Episode 336 - Steve Utkus: Investor Beliefs and Financial Advice

24:07It's not a single representative agent model, but these tiers of people with different beliefs all competing. We all observe the same price. Market closes on a specific price to a specific day, and we have some general view of aggregate dividends, but to get a price-dividend ratio today, but it's where we disagree is the other two components. Very interesting. How do investors' subjective probabilities of stock market disasters affect their expectations for future stock returns? So this is my favorite belief because it's all about stock market disasters. And I'm the guy who in 2024, when everyone says markets up, whatever it is throughout the year, I always say, and what do you think the chances next year will be down 35?

24:50I'm always thinking about that. I think I'm one of those pessimistic groups, slightly more conservative allocation. We asked about this probability of greater than 30 % drops. And so no surprise, if I believe there's a greater chance of a stock market disaster, I believe in lower overall stock market returns. Bigger stock market disaster, lower overall stock market returns. Small stock market disaster, higher overall returns. So that's what we found. How does that one line up with theory? So that's the other aha moment from this paper from an academic finance perspective, which is the theory is if I believe there is a greater probability of a disaster, I should demand a higher expected return.

25:36That's what we've all been taught. That's standard models. But in fact, this model is there's a group of people who haven't had this distribution, big disaster probability, mean shifted left. People with this probability distribution, small disaster probability, mean shifted right. It's a very different model than if there's this big stock market disaster, my mean should be way over here to compensate me for it. So that's a very interesting example where the beliefs did not line up with the classic explanation for why you should demand a higher stock market return as an investor. That's where I think some of these facts we organize, some of them are really just takeaways for the academic, the empirical finance community to think about the next generation of models for thinking about how we think about risk and return and overall valuation levels in the market.

26:25But as you can see, some of these are pretty profound ideas. You don't allocate based on the variance or the portfolio, you allocate based on the downside risk. If there's a greater probability of a disaster, you demand less. You expect less. So speaking of stock market disasters, how did investor expectations about economic growth and stock returns change during the COVID-19 stock market crash? So here we were going along administering our survey, and it was February 2020. And we had our regular administrative meeting and we organized it. It was in the field and then the whole world fell apart.

26:59And one of the great benefits of this survey, and I have to thank our marketing research partners, they were so nimble about this, is they said, well, they had worked with us on this process. Let's do a special survey right in the middle of the market collapse. It turned out stocks peaked early February globally, and we were in the field two weeks later, and then stocks went like this. And so we went into the field off cycle in March and then in April, and we did this analysis. I was looking at some of the numbers. They're not too surprising. So we have February to April with a data point in the middle.

27:31No surprise, expected returns fell, but surprisingly, we're still positive. So until the crash, they were hovering, investors were saying, we think the market's going to do 5%, 6 % a year. Two months later, they were 1 % to 2 % a year. They actually fell a little bit late. They didn't go negative, which I found interesting. Obviously, there were plenty of people saying negative returns, but the mean did not go negative. The probability of disaster, let me look at my notes, doubled, no surprise. People were more worried about a potential disaster. But 10-year expected returns rose slightly. This is April.

28:07I think they drifted down a little bit later in the year. But as of April, people were thinking this is not going to affect 10-year returns. In fact, it might be slightly more positive because prices had fallen. So expected returns should rise slightly over the next decade. The same thing sort of happened in the economy. There was a slowdown in expectations for economic growth, but nothing like what happened, say, during a global financial crisis when rolling three-year GDP was like 0.3%. The mean was still around 2. I think it was 2.2. There wasn't an anticipation of sort of major economic contraction, even though, in fact, there was, but perhaps unanticipated because of no one really realized what was going to happen.

28:46But at least through that period, it was really a downward shift in short-term expectations, not long-term. Yeah, that's really interesting that short-term went down, long-term went up a little bit. Like they believed in momentum, but also understood that expects returns increased. But not too much, because I would have thought, given the size of the stock market crash through April, I think it was down 50%, 60%. It was pretty sizable. It was big, yeah. Yes, numbers should have gone up more. What impact did pre-crash, so before the crash, optimism or pessimism? We talked about those kind of steady states that people in your sample have.

29:22What impact did that have on whether people sold out of equities after the crash? Well, roughly speaking, there wasn't a lot of selling, actually. This is a general rule in buy and hold investors, even based on a severe market shock like this. 70 % of investors didn't do anything. 30 % did. The optimists were more willing to trade than the pessimists. but the optimists also had a bit more inequities anyway. They had higher 60 % average equity allocations, as I recall. So for example, of the optimists who traded, okay, so that's roughly 30 % of them, they shifted about 4 % of their portfolio on average.

30:00Clearly, some moved more, some moved even smaller amounts. The pessimists shifted 2%. So it was almost, even among the traders, the shifts were, I don't know what you described them as, microscopic? Yeah, small for sure. Yeah, small for sure. And it was almost like, okay, the market's declining. I think I might sell out a bit among the traders. Again, the 30 % who were traded. They were trading away from equities in both camps? In both sides, yeah. Now, I will say this. That's the net movement. Gosh, I don't have the gross movement in front of me. And I think it's in a spreadsheet somewhere. I don't know that we published it.

30:34But we know from prior experience that although the net movement was away from equities among Among all traders, there was a group of people who were trading into equities. This was the net movement of optimists away from equities, but there probably were some optimists who were buying as well. It's important to realize markets are two-way, so there's always people on the other side of the trade. And what do you think are the lessons for investors in how pre-crash beliefs affect selling behavior after the crash? Well, the lesson from this crash was don't do anything. Yeah, it was so quick. It's a lesson from most crashes.

31:07The other lesson I would take away from this, if you're going to do anything, don't do too much of it. This is actually a longstanding belief. I remember about 25 years ago when I was reviewing first draft of Jack Bogle's Bogle and Mutual Funds book, there was a chapter on asset allocation. And I had been doing some work on that for some reason. And I read the chapter and even I think Jack at the time was writing it, like, if you're going to trade, don't trade too much. This idea of swapping in and out of the market based on tactical beliefs was sort of rebote at Vanguard. So I think you see that sort of reflected in the messaging to clients, if you're going to trade, make small trades.

31:39I still believe that personally as well. It's otherwise too damaging. And by the way, the optimists who oversold made a mistake, obviously. So the optimists reduced their equity on net by 4 % and pessimists by 2 %? Yes. So the optimists reduced their equity by more, but they had a higher equity allocation to start though. That's right. And again, underlying that, and I wish I had the numbers, but there's some group of optimists who are increasing, which means that the optimists who were decreasing were doing more than 4 % on average. And let's say that was 10%. Let's just make that 10 % for the moment.

32:11Just making that up. They then, subsequently in April, traded more back into equities. I did exactly that. I think I was 80-20 in my portfolio, 80 % equity, 20 % fixed income at the time, not across my whole portfolio, but in one of my accounts. And I managed to bottom tick the crash and went from 80-20 to 100 % equity. Just dumb luck, but I literally bottom ticked it to the day and I've been 100 % equity ever since. Congratulations. little thing. Didn't really do much, I think, long-term, but it was just a funny thing. So we talked about traders, optimists who were moving the other way. And it's just funny that I happened to have been one of them by luck.

32:46There's a senior thought leader within Vanguard at the time, I'm not going to give his name, who did exactly the same thing and crowed about it. I don't think I told anybody, but yeah. And we're like, this is not the advice we give the class. We say, stay the course. He said, yes, but no one said over-invest in equities when they're down. He said, we're silent on that question. That's too funny. I was already 100 % equities. I had nowhere to go except using leverage, which I did not want to do. I was going to say that's the next move, I guess. Yeah. Well, based on that earlier discussion we had prior to the podcast, you're going to stay that way the rest of your life.

33:18You won't have any choice to make. Listeners will know we're talking about the Scott Cedarburg paper, which I've reviewed the updated draft of. It's not out yet, but by the time this episode comes out, it will be out and everyone will have been very excited to read it. Okay. I want to move on to your other survey paper on ESG. What survey motivations did people give for investing in ESG assets? We were using the same bi-monthly survey infrastructure, but we decided we'd add a few questions because it was a hot topic in 2021. By the way, I do have to thank Charles Hsu at Vanguard and Joe Tan at Yale.

33:49They also helped on this project. They were part of this effort. So we decided to add these questions. Even today, when I watched the discussion about ESG, No one cites any data. I wish they would cite this paper, but actual investors believe it's all about extreme points of view. But as you imagine, in any marketplace, there are two points of view, if not more, on any particular issue. We added these questions on ESG. First of all, we thought to ask, are ESG factors important or not in your investment decision making? And it was about 50-50 split. 45%, not at all. 55 % said could be partially or somewhat or fully.

34:26Among the people who believed in ESG, it was very interesting. The dominant reason was the ethical aspects do the right thing. The second dominant reason was climate change. Forget the S and the G, it's all about E and not just all E, but climate change E. And then there's a small group of people said, oh, it's just a way to make money. The reason why I'm investing in ESG, and they had higher expected returns. The other two groups that do the right thing and the climate change people actually thought there was a penalty associated. On average, it worked out to be 1 % a year return associated with doing the right thing or hedging against climate risk.

35:03But there was a group of people who, of that 55%, that small group, who believed that you're going to do better in the long run. All those stories about stranded assets and are going to come down to haunt all those stocks and you're going to be on the right side of the return distribution. That's really interesting because that seems like the two bigger groups, they have a taste for ESG and therefore should expect lower returns, which they do. And then the smaller group, maybe they have like a hedging motive. They think climate's not properly priced, so therefore they expect higher returns. They do the right thing and the climate people both think there's a penalty.

35:37There's actually a group of people say, I'm investing in GSG just because. My main reason is because I think it's going to have a higher expected return. It was the third group. The key point I continue to make when I ever offered this question is to observe that there are two sides of the trade. There are some people who think it's important, some people who think it's not. Otherwise, you wouldn't expect that. And there are heterogeneity and beliefs, as we were saying. It's not all about necessarily doing the right thing. For some, it's just a pure climate edge. That's the second most important.

36:05So how are ESG motivations related to portfolio behavior? So first of all, there's a big caveat here. We only had around 4 % of holdings in ESG products because they were just being launched at Vanguard on the platform. And as you know, when you launch a product, the group of investors who are self-directed, it could take decades for it to be incorporated into their portfolios as they have new money cash coming in, as they reconsider their portfolio allocations. But as a general rule, if you had any of these particular reasons, you're concerned about climate risk, you're more likely to be concerned about doing the right thing, you're more likely to invest in ESG products.

36:39You saw that even in a small sample. I thought that was quite interesting. It is a small sample because most ESG investors, when you looked at the construction of their portfolios, are using it as a minor portfolio holding. You rarely saw someone who, say, had it in an ESG, all ESG stock portfolio. You talked about the lower expectations that those two groups have. How important are financial returns to the investors with ethical and hedging motives? That's the interesting thing. If you take people who have non-pecuniary motives. And among those groups, on average, they thought they would do not as well in ESG.

37:12But within that group, there are some people who thought they would do better based on their expected returns. Because we asked them in this survey, because it was about expectations. We asked them about the expectation for ESG investments versus we had already asked them about the stock market. So we could compare the two. It turns out the more optimistic you were about the return prospects, the more you put in ESG. So I'm concerned about climate risk, I don't think ESG is going to do that while I allocate a certain amount. If I'm concerned about climate risk, but I think ESG is going to beat other stocks, I'm going to put a lot more money into it.

37:43So even among ESG investors, there's a differential based on financial expectations, which I found fascinating. It's a curious wrinkle. That really is fascinating. People care about this stuff, but they also care about their financial returns. Right. Conditional on believing in it. And it gets back to this idea we had about heterogeneity, there's the optimists and the pessimists. There are ESG. When I talk to people about this, I do try to clarify where they stand because there are ESG investors who believe it's a penalty, it's a cost, and they are willing to assume a cost of X. But then there are also people who are ESG enthusiasts who believe it's a positive benefit, a positive benefit of Y.

38:23And you have to really differentiate those two groups and understand their motivations because they're going to do something completely different when it comes to portfolio allocation. Of course, the optimists, they're really going to ramp up their interests and they're going to be big proponents. We went through three of your papers on investor beliefs. It was a lot. Yeah, it's a lot. You're going to shift now to your papers on financial advice, where there are, I think, even more papers. On to three. Same numbers before, three. The magic three. I'm super excited for these ones. I found all these papers to be really interesting.

38:53So the first one, I think this one's published in the Journal of Financial Economics on the effect of robo-advice. Your perspective from Vanguard is just such an interesting place to do this research from. How impactful have robo-advisors been on the portfolios of previously DIY investors? Well, actually pretty profound. Before I get to that, I just want to say it's a project with my longstanding collaborator, Alberto Rossi at Georgetown. And Alberto, when I were actually not sitting far from where I'm speaking, we were at the Wharton School at a seminar. Some came and said, Steve, I have an idea for a project.

39:27Here we are many years later. So at the time, Vanguard was beginning to roll out what is a hybrid robo-advisory service. It's not actually the largest robo-advisory service, but it's high. That's an important distinction. It has a human element to it. The investment process is highly automated. The methodology is highly automated. You can customize it. An advisor can customize it, but it's a structured customization. Advisor just can't arbitrarily pick something based on their own personal beliefs, but on this structured methodology. It varied a lot, but the best way to think about it is it fixed the common portfolio errors that you see most retail investors making.

40:03The biggest one being too, too, too much caps, sitting on cash, uninvested, regardless of risk aversions, just sitting there, being undiversified internationally. There were some people who were very well diversified internationally, but that was not the norm. Not thinking intentionally about portfolio equity risk share. What's interesting is on average, the portfolio equity risk share pre and post like DIY, say advised investors, didn't shift that much. But individually, there are a lot of people whose share went up and went down because they hadn't actually gone through any structured process.

40:39They sort of ended up where they were, not based on a sense of what level of risk am I willing to take with my portfolio, but they really ended up there almost by accident. The other thing was active-passive mix. So there was a strong emphasis on passive with active as a supplemental strategy, but we had DIY clients who just, for example, put a whole bunch of money into a small-cap active fund with no real sense of why they're allocating that much money to small-cap or to active versus an active-passive blend or anything like that. that's pretty much what the investment advisory methodology did.

41:11And the way to think about this is any financial advisor has an efficient frontier that they believe in. And luckily, the efficient frontier we were offering people is a beautifully efficient empirical in academic finance terms, efficient frontier. So we were able to measure improvements in sharp ratios across the sample. And on average, sharp ratios rose. But it's through fixing all of these portfolio construction errors and moving people closer to a very efficient frontier. That's really the effect of the robo-advisor. And that's what you'd expect any advisor. But this was a particularly efficient frontier.

41:48Seems really impactful. It seems like the robo-advisors have probably been a pretty good, positive innovation for previously DIY investors. Not everyone, though. Interestingly, there's a group of people, and they're the people more likely to leave the service over time. They sort of came by, got a portfolio checkup, said, you read Bogle on mutual funds, you're very well organized. And then they went on their way. By and large, one of the things that we found encouraging, and actually the business leaders of the service found encouraging, is that the people who needed it most are the people who stuck around.

42:18Because it was the people who made the largest errors who were more likely to say, I really perceive this service to be valuable. Now, they have very high retention rates, But the people who did a really good job, more often they were more willing to say, okay, I don't really need an advisor. I'll come back in a couple of years and get another portfolio check. But most of the clients who stayed, they were fixing really significant individual portfolio errors. I think you more or less just answered that. But what type of investor benefits the most then from switching to a robo-advisor? The ones who make the most mistakes.

42:48And the high of sharp ratio gains were among the people who are doing all those problems that we were just mentioning. people struggle with the technology of portfolio construction. I know for us, a lot of it's just intuitive and because we are used to recommending portfolios to clients and thinking about portfolio risk and how to put the pieces together. But I think that's really the real advantage where this comes into play. And particularly, remember, as clients get new money or they have to withdraw money, half of these clients are still having inflows because they're working. Other clients were spending from their portfolios, so rebalancing their strategy, maintaining their strategy, in the face of market stresses, all those reasons really were the opportunities for having benefit from the service.

43:30How does switching to a robo-advisor affect investors' time use? I assume you guys think about this a little bit. I mean, one of the advantages of advisors is labor specialization. Your clients don't have to do it on their own. We estimate you save about six hours of monitoring and managing your portfolio a year in this particular setting where you switch from being DIY to having the Vanguard advisor. The interesting thing is, this isn't the time spent. For example, if you're a DIY investor, you have to spend a considerable amount of time learning and building sort of an endowment of financial knowledge.

44:01What we're measuring here is just the time needed to manage your portfolio on an ongoing basis, but not necessarily the hours that you need to read or engage yourself in personal development efforts to build your financial knowledge. So I think that's why when six hours steams on one hand, a lot of time to be spending managing your portfolio in a given year. But on the other And that's all it is. It's not any of the information you need to gather to develop points of view, to develop information about how you should allocate or change or trade your portfolio. And it sounds like a lot of the people in this sample maybe should have been spending more time building the endowment because they had significant portfolio improvements.

44:38That's right. For example, you see this, I'm sure, in your own business, that the cash problem is partly a knowledge problem. What do I do with new cash and how do I allocate it? But it's also an inertia problem. I have to get to a computer. I have to spend time. I have to think. I have to execute a trade. I have to follow up. Did it go through correctly? Is it the right amount? Those are a lot of daunting questions for someone who's trying to run another part of their life. That's where the advantage of the advisor comes in. I think people delay based on stuff like, I'm going to wait till the election's over.

45:08I'm going to wait until whatever. There's always going to be an election. There's always going to be a war. There's always going to be a recession or a boom. So if robo-advisors can automate the portfolio management side of things, then what needs are human financial advisors satisfying? This was the second paper that Alberto and I did. There was a Vanguard survey that had gone out and we decided to write an academic version of it to look at the non-pecuniary factors involved in selecting, why do I use a financial advisor? So presumably one is to manage my money, maybe two is to give me advice on other financial matters in my life.

45:39But three, what are the other non-financial, non-portfolio management related, what I call non-pecuniary factors? From the survey, it's interesting. You wouldn't be surprised by this. It's pretty basic. Number one, peace of mind. This whole notion that I'm better off and I sleep better at night because I have someone in charge of my money. Two, is this expertise question. If I need to talk to somebody, there's someone who's a financial expert who can answer my questions. I see this, by the way, with my friends who have financial advisors, that they really do rely on them as a point. And not the sole point of view, I would say.

46:15They actually solicit input from lots of different parties, but they actually rely on that person as a source of financial information. And then the third is this delegation issue, bringing up time and delegating to someone who's professionally qualified. Those are standard reasons. It wouldn't surprise you that those are common reasons clients. So this was sort of a separate paper, but some colleagues of mine, Cindy Pagliaro and Anamadama, they took the same survey and they deconstructed, they tried to estimate the total relationship value due to emotional factors versus financial factors. And they came up with a 50-50 split.

46:50Clients assigned value to over 20-some activities that advisors did for them in the survey, and they used the same survey data we did. And they partitioned that into the value derived from hard things like managing a portfolio and the other stuff for like personal coaching, interaction with the advisor and trustworthiness of the advisor and the value from that. They signed 50 % to these, I call them social psychological factors or emotional factors, which I thought was quite interesting. What was the title of that paper? I don't remember off the top of my head, but I'll find it for you. But it's the same data set, but they just did this estimate.

47:26This is relevant. You had Yuhani Linema on here who was talking about all the results. I think this is one of the interesting challenges for academic research and portfolio construction, because this work is great showing that the portfolio management side, the portfolio management pillar is not on average adding value relative to fees charge. And then advisors sort of put everyone in the same portfolio regardless, et cetera, et cetera. But that does raise this question about what are these other attributes to sorts of value? is this the cost drag of paying for this, or is this because people aren't aware of the cost drag here?

48:01Maybe they would demand more value from this. They understood that. I do think this research is all pointing to this question of the non-pecunary benefits of financial advisors, which I think is really important, and how to measure it. I think it's going to be the next wave of challenge in the industry. I know in one of Ioani's papers, I don't know if it's in a published paper or if it's in one of their working papers, but they make that comment of, we see this advised clients are underperforming the market, which either implies that they're making a mistake by paying for advice or that they're deriving a pretty significant amount of value from the service.

48:34Or a combination. That's probably closer to where the answer is. So you mentioned some of the top needs that cause people to want an advisor, peace of mind being right up there. I got a real quick story. We recently had a conversation with a client who is fine financially. And they told us that for them, it was completely life-changing to have a budget, which we helped them create, and to have a financial planning model with the Monte Carlo simulation that based on their budget shows them they're going to be okay. They're going to be fine. They're quite wealthy, but I just thought such a simple thing for them to say that was life-changing.

49:09I thought that was fascinating and it fits with the peace of mind idea. What needs are not important? What needs do people not find important from an advisor? Well, let me respond to your scenario actually a little bit. In this paper, we had actually all these very granular needs, like the transparency of fees, portfolio management and allocation, tax planning, budgeting, some broader financial planning considerations, and even interpersonal personal issues like a person I can trust, a person I can have a connection with. Notice those are two different, very distinct questions. And one of my favorite was a person who can resolve disputes between me and my partner or spouse, which you know is with married couples or unmarried couples is a really important problem for financial advice.

49:59When we group them up into five high-level categories, there's one called trust and transparency. But the second one was exactly what you were saying, which was, we called it self-improvement, which was a terrible term, but what it meant was I got my life organized. I have a plan. I am successful because I have a plan. Someone's in charge. We fixed problems and we're moving forward. And I have a vision going forward. When you talk in general about research about financial advisors, there's a lot of focus on behavioral coaching during market downturns, which I think is a really important service feature.

50:33we've done that to great an extent because there are all these other attributes that I just listed that come into play. At the time we were doing this research, one of our colleagues working on this had just hired a trainer at the gym and said, it's the same kind of concept. I'm getting a plan, I'm executing on the plan. It's not necessarily I'm losing weight and I look great or I'm afraid. It's actually I have a plan for my physical fitness. There's a sense of ownership and pride and success that comes from them. And the other thing, side to trust, self-improvement, and then this knowledge, having access to knowledge, getting more knowledge about my bears, knowing more about the markets.

51:11The thing that surprised us most, and this gets back to what we were talking about with Yohani's paper, which is the investment component of the value chain was the least important to traditional clients who have advisors. In other words, It's portfolio construction, rebalancing, tax loss harvesting, performance, relative performance. First of all, obviously, I think you should report on performance and you should report on fees. And people should understand that and know that because that's an important benchmark. We have to do that from a regulatory and fiducia perspective. But reminding clients of these other attributes are really quite valuable because they are valuable to clients.

51:51And it's important to know that people devalue the investment performance relative to the marketing pitch that an advisor gives to a client. There's a lot to be learned there from a very practical point of view about how you pitch things to clients and also what clients derive ultimate satisfaction from. So interesting. That organizational piece is huge. Just getting organized with your finances is such a massive catalyst towards financial success. And on the other hand, rarely do I meet somebody who's very well organized financially, who's not also well on track to meet or exceed their financial goals.

52:24Just a balance sheet and an income statement, honestly, for most people can be a massive, massive catalyst and it can remove such a huge mental burden as well that it often becomes the thing from which they can leap forward, at least anecdotally in my experience. All I would say is that the survey data of large groups of traditionally advised clients, as well as other types of advised clients, like people who use robot advice services, They also have this broad sense of self-improvement, self-organization, finally taking charge of my finances, which is quite distinct from coaching me during market downturns, which is distinct from helping me and my spouse or partner resolve disputes about money.

53:01There's a rich territory here that goes beyond just behavioral coaching and market downturns. So how are unadvised investors' needs different from those that work with a robo or traditional advisor? As you'd expect, unadvised people are less interested in trust because there's no one to trust. It's really, they're executing on their own. They're also less focused on having these knowledge attributes, having someone to talk to because there's no one to talk to. They're really doing all of that on their own. I will say this. One of the things we did not ask, but we thought about it afterwards is, for do-it-yourself investors, there's a big question about trust in the institution they're dealing with.

53:37So let's say you're a US investor and you're dealing with E-Trade or Vanguard or Fidelity or whoever, and you're self-directed, there still is trust elements, but it's not the trust in an advisor, but it's more institutional brand trust, a company I can work with successfully, that sort of thing. So I just wanted to make that point. When I say trust, I mean, having a person you can trust, obviously it's not relevant because of course they trust themselves. What determines how much value investors place on advice? If you ask now, where do they assign the most value? It turns out this trust category, Trust is a broad category.

54:11It's not only a person that can trust, but it's also transparency on fees and knowing what you get for value for the money. The overall perceived value of the relationship comes from that category. And again, as we said, it's really that. It's the self-improvement and this knowledge category. All those, these three categories are the ones that drive this perceived value. So if you want to increase client's perceived value, those are really the top three you need to focus on. And in the paper, we have the itemized questions. So you could see, for example, under trust, It's not simply about a person you can trust, but it's also about transparency and understanding how people are getting paid, even though people don't understand.

54:46I'm going to talk about that and I know it a little bit. It's a broader category than this, quote unquote, person you can trust. So that's the category label. How do investors think about the trade-offs between the fees that they pay and the value of advice? I don't know if you have this experience, but literally every survey I've done in my career on fees, no one understands at all. And that's the conclusion that we make from this survey. Years ago, I sat down, I was having coffee with two friends of mine who are entrepreneurs, small business entrepreneurs, quite successful. They had a portfolio being run by a family member, a nephew who worked for a big, very reputable US brokerage firm, but it was very much clearly organized along an RIA model.

55:28It wasn't a transaction-based compensation. But I asked them, I said, so just out of curiosity, this was way back when I was doing some research on fees before this project. And I said, how's your nephew get paid? I'm sure. No, he probably doesn't get paid. Does he get paid? Who pays him? Back then, we're talking about multimillion dollars portfolio. He surely must get paid. And I said, I think he does too. I know he gets paid, he gets a salary, but how does it come out of your money? And they said, that's a good question. Now, these were college-educated, very intelligent and aware. You can't say, oh, it's a lack of schooling.

56:07They're very talented business people. They knew where every penny went in their business. That's the extent of the challenge. So what we saw in this survey, clients seemed to have a sense of how they were getting paid, we thought. So half said AUM, and then smaller fractions said transactions, flat dollar, I'm not sure. We thought, okay, that seems low for AUM fees, but let's go with that's right. Let's ask another question quantity-wise. How much are you paying a year? 70 % refused to answer the question. 30 % who tried said the mean fees were 6.7 % a year. Not 67 basis points, 670 basis points.

56:50Some people said, I pay one basis point. Some people say I pay 10 basis points. And we thought, well, there are a few people in this survey who were doing robo, but even the robo stuff was a little bit higher than that. Some clients said 90 % a year. That's why the mean got to be six. We should have done a trimmed mean. That then led us to question whether they really understood the question in front of that. So what I would conclude from this, if you're a regulator or an industry participant or you're a client, people really do need help understanding how advisors getting paid from this. This is a broad-based national survey.

57:25We're not picking on any specific firm. It really does highlight the need for a very simple, straightforward, we get paid this way and roughly this amount a year and simple, basic information so people can really know what they're paying. I've definitely seen the same thing. We are super transparent about fees and it's disclosed multiple times to clients when we're onboarding them. But if you ask a client how much they pay us, in a lot of cases, they don't know. maybe we should increase our fees to 90%. They're getting a ton of value from those relationships. Or at least 670 basically. Clearly some of this is a percentage problem.

58:03A lot of people struggle with percentages. And obviously if you paid 95 % fees, you wouldn't have any money next year, virtually no money, certainly two years. You'd have zero. The second thing is my suspicion is that because people switch advisors once a decade, with that, maybe more frequently, seven years, maybe less frequently every 15 years. And if they do, that's when they think about prices. There's no frequency in transparency. But it does say people do need help. Would correcting investors' miscalculations about what they're paying for advice change their decision to pay for it? That's what we'd like to conclude.

58:39You'd think it would be a revolution in the marketplace if people knew what they were paying. There's two arguments against that. One is that people don't value many of the financial aspects. They value the non-pecuniary aspects. So we really don't know the price. What would you pay for having a good relationship with a person you can trust who is open and easy and accessible to talk to, is an expert you can speak to, who helped organize your finances? We don't really know the price of that. I think you would find that for the people who would say, gosh, this is a lot of money and I need more justification for value, you'd be also surprised by the number of people who said, wow, I only pay that to get that value.

59:20I really don't think we have a very clear indication. We do know that among the 30 % who gave us fee data, we do know that regardless of what fees, their level of trust was unrelated to the fee level. So in this very small sample, granted, 70 % gave us no fee data, but this 30%, at least it suggests there isn't a very clear indication of how it would work out. I'm actually in favor of the disclosure, just because people should know. It's not really clear which direction it will go. I think I know how you're going to answer this, but what reasons do traditionally advised people in your sample give for not switching to robo-advising?

1:00:00Well, it's the human element. It's definitely someone to talk to separately as part of the survey. After we asked about all these value questions, we did ask this very specific question about among robo-advised people, why'd you choose it? And then among non-robo-advised, would you consider switching? And they said, look, it's really having someone to talk to. I don't want an algorithm in charge of my money. I want a person in charge. And number three was, I don't trust technology, which is what led to our third paper on algorithmic aversion. We were presenting results we were just talking about earlier from the Vanguard DIY to advise clients at a seminar.

1:00:39And Rude Rabidori at Imperial College discussed it. And he said, There's an underlying theme here among traditional advisors, but even among people who choose to switch to a robo-advisor, this idea that you might be averse to technology being in charge. That's the biggest factor for why, broadly speaking, traditionally advised clients are used to that human contact. They're not used to the machines being in charge. I think that's going to change. Technological adoption is a generational thing. And I think younger people are much more comfortable relying on algorithms to suggest whether it's streaming options or healthcare choices or debt choices or cars you should buy or how to buy cars.

1:01:19There's this whole technological revolution that's being led by younger people. So it's only a matter of time, I think, that there'll be greater and greater reliance on algorithms. But as a general rule, if you ask traditional advice clients today, it's dislike of algorithms, the preference for human contact. Algorithms could get more human in the way that they interface with people too. Like with AI, LLM type communication, it feels a lot more natural, but I don't know. I've been thinking a lot about AI. One of the things that I still find is that when I have expertise in something and I start trying to get information from Chai GPT, for example, about that thing, whether it's an academic paper that I'm familiar with or a more general concept, I find it still makes errors that are really hard to identify unless you already have significant expertise.

1:02:04Andrew Chen, who's a past guest on this podcast, he tweeted a while ago that as AIs get better, AI problems are just becoming human problems. You have to trust the AI in the same way that you have to trust a person. So it'd be interesting to see how all that stuff changes people's perception of algorithms and technology. Yeah, I found that to be the case too. For another paper, I'm working on a paper on health span, unrelated topic. I do some retirement stuff, aging with a friend of mine, and Olivia Mitchell at Worden. And we were both like, okay, let's enlist chat GPT as a research system. That wasn't very useful.

1:02:39No, I found the same thing. It's scary. If I'm asking you to help me interpret a paper that I'm already very familiar with, I'll find glaring errors that you wouldn't know unless you're already familiar with the paper. So now I'm scared to ask it about a paper I'm not already familiar with. And it's like, what's the point? It's very good at writing a very nice, the French term is Pricet, but these summaries that are these beautiful bullet point summaries. For example, I think they would do a decent summary of this paper we were just discussing. Oh, trust is important. They sort of ended with that.

1:03:07What effect does a relationship with a good, and you can define good, advisor have on investor behavior through periods of poor market performance? So this is a segue to this third paper with Tarun and Ansgar Walter, one of his colleagues, and Fiona Gregett, as well as Alberto, Fiona Gregett, Vanguard, and Alberto Georgetown. And so we sort of took this CAS environment where people were assigned robo-advice. And we began to study the impact of the advisor, the so-called behavioral coaching question, but using this robo-advice setting. And we didn't really have a measure for the quality of an advisor.

1:03:41So we just said, who are the people who managed to retain clients? That's sort of a measure. We could have obviously gone back and tried to get attributes of the individuals. We could have actually gone through the client video chat transcripts to see how good they were. But there were all kinds of daunting problems with that. But we thought, we're going to pick this one thing, which is who are the advisors who keep more clients in the service? How do they behave during periods of market turbulence? Well, this was a really striking thing. They do the same that poor advisors do during periods of market turbulence.

1:04:16In other words, the good quality and the poor quality advisors both reach out, both do handholding, both talk about long-term investing. The big difference is that the high quality investors talked to clients more before the market turbulence during periods of benign markets or rising markets. So basically, what it suggests is a spillover effect. The more time you spend building a client relationship and there is no market turbulence, the more willing that client is, say, to trust you during periods of market downturns, which I thought was actually a very pretty and practical tool to think about from an advice perspective.

1:04:58If you're running an advisory business and you're worried about, oh, if there's a market down there and how many clients might leave us because they're disappointed, the answer is don't sit around and prepare better bear market communication strategies and tools for your advisors to reach out. Start building the relationship now because it's that relationship that's going to spill over into the bear market. So it's largely about communication. Was there anything else that changed with, call it lower quality advisors? They're exactly the mirror image. They were less likely to reach out. And interestingly, you might find this fascinating because you're in a business like this.

1:05:32In benign market conditions, they had similar levels of communication with clients, except the client communications were driven by the client reaching out. If your business model is don't call the clients when times are good because they don't want to hear from us. The answer from here is they're going to trust you more in the market downturn and they're more likely to stay with you and not be disappointed. And it was really kind of interesting. We were able to deconstruct how much of this had to do with the quality of the advisor persuading me that the robo-advice was doing a good job managing my money.

1:06:09So we saw that if you were with a low quality advisor, as a client, you spent more time on the website trying to understand parts of the website that explained how the methodology works. Whereas if you were with a high quality advisor, you never went online. So the two elements here are number one, do proactive outreach to clients, but be a good, I want to say salesman, I don't mean selling, but I mean promoting or communicating a good educator about the investment process that we use to manage your money during good and bad times. So I know it sounds like really basic information. It seems very intuitive.

1:06:47This is empirically verified that if you do proactive reach out and you do a better job explaining what you're doing, you're going to retain clients longer. So it's the frequency and quality of the communication, essentially. That's right. And the talent that the person has in explaining why your money is being managed in a sound way. And that's what I found really interesting is we see the clients of the low quality advisors going on trying to figure out how their money is being managed, not just looking at their accounts, but looking at the explanations for how we manage money on your behalf.

1:07:18And when they left the service because they had lower retention, in exit interviews, they cited dissatisfaction with the methodology. So they weren't just dissatisfied with the advisor, they were dissatisfied with the robo-advice methodology. Was it their understanding of that methodology or lack of understanding of the methodology? Their lack of understanding, exactly. They just trusted more. They found it less trustworthy. So getting back to the point, even this very successful hybrid robo-advisory service, the quality advisor really stood out as a critical success factor. We did a talk for a small group of clients recently, and we just did basic stuff.

1:07:55We talked about the origins of asset pricing models and market efficiency and whatever, index funds, challenges with managers outperforming, lack of persistence, basic stuff. We use index funds and dimensional funds primarily to build portfolios for clients. We talked a little bit about that and why we think that makes sense. I said just basic stuff. Afterwards, the feedback was like, That was such incredible information. I feel so much better of what you guys are doing now. It's interesting how I would call it basic, but then to a client, it's really important information to help them understand what it is that we're doing and why that all really resonated.

1:08:26Well, that's just it, Ben. It's basic to us because we've been in it for a long time and it's second nature. But to the general public, that's really, really deep, fascinating information, I think. And really helping understand the black box, how my money's being managed. There's a lesson here for robo-advice, which is you have to explain what the machine is doing on your behalf and by behalf of the advisor. But the broader investment for non-traditionally advised, or traditionally advised clients, or people with less automated processes is still this communication about the investment methodology that matters.

1:08:57I don't know how you think about this, but honestly, the more I talk to RIAs, most of them do have some automated processes anyway. Even quote-unquote traditional shops, the strategic allocation process, all standardized, the customization process. There's 15 levers you can flip, but you can't flip 20. So there's a standardization that seems to be occurring. So I just think longer term, more and more of different aspects of the investment process, even like rebalancing strategy. It's not going to be sort of a, hey, we should take some money off the table or this sort of casual conversation with a client and then trying to figure out the tax piece.

1:09:32It's going to be much more rigorous and much more automated with the advisor communicating what the methodology is saying rather than doing the math. Our business on portfolio management is hyper-automated on rebalancing on asset allocation models. So yeah, I totally agree with that. In this sample, so we talked about helping them get through market crashes. What other benefits are investors in this sample getting from the human advisors? We did some really interesting calculations. We built this really fancy model, which you haven't asked me any questions about, which is fine because it's too complicated to discuss today about algorithmic aversion among investors and clients.

1:10:08That model allowed us to come up with these really fascinating estimates, which blew my mind. A high quality advisor in our model is worth a 30 basis point increase in lifetime total return. That seems pretty shocking. Another way to put that is if I'm with a high quality advisor and someone said, oh, Mark's my high quality advisor, but Mark's too busy. So we're going to assign you to Ben and he's kind of low quality. I, as a client would ask for 10 % increase in my current wealth to switch to the low quality advisor. And if I'm running a firm from a profitability perspective, it's a 25 basis point increase in my gross profits and my sort of corporate surplus from that relationship by having a high-quality advisor.

1:11:00Depending on which way you look at it, whether it's the client perspective or the business perspective, this whole question of high-quality advice versus low-quality advice is really at the heart of the economics of the business and benefits of clients. That's why, to me, this paper we did, it's kind of interesting, academic, but it just scratches the surface. So now, I think there's a real opportunity for academia and for industry to go deep on the determinants of high-quality advice. and maybe it is running seminars on manager persistence and capital market sufficiency and all that sort of stuff.

1:11:32Could be, because it could be that's the sort of information about the investment process that builds trust and transparency and strong relationships. There's real money to be made here for the client and for the firm by thinking more about quality of the advisor relationship. This podcast, I think it's another example. We get a lot of new clients from the podcast. We have a lot of clients that listen to the podcast and it's much more scalable and systematic than doing in-person seminars. Maybe it's not quite the same, but it has some of the similar effects. You mentioned your model being too complicated and I didn't ask about it.

1:12:05Yes, because it was too complicated and I was reading it. I was like, I don't even know what to ask. Those numbers are crazy. Can you give some intuition about where that's coming from? Well, it's literally coming from this, in a world in which I'm algorithmic adverse, a high-quality advisor persuades me that the advisory methodology that is accompanying us along the process of managing our money is, in fact, valuable and worth following. Therefore, I stay with the advisor. It's really a client retention effect. It's the effect of high turnover. If I had said it the other way, there are two firms, one firm with high client turnover, one firm with low client turnover.

1:12:40You know, economics of the high turnover client are terrible relative to the economics of the load turnover firm. So it's that kind of idea. Going back to the survey work with Alberto, what elements of trust are we? What elements of self-organization are we driving? What elements of those needs are driving the value? I think there's a lot of work to be done on this. So you talked about communication, but what are the attributes that define a high retention advisor in your research? This is where I think there's this real opportunity to make it tangible for individuals. So in our research, can you imagine going to a firm and saying, okay, Ben, I'd like to see your 10-year client retention numbers compared to everyone else in the firm.

1:13:22And if you're not at the top half, I'm not taking you. The metric that we had came up with is obviously very imperfect. So I think that's the real opportunity here for firms to figure out what are the drivers of advisor quality and what are the characteristics that we want to lead with clients. That's actually where we recognize in this paper, we're sort of at the edge of what we could do because we couldn't get into the life histories of our advisors, their characteristics, simple demographics, their psychological characteristics. I think if I were a client, I'd probably look for all those attributes that we talked about earlier.

1:13:57Someone you trust, someone you can work with, someone you have a communication with, someone who's transparent with you, who you feel is transparent with you. That's what you really have to rely on. But ideally, you'd ask about 10-year client retention rates. You could probably ask about that. We'd give people those numbers. We track them. I don't think I've ever been asked that. I get asked for referrals, direct testimonials. I get asked if they can talk to one of my other clients directly, but not necessarily. I don't think I've ever been asked about retention rates. That's really interesting.

1:14:21When people ask for referrals, I say, we can do that. We've got clients who are willing to talk to you, but I'm going to pick the best ones. They're going to give the best. I don't know how valuable this is to you. If you want to talk to someone, that's fine, but I don't know. I'm always a bit hesitant to do that. We talked about AI and where technology is going and stuff like that. What do your results in these papers suggest about the role of human financial advice in an increasingly automated world? It's the same thing we talked about earlier. Behind the scenes, traditional advisors have a lot of automated processes, and it's only going to become more automated.

1:14:50The example of these robo-advisory services and hybrid robo-advisory services, it's interesting who uses them, by the way. If you look at broad industry data, this is maybe five years old or so. I haven't really looked at this in a while, but it's young people who are interested in a new thing on the block. But it's also very affluent, older investors who are experimenting to see, oh, I'll take 10 % of my portfolio and give it to a robo-advisor and see what it does with it compared to what my traditional advisor is doing. So there's going to be this gradual technological adoption. And I'm with you that there's going to be this human interface because even if there's this next generation of quality, right now the AI technology is just too erratic and hallucinates too much.

1:15:34I could see it as an augmentation to a very domain-specific digital advisor. So I'm going to create a human-like figure who's going to talk to you rather than the digital advisor that does everything through the CX interface of the digital device you're on. But I can't see it replacing traditional for a while. But I do see this world in which the human component becomes the explicator, the explainer of what the machine is doing. There's some research on the impact of AI on knowledge workers that kind of suggests that it brings the lowest quality ones up closer to the average. It doesn't necessarily make the best ones better, but it could have the same effect on financial advice where a very mediocre financial advisor gets a lot better because maybe they're getting help or prompts from an AI assistant.

1:16:21That could happen. Yes. And the AI assistant who reads this paper will say, call up the guy who hasn't reached out to a client. You actually need to reach out to these three clients proactively this week because come the next market downturn, you're going to lose out. So what do you think financial advisors should be focusing on in their practices to be as valuable to their clients as possible? This is me speculating more as a manager and hirer of people and a person who manages different parts of businesses over the years. But I think the human interpersonal skills side is absolutely critical.

1:16:51And it used to be that, of course, the investment business meant sales skills, and it still does in a lot of corners. But But now I think the leading advisors, it's empathy, clarity of communications, reading the client, client and partner for comprehension and understanding. It really is the soft, emotional intelligence skills, I think, are definitely what I would invest in if I were, say, running an advisory firm today. And I would hire for that as well as invest in it. I definitely think this idea of the persuasiveness of the investment approach, if Mark is really that good at explaining the investment process and Ben isn't, we should get Ben learning from Mark and we should be distilling the best explication, the best explainer of our investment process.

1:17:44We should make that more universal. And then the other things I think would just be basic building block things. First of all, this general financial knowledge question. You see that in all these surveys that after trust and transparency, the issue is having access to an expert. So the depth and roundness of the training for the individual. I do think with AI, though, and especially in larger firms, it's not about you knowing everything, you the personal advisor. It's about you being seen by the client as a person who can get the information that I need, not immediately at your fingertips, but through other channels or through an AI chat box that you then filter to make sure it's correct.

1:18:22The fourth thing I would say, based on the whole body of research, is this transparency around fees and value added. I think you just need to be absolutely transparent in dollar terms and percentage terms about how much people are paying. But I also think you don't just leave it at that. You actually have to talk about your value added in terms of capabilities and not just the numerical, we rebalance your portfolio, we did this, we did that, not the sort of transactional piece, but also the emotional planning, organizing piece. I think those are pretty basic ideas that come out of this research that seem pretty fundamental to the future of financial advisors.

1:18:57Really deep, interesting stuff. All right, Steve, our final question for you. How do you define success in your life? I'm actually going to answer a different question slightly, which is how do I define success in a particular point in life, which is transitioning from work to retirement, which I did four years ago. So that's a very specific thing that I have lots of knowledge in. So I have really three lessons I would share with your audience. The first one is timing and knowing when to leave. I remember a colleague of mine, I was giving a actually a going away retirement speech for him years ago, about a decade ago.

1:19:32I talked to him and he said, the critical thing in timing is knowing when to leave the party. You want to leave the party when it's in full swing and everyone's having a good time. You don't want to hang on until three o 'clock in the morning. That's my first lesson is people contemplate this for you guys, a future transition to retirement is really thinking carefully about the timing and leaving the party when it's in full swing. The second is this idea, particularly important, successful attributes, defining a life independent of your prior work. It doesn't mean necessarily not doing things.

1:20:06For example, I'm doing this work, which I really enjoy. I keep abreast of financial information. I'm engaged with some academic research projects that I mentioned. I'm working on some stuff where I'm actually on the client side. But you have to define a life that is independent of your work. The work elements can be part of it and they can continue, but it has to be independent. And then the third element of success I would point to, the people I see who do this particularly well, is dealing with health and medical issues, which arises your age, with grace and perseverance. We've all seen these ads, you know, they're a happy couple walking in the sunset on a beach and it's all about financial planning, but I don't know, he might have cancer and he might have heart disease.

1:20:46And that whole health issue is often hidden in discussing the aging process. I have a personal motto I use from Jack Bogle, who always used to say to the Vanguard crew, which is the term used for Vanguard employees, he quoted this old English expression, press on regardless. And so as you age and you move into this third phase of life, pressing on regardless. That's my motto for not just the health issues, but just this new phase of life. That was an incredible answer to the question, Steve. And it was relevant. I mean, it's directly from my experience in the past couple of years. All right, Steve, this has been an incredible conversation.

1:21:25We covered a lot of ground. Your research is super interesting and relevant to our audience. So we really appreciate you coming on the podcast. Well, I really appreciate being here and I really enjoyed dipping into all the history, the extensive history of your podcast. There's really such terrific information available. And I actually changed some financial aspects of my financial plan based on your podcast, which I find exceptionally valuable. Super cool to hear that. Very cool. And we do appreciate it. Thanks for having me.