stocks with the highest returns over the past six to 12 months continue to deliver above-average returns in the subsequent period.
Mark Carhart, in his 1997 study “On Persistence in Mutual Fund Performance,” was the first to use cross-sectional (or relative) momentum, together with the three Fama-French factors (market beta, size and value), to explain mutual fund returns.
Initial research on cross-sectional momentum was published by Narasimhan Jegadeesh and Sheridan Titman, authors of the 1993 study “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.”
As my co-author Andrew Berkin and I show in our book, “Your Complete Guide to Factor-Based Investing,” the evidence supporting the momentum factor (both cross-sectional and time-series, or absolute, momentum) and premium is persistent across time, pervasive around the globe and across asset classes, robust to various definitions, and implementable. We also provide the well-documented behavioral explanations for the factor’s existence.
A Look At Fundamental Momentum
Dashan Huang, Huacheng Zhang and Guofu Zhou contribute to the literature on momentum with their March 2017 study “Twin Momentum.” Based on seven major fundamental variables (return on equity, return on assets, earnings per share, cash-based operating profitability, accrual-based operating profitability, gross profitability and net payout ratio) and their moving averages, they constructed a measure of fundamental implied return (FIR) to capture the expectation of future stock returns.
Similar to price momentum, fundamental momentum is formed by buying stocks in the top FIR quintile and selling stocks in the bottom FIR quintile. And, as with price momentum, the formation period is the previous 12 months excluding the most recent month. The authors’ study covered the period April 1976 through September 2015.
Following is a summary of their findings:
Twin Momentum Strategy
In addition, Huang, Zhang and Zhou constructed a twin momentum strategy that would simultaneously exploit both price information and fundamental information. The strategy takes long positions in stocks in the top past return and FIR quintiles and short positions in stocks that lie in the bottom past return and FIR quintiles.
They write: “The resulting twin momentum strategy earned an average return of 2.16% per month, more than doubling that of price momentum (0.93%) or fundamental momentum (0.88%). Moreover, its standard deviation is only 8.34%, compared favorably to that of price momentum (6.78%). Its monthly Sharpe ratio is 0.26, which is much higher than that of both price momentum (0.16) and fundamental momentum (0.14), as well as the market portfolio (0.13) in our sample period.”
The authors also found that their results could not be explained by any of the current (three-, four- or five-factor) asset pricing models. They write: “The twin momentum monthly alphas are always economically large and statistically significant.” They also showed that the alphas came from both the long and short positions; thus, it’s unlikely explained by high arbitrage costs alone.
They did find that the turnover of twin momentum is very high—about 88% per month—comparable to that of price momentum. However, breakeven transaction costs (the costs high enough to offset the premium) are about 2.5%.
That is well above the costs that would be expected, especially with patient trading strategies. The transaction costs required to make the profitability of twin momentum insignificant at the 5% level are 1.60%, again, higher than would be expected in live strategies. Thus, the returns cannot be explained solely by high transaction costs.
In addition, the strategy is not explained by the size effect—twin momentum works in all size groups.
For example, as the authors explain, “in the megacap group (excluding firms below the 80 percentile of all firms), twin momentum earns a monthly average return of 1.42% and its monthly alpha is at least 0.63%, significant at the conventional level.”
Support For Fundamental Momentum
In his February 2015 NBER paper, “Fundamentally, Momentum Is Fundamental Momentum,” Robert Novy-Marx presents the evidence demonstrating that momentum in stock prices is not an independent anomaly. Instead, it’s driven by fundamental momentum. As Novy-Marx writes, it’s “a weak expression of earnings momentum, reflecting the tendency of stocks that have recently announced strong earnings to outperform, going forward, stocks that have recently announced weak earnings.” Following is a summary of Novy-Marx’s findings:
Novy-Marx’s study provides support for the findings of Huang, Zhang and Zhou, and provides insights indicating that with equities, there could be a better way to exploit the anomaly than by using a price-only momentum strategy.
It’s worth noting that AQR Capital includes fundamental momentum in its multistyle funds, which incorporate momentum as one of its three factors (value and quality are the other two). The firm uses three measures of fundamental momentum: analyst revisions, earnings momentum and margin growth. However, unlike Huang, Zhang and Zhou’s twin momentum strategy, AQR overweights price momentum relative to fundamental momentum.
Summary
The preceding results demonstrate fundamental momentum is different from price momentum. It also exists not only in the past winner stocks, but also in the past loser stocks.
Huang, Zhang and Zhou concluded that “although fundamentals are shown to matter … it will be valuable to apply the twin momentum strategy to other markets, such as bond, commodity, and currency markets, to see whether the predictive power of fundamentals are understated relative to the traditional price momentum.” (Note that this would help to meet the pervasive requirement that Andrew Berkin and I established in our aforementioned book.)
Finally, they added that “it will be of interest to examine whether and how much a twin momentum factor, with a role similar to the popular price momentum factor, can explain various stock and mutual fund returns as well as existing anomalies.”
This commentary originally appeared August 4 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Larry Swedroe unpacks research into the demographics of value vs. growth investors.
Larry Swedroe, Director of Research, The BAM Alliance
One of the great debates in finance is whether the source of the value premium is risk-based or behavioral-based. Extensive empirical literature on the value premium, which provides support for both explanations, has focused primarily on stock returns and the manner in which they are related to macroeconomic and corporate variables.
Value/Growth Investor Demographics
Sebastien Betermier, Laurent Calvet and Paolo Sodini, who contribute to the literature on this issue with the study “Who Are the Value and Growth Investors?”, published in the February 2017 issue of The Journal of Finance, took a different approach. Their paper investigated value and growth investing among Swedish residents over the period 1999 through 2007.
Following is a summary of their findings:
Betermier, Calvet and Sodini concluded that their findings “appear remarkably consistent with the portfolio implications of risk-based theories. The strong negative relationship between a household's value loading and its macroeconomic exposure provides direct support for the hedging motive. Households in cyclical sectors go growth, which reduces their overall exposure to aggregate income risk.”
They add: “The value ladder [increasing exposure to value as investors age] provides further validation of the hedging motive. Over the life cycle, the household becomes less dependent on human capital and its hedging demand should get progressively weaker.”
Further Conclusions
The authors also found that sound balance sheets have positive effects on portfolio value tilts, providing further support for the risk-based explanation of value. This aligns with portfolio theory, as more financially secure households generally should be better able to tolerate investment risk.
Betermier, Calvet and Sodini note that their findings were not all one-sided in favor of a risk-based explanation. For example, overconfidence—which is more prevalent among men than women—is consistent with their finding of a growth tilt among male investors. They also found that, as “attention theory predicts, a majority of direct stockholders hold a small number of popular stocks.”
In addition, some of their evidence can be explained by complementary risk-based and psychological stories—the growth tilt among entrepreneurs, for instance, can be attributed to marked overconfidence in own decision-making skills.
Summary
While the results of their study provide strong support for a risk-based explanation of the value premium, as the authors observe, it’s not a one-sided story. In other words, their results, while providing support for the idea that the value premium is not a free lunch, also offer support for the idea that it just might be at least a free stop at the dessert tray.
There’s one last point to consider. Their finding of a value ladder, combined with the aging demographics of the U.S. investor population, might indicate we should expect an increased demand for value stocks. All else equal, that would lead to a larger realized value premium.
This commentary originally appeared July 5 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE