5 Basic Finance Lessons Many Clients (and Some Advisors) Forgot This Year
What You Need to Know
The value of financial advice is often greatest when markets are rockiest.
Advisors must ensure clients don’t forget the basics of taking risk and seeking reward in the markets.
Healthy skepticism and a long-term perspective are essential for client success.
The American College of Financial Services published a new podcast this week featuring Michael Finke, a senior leader at the college who directs the wealth management certified professional designation program, and David Blanchett, managing director and head of retirement research at Prudential Financial’s asset management business, PGIM.
During the discussion, Finke and Blanchett spotlighted the market challenges investors have experienced in 2022, with a particular focus on what they called the “spectacular decline” in the value of cryptocurrencies and related digital assets.
According to Finke and Blanchett, the crypto losses and the broader client pain suffered during 2022 offer some key lessons for financial advisors to carry into the next year. The pair emphasized how advisors must work hard to remind their clients that there is no free lunch in investing — and to combat their own feelings of “FOMO” when exciting new investment opportunities appear that seem too good to be true.
In the conversation highlights presented below, Blanchett and Finke offer up five basic finance lessons that clients (and many advisors) seem to have forgotten this year.
1. Hindsight Remains 20/20
As Blanchett pointed out, individuals are really good at spotting what they perceive to be attractive investments — but only after they go up and much of the potential profit has already been reaped by others. As it is commonly put, investors are prone to chase past performance and buy assets only after they have appreciated in value.
This hindsight bias applies to traditional assets, Blanchett said, but especially to new and emerging assets and specifically to cryptocurrencies. Prior to this year’s meltdown, investors of all stripes, from the most sophisticated to the most novice, were simply dazzled by the meteoric rise of the value of cryptocurrencies. They could not help but buy into the hype generated by celebrity endorsements and Super Bowl ads.
As Blanchett noted, many investors probably did feel some degree of uneasiness with respect to piling into cryptocurrencies that were hovering at or near record highs, but they couldn’t help chasing the possibility of magical returns.
2. Reward Only Comes From Taking Risk
“Another related lesson learned this year that will be carried into next year is the simple fact that, if you are trying to make a return above and beyond what is reasonable, you are going to be taking excessive risk in the attempt to accomplish that outcome,” Blanchett said.
As Finke and Blanchett pointed out, a huge amount of wealth has been destroyed in 2022 simply because people forgot the basic mantra of investing and life: If an opportunity seems too good to be true, it probably is.
“That’s true about crypto-type assets and also about any other asset type, for that matter,” Blanchett said. “This type of magical thinking has happened before, sadly, and it will happen again. What we have been reminded of is that opportunities for an outsized return are only possible because you are taking excess risk and because you could lose much more than you might anticipate.”
3. No Free Lunch Means No Free Lunch
Finke said that prior to the crypto crash, it was all too common to hear investors say they had found a no-risk investment opportunity that would deliver returns in the realm of 9% or 10% — for example, by investing funds in the FTX or Celsius platforms.
“When you hear something like this, your first thought should be, wait a minute: There is no free lunch in investing,” Finke said. “Another point to make is a little more subtle. You have to ask yourself, well, if this really were a true risk-free opportunity, what is stopping people from borrowing Treasurys and putting all their money in Celsius or FTX as an arbitrage opportunity?”
As Finke explains, such an investor could reliably pay back the 2% or 3% interest on the Treasurys while they are at the same time enjoying a 9% return. In other words, they could enjoy a free lunch!
“That is what we would think of as a classic arbitrage opportunity,” Finke said. “As such, there are plenty of sophisticated hedge funds and other sophisticated actors out there in the market who would have done this — but they wanted nothing to do with this approach. Why? Because they understood that you have to be taking risk in order to be compensated for risk.”
