OUR CLIENTS HELPING IRRATIONAL CLIENTS MAKE RATIONAL DECISIONS. Harold Evensky, CFP HELPING IRRATIONAL CLIENTS MAKE RATIONAL DECISIONS

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1 Everything that can be invented has been invented. Charles H. Duell, Director of US Patent Office, 1899 Sensible and responsible women do not want to vote. Grover Cleveland, 1905 Who the hell wants to hear actors talk? Harry M. Warner, Warner Bros. Pictures, 1927 HELPING IRRATIONAL CLIENTS MAKE RATIONAL DECISIONS WHAT DO OUR CLIENTS WANT? Page 1

2 HOW DO THEY PLAN ON GETTING THERE? THE SOPHISTICATES Leaping tall buildings in a single bound is nice but can you outperform the S&P index? THE MASSES ARE THEY ARE THEY RATIONAL? Page 2

3 HOW CAN WE HELP? IT ALL STARTS WITH BEHAVIORAL FINANCE Daniel Kahneman 2002 Nobel Prize in economics for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty IN CLASSICAL FINANCE PEOPLE ARE RATIONAL IN BEHAVIORAL FINANCE PEOPLE ARE NORMAL Page 3

4 HEURISTICS MENTAL SHORTCUTS OVERCONFIDENCE COMPARED TO OTHERS IN THIS SESSION, ARE YOU: AN ABOVE AVERAGE ADVISOR? OVERCONFIDENCE I CAN TIME THE MARKET Page 4

5 FEBRUARY OVERCONFIDENCE I CAN PICK MANAGERS BETTER THAN MOST APRIL SEPTEMBER Page 5

6 THE COST OF A GOOD IDEA Terry Odean s research When an investor sells a stock and immediately buys another REPRESENTATIVENESS IF IT LOOKS LIKE A... The stock that is sold does better by 3.5% in the following year REPRESENTATIVENESS HHTHTTTHTH TTTTTTTTTT REPRESENTATIVENESS MORNINGSTAR GAVE THIS FUND... IT MUST BE GOOD Page 6

7 AVAILABILITY AVAILABILITY DOES WARREN BUFFET BUY IPO S OR INSURANCE COMPANIES? SALIENCY OVERREACT TO NEW INFORMATION SALIENCY INVESTING IN THE HOT PRODUCT OF THE LAST 10 MINUTES? Page 7

8 SALIENCY NOT TAKING AN UMBRELLA TODAY BECAUSE IT DIDN T RAIN YESTERDAY IS A GOOD WAY TO GET SOAKED BUYING YESTERDAY S HOT INVESTEMTN IS ALSO A GOOD WAY TO GET SOAKED MENTAL MATHMATICS HOT TECH STOCK - IF GOVT. SAYS GO 90% PROTOTYPE GOOD 90% REGIONAL TEST OK 90% NATIONAL ROLLOUT 90% DO YOU INVEST? 66% MENTAL MATHMATICS LAST YEAR, I MADE 80% THIS YEAR, I LOST 60% MENTAL MATH THEREFORE I M REALITY AHEAD 20% BEHIND 28% MENTAL MATHMATICS 10 TOSSES 8 HEADS 100 TOSSES 70 HEADS SAMPLE SIZE CASE DATA vs. BASE DATA Page 8

9 MENTAL MATHMATICS CASE DATA vs. BASE DATA MY FRIEND MADE MONEY!!..MAKET TIMING..DAY-TRADING IMPLICATIONS FOR PLANNERS Reality Investors are subject to bounded rationality. Strategy Recognize the bounds of experience, logic and authority and the use of mental frames FRAMING THE WAY A QUESTION IS FRAMED, DETERMINES THE OUTCOME APRIL Page 9

10 SEPTEMBER FRAMING Which would you rather have? 10% fat or 90% fat-free f WOULD YOU RATHER BUY PRUNES OR Page 10

11 WOULD YOU BUY THAT STOCK TODAY? FRAMING NAME THE TOP 10 BASEBALL PLAYERS PAINTERS MOVIE ACTORS DRESS DESIGNERS MONEY MANAGERS FRAMING THE MINUTE I GET INTO THE MARKET, IT WILL GO DOWN 20% FRAMING CONTAGEOUS ENTHUSIASM WHAT COULD GO WRONG? Page 11

12 FRAMING > IF YOU ARE RIGHT, YOU LL MAKE A HANDSOME PROFIT. > IF YOU ARE WRONG, YOU LL NEED TO WORK 3 MORE YEARS. MANAGE EXPECTATIONS MANAGING UNREALISTIC EXPECTATIONS IMPLICATIONS FOR PLANNERS Reality What is forecast does not happen. What happens is not forecast. Strategy Manage expectations Monte Carlo simulations, standard deviation of anthrax Page 12

13 FALSE CONFIDENCE COMPLEMENTARY ANALYITICS Sensitivity Analysis What-if Scenarios Page 13

14 Sensitivity Analysis Year 1 2 STD Year 2 1 STD What-If Scenario Planning IMPLICATIONS FOR PLANNERS Reality Investors are loss averse not risk averse Strategy Risk tolerance questionnaires becomes - Behavioral based risk coaching Page 14

15 IMPLICATIONS FOR PLANNERS Reality - Intuition is fragile. Basic investment and statistical principles are not learned from everyday experience. Strategy Education SHARPE & CAPM SYSTEMATIC RISK Market Risk Business Risk Purchasing Power Risk UNSYSTEMATIC RISK Financial Risk Interest Rate Risk MARKOWITZ 7 6 & 5 MPT Investment A Investment B Portfolio (equal weightings of A & B) Page 15

16 Return BRINSON, HOOD & BEBOWER 94% Market Timing Security Selection Asset Allocation Risk Anchoring on the Efficient Frontier IMPLICATIONS FOR PLANNERS Reality The financial decisions of real investors are often wrong due to behavioral factors. Strategy Implement a structured and disciplined i d decision i process Investment policies, behavioral based performance reports POLICY 34% FIXED ROR 5.0% RISK 14.0% MMA 2% CORE SHORT 18% CORE-CORE 32% INTER 14% LARGE/MID VALUE 5% SMALL CAP VALUE 7% INTERNATIONAL DEV 10% SATELLITE EMERGING MARKETS 4% COMMODITIES 4% SPECIAL 4% Page 16

17 MELANA SCANTLIN & JOE AVERAGE ASSETS UNDER MANAGEMENT QUARTERLY REVIEW AS OF October 31, 2003 ADVISED BY MICHAEL ANDERSON 10.0% 8.0% 6.0% Current Allocation 4.0% 2.0% 0.0% Quarter One Year Three Year (Ann) Inception (Ann) Melana Scantlin & Joe Average CPI Quarter Year Asset Growth One Year Three Inception Initial Investment $2,176,863 $2,078,729 N/A $2,424,127 Net Inflows $8,877 $61,345 N/A ($296,365) Ending Investment $2,320,383 $2,320,383 N/A $2,320,383 Portfolio Change $134,643 $180,309 N/A $192,622 Returns Quarter One Year Three Year (Ann) Inception (Ann) Percent Growth 2.87% 8.46% N/A 7.07% CPI 0.98% 2.40% 2.15% 2.41% Portfolio -vs- CPI Growth of $10,000 Since Inception $11,000 $10, % 53.2% 31% 3.1% 6.3% 7.3% 5.1% 1.2% 3.8% MONEY MARKET FIXED INCOME LARGE CORE LARGE VALUE SMALL VALUE INT'L DEVELOPED SMALL GROWTH EMERGING MARKETS TACTICAL OTHER Proposed Allocation 23.0% REMEMBER WHAT REMEMBER WHAT IT S ALL ABOUT $10, % 3.0% $10,400 $10,200 $10,000 $9,800 7/31/ /31/2002 1/31/2003 4/30/2003 7/31/ /31/2003 Portfolio CPI 7.0% 8.0% 3.0% 2.0% 3.0% 3.0% Report Generated on December 2, 2003 Page 17

18 President Page 18