I remember a commercial that declared, “An informed customer is our best customer.”
 
The commercial offered no proof, no argument, and no evidence of the claim.
 
However, with respect to financial advisors, there now is proof, argument, and evidence. It is those facts with which I deal in this essay.
 
The facts come from research conducted by Olivia Mitchell of the University of Pennsylvania’s famed Wharton School, and two co-authors.[1]
 
The Claims
Here are the claims:
 

1. The smarter a person is, the more likely the person is to seek help from a professional financial advisor.
2. The more financially literate a person is, the more likely the person is to seek help from a professional financial advisor.
3. These same people are less likely to accept “free” advice that is accompanied by a conflict of interest.

However, there is a catch. The study also found that “those with higher cognitive function also tend to distrust financial advisors,” and are therefore less likely to seek the advice they need.

Why Cognitive Function is Important
Theoretically complex issues are endemic to financial life, regardless of the level of complexity of a person’s situation. For example, in addition to the complexities inherent in required government programs such as social security and medicare, a “mass affluent” client will likely face challenges such as income tax planning, provision for survivors, tuition finance (for children and/or grandchildren) and risk management. High net worth clients have the added complexities of the estate tax (possibly federal and state), and often income taxes as well.

As static problems, each of these issues is complex. (A static problem is one in which all the facts are given, and presumed known.) Static problems are complex enough on their own. But in the real world, most or much of the time we are dealing with a playing field on which the goal posts may move. For example, we all know (or can look up) what the current rules for social security are. But we also know that those rules are likely to change. And it is impossible to predict with precision what those changes will be, or when they will occur. Maybe congress will cut benefits, or restrict benefits, or further tax benefits, or change the eligibility requirements, or the eligibility age, or whatever else legislative aids concoct.

It is not hard to recognize that, everything else equal, a smarter person will be better able to grapple with the complexities and uncertainties of financial life.

Evidence
Olivia Mitchell and her colleagues measured this effect. Here’s one of the multivariate probit regression models they used:

Pr(Y_i = 1/X_i)=Φ(β₁ x Cognition_i + β₂ x FinLit_i + δ’X_i)
I’m just joking!

Not about the model (this really is the model they estimated). I’m joking by putting this equation in here. I don’t expect many of our thousands of readers to recall what a probit model is, or how it works, or why use it, or a dozen other issues implied in here.

In fact, this example of complexity is pretty much the point of this essay. Just as your clients rely on you to know about and understand the complexity in their financial lives, we, as practitioners, must rely on other experts (in this case professors who have the luxury of spending their days thinking about things like how to measure the role of intelligence) for much of what we need to know to do our jobs right.

Here’s a general explanation of the model. Don’t worry if you don’t follow all of this. There’s a lot of statistics/econometrics behind what they’re doing, and if you haven’t studied those subjects, this might just be a foreign language.

The left side is the probability that a person (the “i^th” person – don’t worry if you don’t follow) seeks professional financial advice. By definition, a probability must be between zero and one, inclusive. Because they are estimating a probability, they cannot use a linear regression.[2] Instead, they use a probit regression.

In an ideal world (ideal in an academic sense of a world that is easy to model accurately), it would be possible to predict who seeks professional financial advice by looking at certain facts about the person. The researchers hypothesize that those facts would be things like financial sophistication and intelligence.

The right hand side of the equation includes those two factors, plus a third term which, perforce, includes everything else. The Φ (the Greek letter phi) is the standard normal cumulative distribution with respect to the model variables. Again, just don’t worry about it if that is Greek to you. (After all, Φ is Greek!)

What They Found
Enough of what they did. What did they find?

They found that just about 1/3 of the 1168 people who participated in the study sought financial advice.

That means, of course, that 2/3s did not. Ironically, it is likely that those 2/3rds who didn’t seek advice need it at least as much as those who did seek it.

We want to know why people seek financial advice, why they don’t, and what we can do to help those who need it get it.

As mentioned above, the study found that smarter people are more likely to seek financial advice, and people with more financial literacy are also more likely to seek financial advice.

So What?
Intelligence
At first, it might seem like we cannot do anything about people’s intelligence. And strictly speaking, that is probably right. However, when it comes to affluent and high net worth prospects and clients, advisors can, and should, “do something.”

That “something” is to do everything possible to build client relationships with people who need help, as early as possible.

The unfortunate reason for “as early as possible” is that on average, people experience cognitive decline as they age. That’s a harsh statement, and as someone who is not getting any younger, I do not mean to cause any offense or upset. But on average it is true.

And it means that, on average, the earlier an advisor can get to a prospect, make the prospect a client, and build a relationship, the better for the client.

Financial Literacy
We can do a lot for people’s financial literacy. People can learn. And many advisors we talk to see their primary role as educating their clients.

“Do It For Your Future Self”
While none of us wants to believe that we will experience cognitive decline, we know that there is a risk. Forget for a second about prospects and clients. Think about yourself. As we think about ourselves, it is obvious that if we could, we would want to take action now to help protect our future selves.

If you knew for a fact that cognitive decline was in your future, you would work hard right now to make sure that you had in place competent, trustworthy people to handle your affairs for you. Or if they don’t fully handle the affairs, to at least advise you to help you handle them well.

This idea of what we would do for ourselves is an idea that, if we can communicate it to prospects, may help them to become clients right now.

While the prospect/client has 100% of his or her cognitive function, that is the time (i.e. now is the time – it’s never going to get any better) to start forming those trusted relationships. In the best case, the client will keep his or her full cognitive function for life. And in that case, there is still nothing lost, and everything gained, from taking advice from a competent and trustworthy advisor.

Offer
We have a number of free resources to help both advisors and clients learn about a variety of areas. For example, if you have clients, or prospects, who own a business, you might want a copy of our Advisor Guide: Selling a Business. We also have advisor guides for retirement plans, real estate, and concentrated stock positions. Please request your free copy here. Or call Connor Barth at 703 437 9720, or email him at [email protected].

You might also request a free copy of Chapter 14 – about the ways the professional financial advisors add value for clients — from our forthcoming book.

Request
Your feedback helps us provide you with content that is useful and valuable to you. If you have any reactions to this, positive, negative, or other, please feel free to email me directly with your comments at [email protected]. Or call me at 703 437 9720. I look forward to hearing from you.

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[1]How Cognitive Ability And Financial Literacy Shape The Demand For Financial Advice At Older Ages, Hugh Hoikwang Kim Raimond Maurer Olivia S. Mitchell, NBER Working Paper 25750.

[2] Technically, they could, and sometimes people do. But as the cumulative normal curve is not even approximately linear over most of the interesting portions, to do so would be to badly specify the model. Improperly specified linear models do have their uses, but this is not one of them. The choice of model specification is part art, and part science. It is also something that very few non-specialists would have enough knowledge to do well.