4 Questions With Behavioral Finance Expert Terrance Odean

Who's your worst enemy when it comes to your investing? The sneaky high-frequency traders? Politicians on Capitol Hill? Uncle Jim, who's always trying to give you a new hot stock tip?

More likely, your worst enemy is your own brain.

For years, researchers in the growing field of behavioral finance -- an academic area that's the love child of a wild fling between psychology, economics, and finance -- have been identifying ways in which our brains are poorly wired for making good investment decisions. Among the big names in the field is University of California Berkeley's Terrance Odean, who once told U.S. News & World Report that he wants to "be like the dentist, and put myself out of business" by helping people be smarter investors.

I recently gave Odean a call to chat about financial advisors. Some of what he told me was featured in The Motley Fool's special report "How to Thwart the Opaque, High-Fee, Underperforming Financial Advisors Who May Be Mismanaging Your Money." However, he had plenty more to say.

Do financial advisors add value?
"Yes, they do add value," Odean quickly shot back. "Good financial advisors encourage investors to follow good investment practices. Left to their own devices, investors don't do that."

For an expert in behavioral finance, helping clients follow good investment practices means keeping them from getting too swayed by their momentary urges and making "dramatic portfolio changes for emotional reasons." An example of what that looks like in practice was advisors "encouraging clients to not get out of the market completely" in 2008.

Boiled down very simply, Odean said that good advisors add value by "[injecting] common sense where it's needed."

What makes a financial advisor a good financial advisor?
"Good advisors start you off with a good portfolio and discourage you from shooting yourself in the foot. ... Good advisors have an eye toward taxes; really good advisors will help you find low-fee funds."

For people with more money and/or more complex financial situations, there's even more that a good advisor should bring to the table. As Odean put it: "For wealthier investors specifically, it may make even more sense for advice when it comes to taxes, estate planning, etc."

As with other experts I talked to, one thing that Odean stressed that customers shouldn't focus on when looking for a good financial advisor is a promise to beat the S&P 500 (INDEX: ^GSPC  ) . Odean told me that's "just the wrong thing to look at" and went even further to say that "your advisor should not be trying to beat the market."

"A rule of thumb," he concluded, is that "if an advisor sells himself as 'With me you'll beat the market,' go with someone else."

What's the best pay structure for clients to pay their broker or advisor?
"The problem is that, first of all, we're not going to come out of this with me saying there's a perfect fee structure."

With that in mind, Odean noted that a "commission-based model encourages trading." This is a big problem because, according to some of Odean's best-known research, investors who trade the most tend to have the worst returns. And Odean knows from experience that commission-based brokers generally aren't interested in working with you if you're not trading a lot. "Many, many years ago," he said, "before I was an academic, brokers would call me up and encourage me to trade and he would be frank that he wanted me to trade or he wouldn't want me as a client."

These days, "more advisory and broker firms are moving toward a fee structure that's a percentage of [assets under management]. ... Now the incentive is not encouraging more trading, but the problem is that it's a zero-sum game," Odean cautioned. "The advice may add value, but what goes in one pocket comes out of the other. If the broker charges you 1%, you earn 1% less every year."

"There is another model: by the hour. Most investors don't go for it, but we do this for all sorts of things -- attorneys, etc." This model, however, requires that investors actually write the advisor a check rather than having a fee quietly removed from their assets, and that's a big part of the reason investors often don't go for it. "People give up 1% of $1 million without complaining, but if you charge them $500 per hour to work on their account, they get upset."

As he stressed at first, it's tough to say that any of the pay schemes is "perfect," but regardless of which structure you use, the bottom line is that "you should always know how much you're paying."

Are financial advisors appropriate for everyone?
While in theory it might be great for everyone to have a third party available to keep their behavioral foibles in check, Odean recognizes that in practice it may not be quite so simple.

For those who have more money, the value of an advisor goes up because "this starts to tie in more complex situations -- estate planning, taxes, etc." While those wealthy investors could likely learn the ins and outs to do it on their own, it may not be worth their time. Odean related it to his own tax preparation: "These days, I don't do my own taxes. Could I do it? Sure. But I don't have the time or interest. It's just not where I want to spend my time."

However, Odean pointed out that an advisor relationship may not be as ideal for investors with lower levels of wealth. "At what point does it make sense for the advisor? If you've got $50,000 and they're charging 1% per year, you're not going to be a highly valued client." What should these folks do instead? "There's a range of wealth at which if you know to hold low-cost, diversified index funds and not do anything crazy, then you probably don't need an advisor." Odean didn't mention any index funds specifically, but Vanguard's funds -- including the Vanguard S&P 500 ETF (NYSE: VOO  ) , Vanguard MSCI Emerging Markets ETF (NYSE: VWO  ) , and Vanguard Dividend Appreciation ETF (NYSE: VIG  ) -- are often regarded as some of the best, most cost-efficient index trackers on the market.

But that doesn't mean that all investors with smaller portfolios should try to do it on their own. The value of a financial advisor largely lies in your "propensity for shooting yourself in the foot." If you're an investor who tends to get carried away by the emotions of the market, then a financial advisor may be a good bet no matter what your wealth level.

Fool contributor Matt Koppenheffer owns shares of Vanguard Dividend Appreciation ETF and Vanguard MSCI Emerging Markets ETF, but does not have a financial interest in any of the other funds mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (4) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 23, 2012, at 10:25 AM, name7865 wrote:

    Excuse me, but getting out of the stock market completely in 2008 was the right thing to do.

    After the drop bottomed out, of course it was then right to go back in. There was no hurry to get back in, any time between January 2009 and May 2009 would have been OK. But every sensible investor should have been completely out of long stock positions by the time the crash happened.

  • Report this Comment On May 23, 2012, at 1:55 PM, TheRealRacc wrote:

    name7865, I read it differently as stating that you shouldn't get out of the market AFTER the crash. If you were aware enough to move to 100% cash before the crash, then power to you. But nobody in their right mind can say that they knew exactly what was going to happen. The point being, you shouldn't want an adviser that claims to know the future. And your adviser should not be suggesting to sell after a large drop in an index.

  • Report this Comment On May 23, 2012, at 2:01 PM, ShrikeTheFoolish wrote:

    Name7895,

    Everybody is correct in hindsight when they can pick and choose their dates.

    However, sensible investing is usually done over the long term - 10 to 40 years depending on age. What you're talking about is a 6 month span where a "sensible investor" should have completely liquidated their entire account and then gone back in.

    Excuse me, but that's just plain wrong. Sensible investors ignored the entire market, kept having a great time with their families, and kept contibuting to their accounts. I speak with people all day long that liquidated, went to cash, and never got back in because they felt there was too much blood in the water.

    Please let us know when you perfectly time the next market crash.

  • Report this Comment On May 23, 2012, at 2:03 PM, TMFKopp wrote:

    @TheRealRacc

    Exactly, well put.

    @name7865

    The point is that a good advisor will help their clients avoid making large, drastic, emotionally-driven changes to their portfolio.

    For most investors, moving their entire portfolio into and out of the market based on expectations of what the broad market is going to do is a disaster waiting to happen.

    Matt

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