News that Britain has lost its top credit rating Aaa rating from Moody’s, having been downgraded to Aa1 could have come at a better time – not on a Friday evening when most people were just about hitting the pubs! Damn you Moody’s! That’s NOT going to stop anyone from having a pint or two, unless off course you are George Osborne! Otherwise, this was a pretty normal week in financial services.
Moody’s cited the continuing weakness in the nation’s growth outlook and the challenges that presents to the government’s fiscal consolidation program. No news there, move on!
So this week, the theme is financial planning and behavioural finance. First we look at valuing a client’s business for the purpose of financial planning, what brain science teaches us about helping clients make better financial decisions and how gender differences play out in financial decision making. We conclude by asking; what is the real value of financial planning? 1.8%pa, 8.5%pa or 10.3%? Pick your number now!
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If you are engaged in financial planning for business owners, you will find this article by Ann Mash in US-based publication Financial Planning really useful. Whether you are considering protection (shareholder/partnership protection for example) or retirement planning, a big conundrum is working out what the business is worth.
An estimated 80% of a typical small business owner’s net worth is tied up in their company but unless they are preparing the business specifically for a sale, owners might be reluctant to pay thousands of pounds to work out the value of their business (hard enough getting them to pay the planner’s fees).
Drawing from the experience of financial planner Mark Tepper, the article provides a list of 8 questions to help value a clients business. Off course this isn’t a certified valuation, it’s nonetheless very useful for the financial planning purposes.
- Can the company stand on its own two feet and operate independently of the owner? No one is interested in ‘buying a job. They want to buy a business! “A good litmus test is if you don’t have the ability to take a month-long vacation from the business, and shut down email and phone communication for that month, then the business is not independent of you”
- Does the company have a stable and motivated management team? This is perhaps one of the most valuable assets a business can have. You need a management team that will stick around post-sale.
- Are there operating systems in place that can improve the sustainability of cash flows
- Is there a diversified customer base? If 70% of the revenues from one big company, this is worrying because the biggest client leaves, you are out of business.
- Are there recurring revenues? “The greater percentage of your revenues that are recurring, the greater the multiple that you will attract” when selling the firm, Tepper says. Firms are typically sold as a multiple of revenues. The acquiring owner would expect those revenues to continue.
- Are the financial statements easy to understand? If client is running a lot of lifestyle expenses — such as cars, vacations or country club memberships — through the company, this is may disguise the true tax position of the business.
- Is the appearance of the business premise consistent with the asking price? There can’t be broken windows or unkempt grounds at $10 million asking price!
- Is the cash flow not only good, but improving? A buyer wants to know he is getting an asset that promises to increase in value, he adds.
This interesting article in US based publication AdvisorOne looks at gender differences with regards to making financial decision.
According to psychology professor Paul Greenberg, the classic male stress response of ‘fight or flight’ and female’s stress response of ‘tend and befriend’ also plays out when it comes to making investment decisions. “We can see gender differences in the number of trades and risk aversion. Men can be more motivated by euphoria-driven behaviour” he pointed out.
Drawing from the book title ‘How to Give Financial Advice to Women: Attracting and Retaining High-Net Worth Female Clients’ by Kathleen Kingsbury, the author pointed out that “There is no unisex brain…. Girls arrive already wired as girls, and boys arrive already wired as boys. Their brains are different by the time they’re born, and their brains are what drive their impulses, values and their reality.”
This difference is clear in male and female investors. Men measure success in terms of beating a benchmark or their friends. As Kingsbury put it, winning “makes their brains happy.” To women, investment success isn’t about winning or losing, but about meeting their life goals and objectives—in other words, surviving and thriving.
The article also points to three specific physical differences in the way the make brains are wired differently from a female brain which can explain this. For example;
- The amygdala and limbic system (center of emotion, fear and aggression; responsible for “fight or flight”) is larger in the female brain than in males’. Scientists hypothesize that this may contribute to women feeling responsible for caring for those they love, even at their own personal and financial expense.
- The corpus callosum (connector that transmits signals between the left and right sides of the brain). Women have more connections between hemispheres, accounting for their proficiency in multitasking and verbal communication. Men’s more limited number of connections makes them less verbal, but enables them to concentrate more fully on individual tasks.
- The hippocampus (hub of emotion and memory formation and recall) is also larger in women than in men, perhaps accounting for women’s greater ability to store and remember details.
This seems to suggest that women are more likely to tune up to an adviser who takes time to listen when they share details of their lives, choices and goals. That, when you refer to specifics of a woman’s situation, the perception is that you genuinely care about her and her future, which can contribute to building a stronger relationship. But is this really unique to females? Aren’t males also more likely to tune up to an adviser who takes time to understand them?
Another very interesting article about how the brain functions! We know it is impossible to read a client’s mind and advisers aren’t therapists, however this article looks at how we can help clients make better decision by understanding what goes on in the brain when people make up their minds.
The article points out that people actually have two brains! Yes, not two sides of one brain, two different ones!
Remember all that stuff about our brains’ two hemispheres; the “right brain” thought to be responsible for creativity, artistic ability, intuition and emotions and the “left brain,” which is thought to be responsible for logic and analytical thinking?
Well, apparently that is simplistic and inaccurate! New thinking is that tasks are not bilaterally segregated; in fact, some parts of the brain can fill in when others are damaged. It’s more true to say, as Daniel Kahneman posited in his 2011 bestseller, “Thinking Fast and Slow,” that people have two thought systems: a fast, instinctive and emotional brain (which he calls System 1), and a slower, more deliberative and more logical brain (System 2).
According to Kahneman, the more cautious and analytical System 2 is lazy and tires easily and therefore we often accept the quick and dirty assessments of the intuitive and largely unconscious System 1.
So what does that mean for financial planners? By nature and training, most financial planners are rational-mind-dominant types. They are often at home with facts and figures. However, clients on the other generally tend to be more emotional in their decision making. For them, money is rarely all about money. It’s often about very complex interactions between their goals, aspirations and relationships. Therefore, planners need to bear in mind their own dominant brain when guiding clients towards a decision! If you make the mistake of relying solely on rational arguments, you’re “missing what’s actually going on with people,”
Here are a few points to note about how client’s brain works;
- Although we think our rational brain is in charge, our emotional brain is more involved in decision-making than we realize.
- Adviser —especially those whose thinking is dominated by their rational mind—need to be aware that a client’s intuitive emotional mind is even more important in decision-making.
- Our rational, conscious brain is relatively slow and limited; it has the power of a £2 calculator! Unbeknownst to us, it often adopts the more impulsive decisions of our unconscious emotional brain.
- When the unconscious brain drives decisions, people who are not aware of this fact can make not-so-smart choices. However, it’s not desirable or even possible to eliminate emotion from the decision-making process.
- Biases such as loss aversion spring from past experiences or memories that are often unconscious. When they distort a client’s decision-making, they need to be examined on a conscious level to rid them of their power.
- Clients who are educated about their thought processes are less likely to make snap decisions.
- The challenge for an adviser is to bring clients’ rational (conscious) and emotional (unconscious) minds into alignment. So it’s vital to recognize their feelings, concerns and fears and create a zone of safety for them.
This article by Alan Dick CFP of FortyTwo Wealth examines the real value of financial planing, drawing on two recent studies; one in Germany and the other in the US.
The rise in DIY investors in recent times, even among larger size portfolios worth £1m- £10m, may suggest that investors are questioning the value of paying for advice.
A recent research conducted by researcher at Goethe University Frankfurt, which examined the actual trading accounts of 8,621 DIY investors found that 9 out of 10 investor exhibited “negative skill” which resulted in an underperformance of -8.5pa after trading costs. And where investors did outperform there was no evidence this was anything more than luck!
Dick also made a reference to a recent study by Morningstar which attempted to quantify the true value of comprehensive financial planning rather than simply measuring investment returns, which concluded that good financial planning strategies such as total wealth asset allocation created “added value” of 1.8% annually.
Dick suggested that a combination of good financial planning strategies and investment advice (presumably by stopping investors behaving badly) may created an added value of as much as 10.3%pa (8.5% + 1.8%). ‘Then again, perhaps Master Card would sum it up as; Investing money 1.5%, tax planning 0.5%, lifetime cashflow forecasting 1%, liability matching 1%, investment coaching 2%, the ability to enjoy your life and sleep at night – priceless!.’
I hope you have enjoyed this and hopefully it’ll make you job a little easier! As paraplanners, that’s what we do! As usual, thought and comments are welcome. Enjoy your weekend!