Perhaps one of the most important, yet often overlooked, metrics by clients of, and prospects for, financial advisory firms is the value-added that advisors provide well beyond the return on an investment portfolio. For decades, professional investment managers have provided prospects and clients with mounds of historical investment performance graphs and statistics as the principal, and perhaps sole, reason to engage their firms. Portfolio outperformance on a risk-adjusted basis over a benchmark has been dubbed “Alpha,” and is frequently reported to firm clients. Arguably, Yale University Professor Charlie Ellis (1975) was among the first to challenge conventional wisdom by identifying and focusing upon the “overcrowding” of talented and ambitious investment professionals in the profession, making consistent outperformance of the popular market indices virtually impossible.

Nearly thirty-five years later, Ellis (2011) hypothesized that the investment management profession had made two specific errors of commission (falsely defining the investment management mission, and incorrectly ordering priorities), and one error of omission (dropping rigorous counseling). Ellis defined rigorous counseling as being a process of helping individual investors gain a better understanding of themselves and their financial situations, tolerance for risk in assets, liquidity, and cash flows, quantifying their individual financial resources vs. their short- and long-term financial needs and objectives, and their psychological needs. In brief, rigorous counseling is not about consistently beating the popular market indices, but rather reframing the issue to focus on assisting clients to establish realistic financial goals, implementing strategies to achieve those goals, with an ever-vigilant eye toward the avoidance of asset exhaustion prior to death.

At approximately the same time, academic researchers and investment management practitioners were joining forces to expand the value-added body of knowledge, by seeking a method to quantify the “all-in” value-add benefit provided by financial advisors to clients, who regularly and innocently made “unforced errors” due to lack of time, disinterest or poor financial numeracy (ability to apply financial knowledge) skills. The first of such academic studies was published by Hanna and Lindamood (2010), who found that financial advisors employing the Six Step Financial Planning Process [in effect at that time] defined by the Certified Financial Planning Board of Standards (2013), was instrumental in “helping clients to achieve financial stability over time, consistent with stated goals and objectives,” over and above increasing the value of a client’s portfolio. This incremental benefit has been defined as “Gamma.”

Blanchett and Kaplan (2013) identified specific instances of “retirement” Gamma, including using appropriate asset allocation strategies, creating dynamic withdrawal strategies at retirement, understanding the appropriate use of annuity products, choosing between tax efficient investing and withdrawal strategies, and building portfolios that account for risks faced by retirees. From this study, Blanchett and Kaplan estimated that a typical retiree could obtain an incremental 23% return on a utility-adjusted basis when using appropriate financial planning techniques, vs. a pedestrian heuristic consisting of a 4% withdrawal strategy and a 20% allocation to equities. This Gamma-equivalent benefit obtained through enhanced retirement planning decision-making from this specific research study was found to be 1.59% annually.

Building on the results of the Blanchett and Kaplan Study, University of Georgia Researchers Grable and Chatterjee (2014) hypothesized that financial advisors who employ the CFP® Board of Standards Six Step Financial Planning Process as well as appropriate financial planning techniques are more likely to build client confidence and financial competence through an integrated wealth management process (“portfolio management plus…..”) that evidences a reduction in wealth volatility. According to Kahneman and Tversky (1979), most individuals prefer wealth stability and enhancement over wealth declines, making most clients risk averse, and prime candidates for an integrated wealth management approach to their finances.

To test their hypotheses, Grable and Chatterjee studied data from the National Longitudinal Survey of Youth (NLSY ’79) dataset of participants who were in the age 50 and above demographic for the period spanning the Great Recession (2007-09). Within the selected NLSY survey sample, data were parsed into those who had met with a financial advisor, and those who had not. By applying various statistical analyses, Grable and Chatterjee found that those members of the sample who had met with a financial advisor experienced a lower mean change in wealth over this time period by 331 basis points than those individuals who had not worked with wealth management professionals. Admittedly, most investors during the Great Recession experienced a decline in wealth; the significance of the study clearly demonstrated that those who had sought or worked with professional advisors fared better during the decline than those who had not done so. The study did not explore the specific factors, recommendations or actions made by wealth managers or implemented by clients that account for this outcome. Further research will be needed to uncover these factors. This differential in “investment performance plus…..” has been coined “Zeta.”

A more recent study published in February 2023 by Professor Shlomo Benartzi of UCLA focused exclusively on three (3) financial advice domains consisting of retirement savings contributions, debt management and reduction, and insurance. Dr. Benartzi’s research focused on these three areas to reduce an element of uncertainty or tradeoffs surrounding many personal financial decisions, which may or may not pay off in the future. A periodic review of these topics by wealth management professionals can place “free money” in a client’s pocket.

With respect to employee contributions to employer sponsored defined contribution retirement plan contributions (401(k), 403(b), etc.), research conducted by Yale and Harvard University professors (Choi, Laibson & Madrian, 2011) revealed that many employees are “leaving money on the table.” This sub-optimum situation refers to instances where employees fail to make retirement plan contributions in a sufficient dollar or percentage amount annually to attract an employer’s full gratuitous match. Studies show that married couples are equally guilty as only one spouse may make contributions at a threshold where employer matching contributions are maximized. While some younger employees (< 59.5 years of age) may have other, more financially prudent, priorities such as student loan debt reduction, the Yale-Harvard Study illustrated that this phenomenon is equally applicable to employees who have at least attained age 59.5, the age at which withdrawals from qualified plans may be made penalty-free. At minimum, married couples should maximize contributions to the spouse’s employer plan providing the most generous match. According to Dr. Benartzi’s research, this retirement planning oversight can be worth as much as 6.93% based on today’s median retirement plan balance!

Understandably, there is a subset of employees who believe that they are very capable of managing their retirement assets, including decision-making surrounding investment options and contribution levels. In a 2007 study conducted by Dr. Benartzi and Nobel Laureate Richard Thaler of the University of Chicago, findings indicated that “80% of the study sample declining professional investment advice and designing their own portfolios, subsequently preferred the professional portfolios when shown the impact of their selections on retirement income.

Although Eagle Ridge Investment Management does not lend money, or sell any products including insurance, the financial planning process necessarily entails a review of both areas with a view toward sharpening the efficacy of existing debt and insurance coverages. A 2016 study by Keys, Pope and Pope found that 20% of homeowners with solid credit scores failed to refinance their mortgage debt at lower rates of interest. Notwithstanding the recent round of interest rate increases over the past year, reported outstanding residential mortgage balances as of the end of Q4 2022 at $11.92 Trillion, based on Federal Reserve Data. Of this amount, approximately 10% constitute non-conventional mortgages, which typically carry adjustable rates of interest.

Incorporating all three focus areas in Dr. Benartzi’s 2023 published study, holistic investment advice provided by professionals accounted for as much as a 2,472 basis point increase in financial benefits to clients, or a 7.5% income boost for a typical household.

In conclusion, one must be careful not to make extrapolations and generalizations from empirical research studies. It is entirely possible that different outcomes may occur under different economic conditions, using different study sample demographics and research study designs.

However, at Eagle Ridge Investment Management, we believe that there is a growing preponderance of evidence that professional investment advisors and wealth managers bring valuable knowledge and experience to the table to benefit clients and their extended families. We welcome an opportunity to demonstrate how our conversancy with cutting-edge, applied research can benefit you, at no additional charge!

(Note: Full citations for the research studies cited in this blog may be obtained upon request.)