Fall 2016 4

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How Does the Average Investor Invest?

by A. Scott White, CFP®, ChFC, CLU

What does research tell us about the average investor? First, the average investor tends not to work with an advisor who is a fiduciary, placing the client’s needs ahead of his or her own.1 Not all financial advisors have fiduciary obligations to their clients. Some are simply held to a “suitability standard”— meaning that the investment recommendation should appear suitable for someone in a given investor profile. There can be a big difference between an investment that appears suitable versus an investment that is in an investor’s best interest. It is perfectly legal for a non-fiduciary to make a recommendation that is better for the financial advisor than the client— as long as it appears suitable for the client. While there is no guarantee that using a fiduciary will generate a successful investment portfolio, it is important for investors to know the difference between an advisor who is a fiduciary and whose loyalty is to the client—and one who isn’t.

According to a 2015 study by Gallup, the average investor does not have a written financial plan that identifies measurable investment goals.2 Also, many investors may use a risk tolerance questionnaire to determine asset allocation, instead of relying on a written Investment Policy Statement that takes into account their unique situation.3 And the average investor may compare his investment performance against an index to gauge an investment’s performance, instead of analyzing the investment selection process that led to the creation of the portfolio in the first place.4 Finally, the average investor may sell out of a sound portfolio the moment it underperforms against an index, regardless of the reason.5

In my opinion, it’s impossible for a financial advisor to understand what is in a client’s best interest without developing a written financial plan that identifies measurable investment goals—and then help monitor progress toward those goals year in and year out. After all, it is only by comparing where you want to be with where you currently are that you can have a comprehensive understanding of any year’s performance. Was our year-end outcome affected by factors we can control or those we cannot, such as changes in tax rates, inflation, Social Security, or medical costs? Without a way to measure progress, once an investor realizes he is off course, it is too easy to simply blame the investment portfolio. You will always be able to identify in hindsight investments that performed better than yours and it is easier to change the investment portfolio than identify the real culprit. The real question is, “Is your investment portfolio designed to give you a relatively high probability of reaching your goals in the face of many different types of investment risk?”

After an investor has followed her written Investment Policy Statement to determine an appropriate allocation to cash and bonds, it is time to build the remainder of the portfolio, which should be designed to last 30 years for the average couple retiring at age 65. Given that time horizon, how does an investor build a portfolio designed to address a variety of risks such as market risk, exchange rate risk, purchasing power risk, business risk, default risk, interest rate risk, and sector risk, to name a few? In my opinion, investors can’t address these risks by building a portfolio based on trading stocks in reaction to economic or geopolitical events; instead, these risks are better addressed by building a portfolio of stocks that represent the world’s most profitable business. These businesses have superior products and services in the marketplace, with solid balance sheets and management teams working for their shareholders’ best interests. Indexes do not screen for these characteristics and the average investor simply does not know how to find these companies or hire someone to do it for them at a reasonable fee.
Many financial advisors recommend building investment portfolios based on economic or political forecasts that may or may not happen. In my opinion, that is speculation, not investing. If financial advisors place importance on events they cannot control like interest rate forecasts, GDP estimates, unemployment forecasts, or presidential elections, instead of on proven sound investment principles outlined in a written Investment Policy Statement, then the chances of having better investment results than index returns might be greatly reduced.

Poorer investment performance is associated with the behavior of acting emotionally based on economic and geopolitical events, as shown in a 2016 Blackrock study that found the average investor’s returns were 2.11% from 1995 to 2015 versus the average rate of inflation of 2.18%.6 These findings tell us that the average investor lost money in real terms.

The way to possibly achieve better than index returns is not just to hire an advisor. Because if you hire a financial advisor who does not work as a fiduciary—one who assists you in writing a financial plan to identify and monitor goals using a written Investment Policy Statement to guide you from making unwarranted changes to a sound investment strategy that identifies your process to select the appropriate investments portfolios to meet your needs—then as an investor you should not expect better confidence in your financial future than the average investor who has not developed a comprehensive written financial plan.

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1) Investment News May 6, 2015 Investors; Investor Confusiton About Fiduciary Duty not Likely to be Resolved by Proposed DOL Rule.
Source: Spectrum Group
2) Gallup.com, July 31, 2015: More Nonretired U.S. Investors Have a Written Financial Plan, Jeffrey M. Jones,.
3) Investment News, October 27, 2013 Blaine F. Aikin, Fiduciary Corner: The Importance of the Investment Policy Statement,
Survey of Advisers Russell Investment
4) Bloomberg View, September 15, 2015 Noah Smith 4 Reasons to Stop the S&P 500 Comparisons.
5) Bloomberg View, September 15, 2015 Noah Smith 4 Reasons to Stop the S&P 500 Comparisons.
6) Inflation is represented by the Consumer Price Index. Average Investor is represented by Dalbar’s average asset allocation investor return, which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Returns are annualized (and total return where applicable) and represent the 20-year period ending 12/31/15 to match Dalbar’s most recent analysis.

The information contained in this report does not purport to be a complete description of the securities markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing materials are accurate and complete. Any opinions are those of Scott White Advisors and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date subject to change without notice. Past performance may not be indicative of future results. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Strategies discussed may not be suitable for all investors. Investing involves risk and investors may incur a profit or loss regardless of strategy selected. Diversification does not ensure a profit or guarantee against a loss.

Individual investor’s results will vary. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.