Seven Deadly Sins of Consulting

Are You Undermining Your Clients' Financial Security in the

Rush to Add Value?

by Scott MacKillop

he way investment services are

T delivered in this country has under-

gone profound change in the last
decade. One of the most significant changes
has becn the shift from the product-oriented
sales approach to the consultative approach
for providing financial services. A symptom
of this change has been the trend toward fee-
based advice. But the importance of this
change has less to do with the way financial
advisors are compensated than with the
ideological framework that is at the heart of
the consultative services movement.
Consulting services can be paid for either on
a fee or a commission basis. The true
significance of this change is 3. Selection of investment managers to overnight into "financial consultants."
found in the fact that the focus is no longer implement the investment policy These freshly minted financial consultants
on product-oriented storytelling, but rather 4. Periodic monitoring and reporting of are joining ranks with the planners and
on client needs. In the consultative services results independent advisors who pioneered the
model, client interests come first. The consultative approach to providing consultative services movement, thus
Along with this new ideology has come investment advice caught on and grew depriving the pioneers of their primary basis
a new methodology for providing invest- rapidly in many parts of the financial serv- for differentiating themselves from their
ment services to individual investors. The ices world, but particularly among financial better-financed competitors.
new methodology is modeled on the con- planners and independent financial advisors. At the same time, we have witnessed a
sulting process used for years by institu- In fact, the culture of this relatively small rapid commoditization of investment prod-
corner of the financial services world is ucts over the past decade. For example, at
tional investment consultants in providing
defined today by the consultative approach the end of the 1990s, there were six times
services to their clients, primarily employee
to advising clients. Clients the number of mutual funds in existence as
benefit plans. The process involved:
responded positively to this approach there were at the beginning of the 1990s.
1. A thorough profiling of client's needs,
because, for the first time, their needs There are now more mutual funds than
goals, experiences, preferences, time
were the focus of the interaction with there are stocks on the New York, Ameri-
horizon (often infinite) and other rele-
their financial advisors. can and Nasdaq stock exchanges combined.
vant characteristics such as risk toler-
Ultimately, the financial services behe- More and more, we see firms that once
ance.
moths took note and initiated a rapid exclusively promoted proprietary products
2. Creation of a statement of investment
migration to the consultative model of open their doors to, and actively promote,
policy or other written guidelines set-
doing business. There are still pockets of the widest selection of non-proprietary
ting forth a strategy for achieving the
resistance (most notably the insurance products. Soon, thanks to the Internet,
clients' goals, while taking into account industry), but we are now witnessing the clients will have direct access to an unlim-
the factors identified as significant in the phenomenon of vast armies of formerly ited variety of investment products. The
profiling process product-oriented brokers laying down their days of the product gatekeepers are over.
arms and being transformed Everyone will have access to everything.
Journal of Financial Planning / September 2000
 As more financial advisors adopt the
consultative model and investment prod-
ucts become morc commoditized, the
quality of an advisor's consulting services
will become the primary basis for differ-
entiation from other advisors. This is cer-
tainly good news for clients, who will ben-
efit directly as financial advisors vie with
one another to improve the quality of their
services. For financial advisors, however, it
means that a thorough review of their
consulting processes is in order.
To help with that process, I have iden-
tified Seven Deadly Sins of Consulting.
The list is by no means exhaustive (our
ability to sin is limitless), but I believe it
will help financial advisors take a fresh
look at how they provide consulting serv-
ices and provide some very practical ideas
about how to improve those services. I
believe that the biggest single risk to your
client's financial well-being is the risk that
your client will abandon the strategy you
have devised for them before it has had a
chance to produce results. This risk is
especially high these days because there
are so many do-it-yourself alternatives and
so much pressure on clients to go it on
their own. For that reason, the "seven
deadly sins" are intended to help you
identify consulting practices you employ
that might inadvertently contribute to
your client's decision to abandon the strat-
egy you have created for them.
Pride
Financial advisors spend a great deal of
their time studying the behavior of mar-
kets and the relative merits of various
styles of investment and types of invest-
ment vehicles. This is a good and neces-
sary part of our profession. Advisors must
understand the forces that affect financial
markets and the alternative ways to imple-
ment an investment program for a client.
The problem arises when a financial
advisor stops looking at the different
approaches to investing as tools to use
when appropriate and begins to believe
that there is a “right answer”. You can see
this problem manifest itself in the debates
between advocates of indexing versus
active management, mutual funds versus
separately managed accounts, and strate-
gic versus tactical asset allocation. The
proponents of these approaches to invest-
ing become extremely committed to the
academic proof statements showing that
their view of the world is correct. But
their pride in being right blinds them to
some important realities.
First of all, as an advocate of a single
approach to investing, you will be right
sometimes and you will be wrong some-
times. For example, indexers looked
pretty smart for much of the recent past.
From 1994 to 1998, the S&P 500 beat the
average equity mutual fund manager
handily. Even if you account for the fees
and expenses that bring down a mutual
fund's performance, the S&P 500 still
looked like the right answer by a wide
margin. But you don't have to go back
too far in history to find periods when the
indexers were "wrong." The periods 1973
to 1983 and 1990 to 1993 are examples.
More recently, the last two quarters of
1999 provide another example. Indexers
would argue that those periods are
anomalies and that, if you look at results
over long periods of time (20 years or
more), indexing is clearly the right
answer. Mathematically, they might be
correct (most of the time), but they miss
the most essential point.
Being a consultant is all about getting
results for your client. Unfortunately, for
the academics (and for those who listen
too closely to them), clients don't make
decisions over 20-year time horizons.
They react on a much shorter time frame.
If you have just told your client that
indexing is a superior strategy and then
we move into a period like 1973 to 1983,
you will be wrong in the client's eyes, you
will lose credibility and increase the risk
Journal of Financial Planning / September 2000
that your client will abandon the invest-ment
strategy you created for them, even
though, over time, the strategy would have
produced the financial results the client
needed.
An excellent illustration of this prob-
lem appeared in an article by Roger
Gibson titled "The Rewards of Multiple-
Asset-Class Investing," published in the
March 1999 issue of this journal. In his
article, Gibson asserts that multiple-asset-
class investing is superior to other strate-
gies on both a risk and return basis. Pretty
strong stuff. He demonstrates this superi-
ority by examining the quarterly returns
of four asset classes (represented by the
S&P 500, EAFE (Europe, Australia and
Far East Index), NAREEIT (National
Association of Real Estate Investment
Trusts) and the Goldman Sachs Com-
modity Index) for the period 1972-1997,
and concluding that a portfolio consisting
of 25 percent of each of these asset
classes beats anyone of the asset classes
alone on a risk-and-return basis. Leaving
aside the fact that Gibson's multiple-asset-
class portfolio would be a pretty
unpalatable brew for most clients, there is
another problem with his conclusion. Like
most proofs of the superiority of a
particular investment style, it depends
heavily on the time period examined and
the data used.
If you look at the data a little differently,
the picture changes. In Gibson's study, the
annualized return of the multiple-asset-class
portfolio was 14.4 percent, compared with
the S&P 500's return of 13.3 percent. The
multiple-asset-class portfolio had only about
two-thirds the risk of the S&P 500. Gibson is
clearly right – the multiple-asset-class portfolio
is superior on a risk and return basis. How-
ever, if you add 1998 to the study and look
at monthly instead of quarterly data
(clients usually receive custodial state-
ments once a month), the S&P 500 out-
performs the multiple-asset-class portfolio
13.8 percent versus 13.3 percent. If you look
at the data on a rolling one-year basis,
the average yearly return of the S&P 500
is 14.7 percent versus 14 percent for the
multiple-asset-class portfolio, and the S&P
500 outperforms the multiple-alsset-class
portfolio about half the time. The S&P 500
is still riskier, but it has better returns. In
fact, during the past three years, the S&P
500 would have outperformed the
multiple-asset-class portfolio every year.
So, which strategy is superior? Ask a
client. Gibson quotes one of his multiple-
asset-class clients as saying: "I would
rather follow an inferior strategy that wins
when my friends are winning and loses
when my friends are losing than follow a
superior strategy that at times results in my
losing when my friends are winning."
What was Gibson's response? "There is
pain in being different."
Perhaps a better response is to put our
pride aside and admit to ourselves and our
clients that we don't have all the answers.
Markets arc inherently unpredictable and
we do not know what strategy will be
superior in the future. And even if we did
know which strategy would be superior
mathematically, as Gibson's client demon-
strates, that strategy might be far from
superior from the client’s perspective. If
our most important task is keeping our
clients on track with their investment pro-
gram over the long haul, then our primary
concern should be satisfying our client's
needs, not guessing what strategy may be
the big winner in the years to come.
We should stop talking about the rela-
tive superiority of various approaches to
investing and focus on identifying the
strategy that is most likely to meet the
client’s long-term return objectives, while
satisfying the client’s preferences and
needs. If clients ask questions about the
relative merits of different types of invest-
ments, we can bring out the charts and
give them a history lesson, but make sure
it is properly labeled as history, as
opposed to a prediction about the future.
By focusing on client goals, objectives,
experiences, biases, preferences and risk
Journal of Financial Planning / September 2000
tolerance, we can have a much more
meaningful conversation with our clients
and avoid the risk that our client loses
faith in us because our "right" answer
turns out to be wrong for a while. We are
much better off talking about the future in
terms of the range of likely outcomes and
the probability of reaching the client's goal
than we are trying to convince the client
that we can see the future. There are
many tools available today to help us have
this type of conversation With our clients.
We should use them.
Sloth
The concept of risk and its proper role in
creating investment strategies for clients
appears to be one of the most misunder-
stood areas of investing. Measuring risk is
complex, far more complex than measur-
ing return. We talk about risk and return
as though they were two dimensions of an
investment that could be measured like
the length and width of a rectangle. But
return is an objective, quantifiable fact,
while risk is experiential and subjective.
Because understanding risk is difficult
and quantifying it even more difficult, we
have looked for ways to simplify risk and
reduce it to a manageable variable. We
have tried to find easy, shorthand expres-
sions of risk such as standard deviation,
beta, Sharpe ratios and other mathemati-
cal abstractions that do not, in any mean-
ingful way, capture the concept of risk as
our clients experience it.
Unfortunately, there is no easy way to
capture risk mathematically. That is
because risk is really a measure of pain,
and each investor experiences pain in a
slightly different way. So providing excel-
lent consulting services to our clients
requires us to do the hard work of going
beyond mathematical abstractions and
engaging our clients in a wide-ranging dis-
cussion about the pain they might feel in
different investment situations.
Researchers in the field of behavioral
finance offer some interesting perspec-
tives on risk as our clients experience it.
Through experiments going back many
years, they have demonstrated that most
people feel the pain of loss about 2 to 2.5
times as intensely as they feel the pleas--
ure of gain. This asymmetry of risk is
important to understand when dealing
with clients, but it is only the beginning.
Behavioral finance also teaches that
clients experience risk differently at dif-
ferent times and in different circum-
stances. For example, clients may be less
risk averse when they are dealing with
what the researchers call "house money."
This refers to the phenomenon one
observes in a casino where a gambler
takes greater risks with his winnings than
with the money he had in his pocket
when he walked through the door of the
casino. Likewise, investors tend to be
more risk averse with the money they
invest originally than with the money
that represents the gains on their invest-
ment.
A recent study by the Decision Science
Research Institute further underscores the
complexity of measuring risk in the invest-
ment context. In that study, financial advi-
sors were asked questions designed to
assess the likelihood that they would
invest in a variety of different types of
investments. Not surprisingly, the study
confirmed that the likelihood of investing
is highly related to the perception of the
risk/return characteristics of the invest-
ment. However, the study also revealed
that the evaluation of an investment is
most strongly related to perceptions of
return and that perceptions of risk are a
secondary factor and far harder to measure.
This was attributed to the fact that
perceptions of risk are multidimensional
and are not applied consistently from
investment to investment. The volatility
of an investment is considered as a risk
factor, but so are the psychological
demands associated with ongoing moni-
toring, predictability of performance,
potential loss of capital and perceived ade-
quacy of regulation. The study also con-
cludes that, because of the multidimen--
sional aspects of risk, at least some of the
emphasis in current financial planning
practice on the measurement of "risk tol-
erance" may be misplaced.
So how can a financial advisor use this
information to improve the level of his or
her consulting services? First of all, be
aware that mathematical abstractions such
as standard deviation do not capture the
concept of risk as your client experiences
it. You would also be well advised to delve
into the world of behavioral finance to
improve your appreciation for how your
clients experience risk. In addition, you
should recognize that simple risk tolerance
questionnaires are merely a starting point
for a fuller discussion you should have
with each client about their perceptions of,
and sensitivity to, risk. And finally, recog-
nizing that downside volatility is dispro-
portionately painful to clients, you should
spend considerable time educating them
and preparing them for the inevitable
downdrafts they will experience. Yes, it's
a lot of work, but in a world where success
is determined by thc quality of your con-
sulting services, it's well worth it.
Lust
"Past performance is no guarantee of
future returns." Virtually every investor
in America has seen this warning. Yet
most of them fail to take heed because
they lust after yesterday's eye-catching
returns. In a sense, this is understand-
able. Investors arc exposed to a barrage of
advertisements, articles and pitches – all
touting the past performance of various
managers, funds and stocks. The message
is everywhere: "performance matters." It
is not surprising that investors implicitly
Journal of Financial Planning / September 2000
accept past performance as a valid basis
upon which to make investment deci-
sions.
A recent study by the Dalbar invest-
ment consulting firm showed (once again)
the danger of this approach to investing.
Dalbar compared the returns of various
indexes with the returns achieved by the
average equity fund investor and the aver-
age fixed-income fund investor for the
period 1984 through 1998. During that
period, the S&P 500 returned almost 18
percent annually, long-term bonds
returned over 12 percent, small company
stocks returned just over 11 percent, inter-
mediate-term bonds returned over 9 per-
cent and T -bills returned almost 6 percent,
while inflation averaged 3.26 percent
a year. Yet the average equity fund
investor received just 7.25 percent annu-
ally and the average fixed-income fund
investor achieved 6.33 percent annually.
During the same period, the average
equity fund returned 13.5 percent and the
average fixed-income fund returned 8.8
percent.
How can this be? How can investors
do so poorly compared with the indexes
and average fund returns? Dalbar chalks it
up to inept market timing, but I don't
believe that is the reason. The term
"market timing" suggests some sort of
analysis or system for determining
whether markets are headed up or headed
down. I don't believe the investors in the
Dalbar study have anything resembling an
analytical or systematic framework for
their investments. They are simply chas-
ing past performance. They invest in the
funds that have produced high returns,
those funds fall in value, and the investors
panic and sell out. It's that simple. There's
no market timing involved at all. It's just
buy high and sell low.
Professor Richard Thaler of the Uni-
versity of Chicago conducted a study that
underscored the dangers of investing
based on past performance. He took all the
stocks on the New York Stock
Exchange and ranked them based on their
returns over a five-year period. He then
formed two portfolios: one with the 35
stocks that went up the most over the five-
year period and one with the 35 stocks
that went down the most. He followed the
two portfolios for five years. You guessed
it. The portfolio of losers outperformed
the portfolio of winners by about 40 per-
cent.
At our firm, we performed a similar
study using Morningstar mutual fund
rankings. We reached the same result. We
looked at the performance of all funds that
had a five-star rating (the highest) on
December 31, 1994, and compared their
performance with that of all funds that
had a two-star rating on the same date.
(See article on page 110, "The Persistence
of Morningstar Ratings.") We tracked per-
formance from January 1, 1995, through
June 31, 1998. During that period, the
two-star funds averaged 20.1 percent
annually, while the five-star funds
returned only 17.3 percent, a fairly wide
margin of difference. There is just no way
around it-buying yesterday's winners is a
strategy that is unlikely to provide good
results tomorrow,
So what does this have to do with you?
You are a trained professional and would
never succumb to the temptation to chase
yesterday's winners. Well, that's good, but
just remember that lust is not a sin com-
mitted only by nonprofessionals. The
mentality of the herd affects us all. It cer-
tainly affects your clients. That's apparent
from the Dalbar study. And be aware that
the constant barrage of media exposure
given to past winners fuels the fires of lust
in the hearts of all investors. Deal with
this issue up front before you end up deal-
ing with it in a defensive posture. Show
your clients the Dalbar study and tell
them about Professor Thaler's study.
There are many other examples of the
dangers of chasing past performance.
Make sure your clients are forewarned so
they will understand why you did not
invest their assets il1 yesterday's beauty
contest winners.
One strategy that you might try with
your clients is asking them to go cold
turkey on the consumption of financial
news. The media are powerful and their
influence on people's behavior is immense.
Unfortunately, that influence is mostly
negative. One story you might want to
share with your clients is about a study
done by Paul B. Andreassen, then a psy-
chologist at Harvard. He formed four
groups of investors and asked two of the
groups to make mock investments in
a stock with a fairly stable share price. The
other two groups were asked to make
mock investments in a stock with a fairly
volatile stock price. One of the groups
investing in the stable stock and one of the
groups investing in the volatile stock were
given a constant stream of actual news
reports about the companies in which they
were to invest. The other two groups got
no news. The investors who got no news
performed better than those who received
news, and the investors who received no
news and traded in the volatile stock per-
formed over twice as well.
Gluttony
Many investors have gotten fat on the
returns offered by the financial markets
since the early 1980s (the investors in the
Dalbar study being a notable exception).
From the beginning of 1982 through the
end of 1999, the Dow rose from 875 to
11,497. The S&P 500 gained 2,100 percent
over the same period. The old saying, "a
rising tide lifts all boats," and Woody
Allen's statement that "90 percent of life is
just showing up," arc both apt here. The
market's stunning performance has created
an entire generation of bull market
geniuses.
Not only did investors do well just by
being in the game, they felt very little pain
Journal of Financial Planning / September 2000
along the way. Betweel1 1900 and 1984,
there were 28 bull markets and 28 bear
markets. Only four of these bull markets
were longer than 1,000 days. Only one of
the bear markets was shorter than three
months. Between 1984 and 1999, however,
there were three bull markets, all of which
were 1onger than 1,000 days. There were
only two bear markets and both were
shorter than three months. Who says, "no
pain, no gain? "
Actually, the picture today is not quite
so rosy for many investors. For some time
now, the most visible U.S. equity market
indexes have been driven by a relative
handful of stocks. For example, in 1999
the Dow gained 25.2 percent while the
S&P 500 rose 21.1 percent. At the same
time, however, 53 percent of all Nasdaq
stocks were down as were 62 percent of all
NYSE issues and 54 percent of the stocks
included in the S&P 500. The problem is
that whether your client actually did well
during the course of the bull market or
not, clients tend to think they should be
receiving returns close to the returns of
the Dow and the S&P 500. This is what
behavioral finance advocates refer to as a
frame-of-reference problem. The Dow
and the S&P 500 have become what are
called "anchors," and clients use these
anchors to assess their investment results.
This represents a serious threat to your
clients' financial well-being because it
means that they are probably feeling like
they could and should be feeding on the
returns of the Dow and the S&P 500. In
fact, this has been a relatively hard thing
to do recently unless your clients' portfo-
lios are constructed around a small group
of richly valued large growth stocks. This
tendency of clients to be inf1uenced by
anchors like the Dow and the S&P 500 is
a powerful one; today it is very likely leav-
ing them feeling frustrated by their inabil-
ity to feed on the "market's" returns.
Education and awareness arc the keys
to avoiding this problem. Look for and
recognize the anchors that inf1uence your
clients' frame of reference. Help your
clients understand what the indexes are
and what drives their performance. Help
them see their portfolios in the broader
context of their own financial goals. And
avoid creating frame-of-reference prob-
lems through the overuse or misuse of
benchmarks (see next "sin").
Anger
Financial advisors make extensive use of
benchmarks to measure the performance
of their clients' investments. This is good
because benchmarks, if used properly, can
be useful tools in a financial advisor's arse-
nal.
But nothing makes a client angrier than
a quarterly performance report full of
managers or funds that have missed their
benchmarks. Unfortunately, because of
the way benchmarks are often used, this is
an all-too-frequent occurrence.
The first reason stems from the fact
that we typically classify managers and
funds as falling within a single style cate-
gory (such as large-cap growth) and then
use a single index as a yardstick against
which to measure the manager. One prob-
lem with this is that many managers and
certainly most actively managed mutual
funds don't fit quite so neatly into a single
category. For example, the Dreyfus
Appreciation fund is typically categorized
as a large-cap growth manager. Yet attri-
bution analysis shows that this fund often
invests in both large value and large
growth companies. For this reason, the
fund cal1not be easily judged by reference
to the Russell 1000 Growth index, which
is often used as a benchmark for large-cap
growth managers.
We also handicap managers by com-
paring them with benchmarks on a quar-
terly basis. Managers often make moves in
their portfolio that take more than a quarter
to payoff. In the meantime, a manager

is likely to fall short of their benchmark,
even though the manager may look just
fine, relative to the benchmark, over a
longer period.
These arc just a few illustrations of
problems that can arise from using bench-
marks to measure manager performance.
Should we stop using benchmarks? The
answer is clearly no. But should we
reassess how we present them to clients
and consider the messages we arc sending
through these presentations? Definitely.
We can start by reviewing the bench-
marks we use to make sure they make
sense. Single-index benchmarks are often
less-than-totally satisfactory yardsticks for
active managers. Consider the use of
multi-index benchmarks that more accu-
rately reflect a manager's true investment
style.
Another idea would be to de-empha-
size benchmarks in your performance
reports. You can use benchmarks any way
you want in assessing managers, but is it
wise to show clients everything you look
at in monitoring the managers' perform-
ance? You naturally interpret manager
performance relative to a benchmark in a
way that your client docs not. In the
client's eyes, if the manager misses the
benchmark, the manager has somehow
failed. And, because you selected the man-
ager or fund, you have failed, too. Con-
sider whether you are undermining your
client's confidence in a sound investment
strategy and creating unnecessary doubt
about your own advice by benchmarking
every manager and fund in your client's
portfolio.
Journal of Financial Planning / September 2000
Another thought would be to bench-
mark the overall portfolio in a way that is
truly meaningful to the client's investment
strategy. Let managers stray from their
benchmarks as long as the overall portfolio
performance is meeting the client's long-
term goals. Show portfolio performance
relative to the client's long-term return
objective and show where that perform-
ance falls within the range of likely out-
comes. As long as the client is on track to
reach his or her goal and returns fall
within acceptable boundaries, let the port-
folio ride. Short-term failures to meet
benchmarks often are overcome over
longer time periods.
In any event, you should give serious
thought to how you use benchmarks in
your practice. Make sure that you mini-
mize the likelihood that you are under-
mining your client's confidence in a sound
long-term strategy. It is far better that
your clients live through a couple quarters
of sub-benchmark performance by their
managers than that they abandon their
strategy because they think their portfo-
lios are full of "bad" managers.
Greed
In 1738, Daniel Bernouli hypothesized
that the rational person would make eco-
nomic decisions in a manner designed to
maximize their overall state of wealth. In
other words, a person's natural greed
would drive them through a rational
process designed to maximize the utility
of each decision. As applied to invest-
ments, this means that the rational
investor would look at his or her entire
portfolio and make investments based on
the impact those decisions would have on
the overall value of the portfolio. Unfortu-
nately, Bernouli was wrong.
Studies from the field of behavioral
finance show that investors tend to com-
partmentalize their investments and ana-
lyze performance narrowly on an invest-
ment-by-investment basis. This tendency,
referred to as “narrow framing”, causes
investors to be more risk averse than they
should be. Let's look at how this works.
First, how would you feel about accepting
a bet where you had a 50 percent chance
to win $15,000 and a 50 percent chance to
lose $10,000? Now assume you have a net
worth of $2 million. How would you feel
about a bet that would give you a 50 per-
cent chance to increase your wealth by
$15,000 and a 50 percent chance that your
wealth would be decreased by $10,000? In
both cases, the bet is exactly the same, but
most people are far more willing to take
the chance once they have expanded their
focus from the outcome of the bet itself to
the impact the bet would have on their
overall net worth.
For another perspective on the same
issue, consider this proposition: Would
you flip a coin where you would receive
$200 if you called the outcome correctly,
but would lose $100 if you were wrong?
Most people don't like this bet very much.
But how would you feel about this bet if
you got to flip the coin 100 times? Most
people would jump at the chance.
These examples demonstrate the power
of getting your client to overcome the
natural tendency to look at the world
narrowly and instead look at their
investments in the larger context. Narrowly
focused clients are more fearful and
experience significantly more regret than
clients who understand that investing is a
process that involves a series of well-placed
bets made over a long time period. Not
every bet pays

off, but as long as the overall state of wealth
improves, all is well.
This concept has many practical impli-
cations for financial consultants. First,
clients should be encouraged to look at
their investments broadly. This message
should be reinforced at every opportunity.
An important example would be quarterly
performance reviews. Spend less time ana-
lyzing individual investments and more
time on overall portfolio performance.
Don't focus on a client's various accounts
(such as a taxable investment account,
individua1 retirement account or 401(k)),
as separate pools of wealth. Look at these
accounts on a consolidated basis. Talk
about investing as an ongoing process and
let your clients know that it's okay to lose
a coin toss now and then.
Envy
Everyone loves a winner. People envy
winners and yearn to be winners them-
sclves. Nowhere is this more true than in
the world of investing.
Terance Odean, a professor at the Uni-
vcrsity of California at Davis, has studied
investment behavior on a wide scale and
has concluded that this desire to be a
winner is very strong in investors. He
refers to the manifestation of this desire as
the "disposition effect." This is a tendency
that investors have to sell their winners and
hang on to their losers. By disposing of an
investment at a gain, it becomes a winner
Journal of Financial Planning / September 2000
and the investor experiences the positive
feeling associated with winning. On the
other hand, by holding on to losers,
investors avoid admitting their mistakes.
Obviously, the "disposition effect”
alone can undermine a successful long-
term investment program. But Odean has
identified another unfortunate tendency in
investors that can work in tandem with
the disposition effect to seriously harm
your client's investment program. That is
the tendency of investors to trade too
often and with bad results. Odcan found
that when an investor sells a stock and
then buys another one, the stock that was
sold outperforms the stock that was pur-
chased by an average of 3.2 percent over
the next 12 months and by an average of
3.6 percent over the next 24 months. The
gap becomes even wider when you elimi-
nate nonspeculative trades made to raise
cash, cut taxes or rebalance the portfolio.
After eliminating nonspeculative trades,
the stocks that were sold outperformed the
stocks that were purchased by 5 percent
after 12 months and 8.6 percent after 24
months.
Odean's research also demonstrates
that the more an investor trades, the worse
their performance becomes. Odean found
that investors typically turn over approxi-
mately 75 percent of their portfolio every
year. He also found that a 70 percent
turnover results in performance that is 3.7
percent less than an index of all NYSE,
AMEX and Nasdaq stocks. When
turnover rises to 200 percent a year, the
results are even worse: 10.3 percent below
the broad market index. This is consistent
with a study done in 1999 by the North
American Securities Administrators Asso-
ciation (NASAA) that found that 70 per-
cent of day traders "will almost certainly
lose everything they invest."
This research has significant practical
application for investment consultants.
Discuss the disposition effect with your
clients. Encourage them to be patient and
forgo the gratification of selling off win-
ners prematurely. Likewise, help them
overcome their tendency toward what
Odean calls "regret avoidance" and assist
them in paring the losers out of the portfo-
lio in a. timely manner. Don't turn a blind
eye if your client has taken to actively
trading a portion of their portfolio. Share
with them Odean's findings on the effects
of high portfolio turnover on performance.
Encourage your clients to be patient and
exercise the restraint and discipline neces-
sary for a successful investment program.
Conclusion
Excellence in consulting requires the abil-
ity to understand how clients think about
investments and to see the world through
their eyes. We must make every effort to
use our understanding to help our clients
reach their long-term goals. In our effort
to add value to our client relationships, we
should be sure that we do not inadver-
tently cause our clients to lose faith in
their long-term investment program and
thus abandon the program before they
have reaped its long-term benefits.
Scott A. MacKillop is president of PMC International,
Inc., Portfolio Management Consultants Inc.'s parent
company, based in Denver, Colarado.