Ariely compares financial advisors to monkeys

Duke behavioral economist Dan Ariely boldly stated in a recent Harvard Business Review article that highly trained monkeys could do the same job of financial advisors.

Ariely, the author of Predictably Irrational and The Upside of Irrationality, says that planners dumb down two basic questions key to financial planning and then charge one percent of assets under management going forward.

Ariely notes the two questions are:

-- How much of your current salary will you need for retirement?
-- What is your risk tolerance on a 10-point scale?

Ariely stated that most people just say they would need 75 percent of current income in retirement, yet when asked how they want to live in retirement and actually think about it, they come up needing about 135 percent of current income. That's because they now have more time to spend on things like travel.

As for the risk tolerance question, I've done my own research that determined the way people feel about risk isn't stable over time. In taking a risk profile survey, I have pointed out that people think they can take a ton of risk in good times like 2007, only to become risk averse in 2008 and early 2009.

Ariely concludes that the real reason people shouldn't pay one percent of assets is that neither question helps to optimize our portfolios.

Financial planner Rick Adkins was more than a little offended as he wrote a rebuttal in the Journal of Financial Planning. He admits there is some truth to the limits of the questions but is disturbed by Ariely's piece. Referring to Ariely's key note address to the Financial Planning Association (FPA), Adkins states that he should have watched a football game rather than listen to Ariely's advice to planners.

My take

Ariely is dead on in his criticism of advisors. Many simplify the important considerations in these two critical questions, only to build unnecessary complexity in creating portfolios which allow them to charge that one percent or more annually to clients.

I also attended the conference where Ariely spoke and, while I'm an avid college football fan, couldn't disagree more with Adkins on the merits of his speech. It was a talk that offered much promise for financial planning to leave the status of a sales vocation and move toward a true profession. While I have been known to be critical of the FPA, I applaud their decision to bring in a speaker who wouldn't just tell us how great we planners are. Adkin's site notes his firm charges from one to three percent annually on assets under management, which wasn't mentioned in his rebuttal. The fee apparently may decrease over time.

My advice

I'm 100 percent with Dan Ariely on this issue. As he says algorithms could do a much better job of helping people understand how much they need for retirement, as well as helping them answer the even more important question of what the level of risk is that will they actually stick with no matter how the market performs.

Think about what activities you would do if you suddenly had 40 to 50 hours a week of free time? How much would those activities cost? Look at your own portfolio and fess up if you were one of the majority of investors who sold some stock when markets tanked. Some people told me they learned their lesson but, when markets were down less than 20 percent last September, admitted they repeated the mistake. Don't ever pay one percent in total portfolio fees.

Max Tailwag'er with award

As far as comparing my profession to monkeys, I do have a slight disagreement with Ariely. Clearly dogs would be a much more appropriate choice as is evidenced by my dachshund being awarded this America's Top Financial Planner plaque.

Besides, Burton Malkiel has already compared stock pickers to blind folded chimps.

[rkagrawala]

As someone who evolved from a monkey, I am offended by this comparison to financial advisors.

[Asuadvisor]

I agree that hourly doesn't have to be a one and done approach. I actually like the idea of the hourly model and was seriously considering it when I started my ria. When polling my prospective clients about paying by the hour most of their thought process' went hourly=lawyer=horrible idea. My sample set was admittly low though.

My only point of my long winded post was to respond to the one line that said don't ever pay one percent in total portfolio fees. It's is ok as long as a large portion on that 1% pays for something besides portfolio management.

I very much enjoy your blog. I was nervous it went away with this new CBS website which makes it much
harder to find you.

[Allan_Roth]

The CBS News web site is still a work in progress as it relates to the MoneyWatch bloggers. It is getting better so hang in there and please feel free to comment. Thanks.

[Asuadvisor]

Allan,

First off I'd like to say I'm a fan of yours and have followed you for years. I generally agree with almost everything you say.

With that said I would like to push back a little on paying an AUM fee. I understand you are very proud of your chosen business model and as the most argumentative person on earth I full expect you to tell me how I'm wrong...JK. I also know you are probably sick of having this argument, but I just wanted to put the other side out there for the benefit of the other readers.

I believe in ongoing financial planning is beneficial as opposed to a one and done type of approach. A plan isn't worth much if it's not implemented and guiding a person through the process, I believe, is worth it. Not to say people can't do it all themselves, but there is a difference between can and will. Also I believe having the ability to call your advisor anytime though the year, without paying extra, is also beneficial. When your neighbor has the next big thing brewing and needs investors it's nice having someone be able to evaluate it objectively to avoid getting into trouble (or missing a opportunity). All these things can be paid for in other ways, like an annual retainer or additional hourly fees for each service. Some advisors include these fees in their AUM fees. Charging 1% for investment management is of course excessive, but charging 1% up to some limit can be warranted if it also pays for comprehensive ongoing financial planning.

For just pure investment management paying an AUM fee can be appropriate but should be closer to 0.25% instead of 1%. The main reason for the fee I believe is for behavioral reasons. I know you have stated financial advisors can be just as guilty of panic selling and the like, but I'd like to think an advisor can add value by being more discipline than the average investor. Otherwise, what good are we (oh-no I just opened myself up for your rebuttal).

In conclusion I think if, for example, an advisor charged 1% up to $250,000, then 0.25% thereafter it wouldn't be excessive if he or she were also offering ongoing comprehensive financial planning.

[Allan_Roth]

While I happen to believe in the hourly model, I don't think it's conflict free either. With that said, I don't agree that an hourly model is only a "one and done" approach. Clients come back to see me when they need help and, if I can add value, they will keep coming back.

Regarding your conclusion, I think any model that provides good financial planning advice that doesn't make the client dependent on an unnecessarily complex investment portfolio is fine.

I suspect we are more in agreement and thanks for your insightful comment.