Looking for a more holistic financial advice

di Nicola Zanella - 18/01/2013

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Let's start with a couple of considerations.

1 - Almost all of the academic research worldwide shows that the majority of people, from young to adults, has insufficient knowledge to independently take the financial decisions that are in their best interests, both in the short and long term.
2 - There is evidence that individuals who arrive at retirement have financial resources largely insufficient to maintain their accustomed standard of living. Obviously, this situation will tend to worsen over the years, given the lower social security checks that are expected in the future.
How does the financial industry respond to these two challenges? Which area of personal finance is typically expected to create value for this kind of customers?
Great importance has been given to designing their financial portfolios, but more specifically, to  searching for the so-called alpha, which means trying to generate returns regardless of market conditions.
How have they tried to distribute such value?
Through tactical asset allocation, which consists in the selection of individual securities in each asset class (security selection) and in the practice of altering in the short term the strategic asset allocation plans in accordance with some expectations (market timing).

And where is the problem?
In competitive financial markets, such as those in more developed countries, where price movements can be explained primarily by changes of premium for different risk factors, there can be no truly reliable alpha, but only different betas (risk factors priced by the market), some of which have already been identified and others yet unknown.
What are the practical consequences of this change of perspective?
You cannot say that the activities of security selection and market timing do not add any value (it is thanks to this type of analysis that our markets are mostly efficient), but it is important to understand that the changes of risk premia in relation to the business cycle make the tactical asset allocation an activity that is relevant only for those investors that differ greatly from the average (or marginal) investor, because of the specific characteristics of their jobs; for example, some jobs are much more (or much less) correlated with the economic cycle and therefore with the stock market.
What should be expected from financial advisor's work?
It is not in his ability to capture some alpha that investors should be looking for added value, but in his possible skills in building a financial portfolio that suits their characteristics. Through effective strategic asset allocation, and only secondarily, in cases that require it, with tactical asset allocation, the aim of which is not to catch alpha.
In the building and management of the financial portfolio, what is the most critical financial choice?
For the typical investor is choosing how to allocate savings among the various asset classes. No considerations about the future behavior of markets should affect the definition of the weights of different assets. Then, it is sufficient to rebalance the portfolio over time, in a way that there are no assets dominating the others and above all to ensure that the composition of the portfolio should follow the development of the natural characteristics of the investor.
Is it possible that in the past strategic asset allocation has been given little importance because it was perceived relatively simple?
Maybe, but strategic asset allocation is one of the most complicated decisions that an individual has to face during his "financial life", as it comes to finding the right balance between the (sub) portfolio with lower risk and therefore lower expected return and the sub (portfolio) at a higher risk and therefore the higher expected return. This is the positive relationship between ex-ante risk and return (risk-return tradeoff) that every investor must solve in order to effectively invest his or her savings in financial markets.
What happens in reality?
As shown by several studies of behavioral finance, the positive relationship between risk and return appears unnatural to simple investors, because they believe in the more obvious negative relationship between risk and return: the higher the risk, the lower the return (benefit) that is expected.
The financial industry tends to transform the relationship risk/return in the most attractive (in customers’ eyes) return/return tradeoff, when they are suggested to choose financial instruments with higher expected return to lowering the probability of not achieving a certain financial goal in the future, considering financial markets (especially stock markets) as a money machine.
How should financial advisors behave?
They should try, as written above, to determine the strategic asset allocation best suited to the specific risk appetite of the client, defining its risk aversion but also his or her ability to take risks or risk capacity, which is primarily determined by its level of wealth.
If a future financial goal is difficult to achieve with the identified asset allocation, the advisor should suggest remedies, which can be, for example, a scheduled program to increase the savings rate over time that mends the cognitive biases of individuals (such as, something like Save More Tomorrow plan created by Benartzi and Thaler).
Only if the advisor’s client is particularly different from the average investor, especially because of the characteristics of its income and therefore of his or her human capital (defined as the present value of labor income), it is useful to consider also some tactical asset allocation.
What is the role of human capital in the financial planning?
It changes the order of critical financial decisions, as the human capital of an individual is comparable to a typical financial asset; the only difference, though not negligible, is that it is not immediately exchangeable or tangible. Through the approach of the human capital (opposite to the more common needs-based analysis), it is clear that human capital should enter in financial planning, because it is a new asset to consider and therefore to protect.
What is the monetary value of life?
As with other forms of insurance, the value of a worker should be determined using the market price of the potential loss. Therefore, the value of insurance protection must take account of all income streams that the worker is potentially able to generate in the future, net of taxes and expenses necessary to deliver them.
In this way, the human capital of a worker can be worth several hundred thousand euros. The human capital of a young man, especially if graduated, is tens of times his current income.
Losing the possibility to generate future income, due to a premature death or total and permanent disability, represents a Low Probability High consequences (LPHC) event, the typical event to insure.
What does this mean for the financial industry?
It means that in order to offer a comprehensive financial planning, advisors should be skilled also in the field of insurance planning, not only in the investments planning. As shown in the pyramid financial approach (see below) I created and developed over the last three years with the help of Marco Liera, insuring the human capital, choosing the right type of insurance and figuring out the amount of coverage, represent critical choices to be taken before even thinking of the asset allocation of savings. Particularly for young people, it makes no sense to worry about investments and stock market, if they have not protected their human capital, their most valuable asset.
Are there other financial decisions that we can define critical in the financial planning?
Yes, there are quite a few. Starting from the decision to buy or rent a home, to the mortgage choice (and the determination of its amount) in case the house is purchased. This is often a decision whose consequences accompany individuals for most of their working lives, until the extinction of the mortgage. It is for this reason that any error in the determination of the loan amount and especially in the type of mortgage may mark deeply the financial life of an individual. Just think of the high interest risk that typically bear borrowers who choose for an adjustable-rate mortgage.
It is possible to make a list of the most important financial decisions faced by individuals in the course of their lives (working and retirement phase)?
It is difficult, because it depends also on the country to which it refers, with the specific level of wealth and relative allocation of tangible and intangible assets.
Referring to the italian case, I believe that for young workers, the decision to protect their human capital and the mortgage choice is much more important than the asset allocation of the little savings they usually own.
It would be wise that financial planning offered integrated solution about investment, insurance and loans, through an holistic approach as shown in the picture below.

This kind of financial planning would be the perfect answer to the needs of individuals for their whole life, transforming mere consumers in customers for a life (the number one goal in marketing).
Yes, there is added value to be delivered and appropriate reward to receive in financial planning, and this has not necessarily anything to do with the search of alpha!

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