The Federal Reserve (or the Fed) is the central bank of the United States of America. It has a balance sheet of (now) almost $7 trillion dollars. The “governors” (like chairpersons) of the Federal Reserve often are a combination of bankers and economists. So why would such experts, when deciding that the Federal Reserve should buy corporate bond ETFs (exchange-traded funds), pay commissions to buy them when there are so many “free” brokers out there? The Fed paid $20,000 worth of commissions in its initial round of purchases, according to Investment News.
One answer? They were paying for advice.
As Jeff Benjamin writes in Investment News, “…the more detailed explanation behind the ETF trading commissions says something about the free trading offers that some financial advisers and investors might not be considering.”
In the case of the Federal Reserve, they needed to purchase $160 million worth of bond ETFs without revealing beforehand which specific ETFs they were buying and how much. Otherwise, other market participants could have purchased those ETFs first and driven up the price.
The “free” platforms for buying ETFs sell what is called the “order flow,” meaning they are paid to direct trades to certain large firms that buy and sell. That means “when the order flow is being sold, it can be harder to know what you’re paying or if you’re getting the best price.” The Fed may have wanted to avoid the risk of that happening here.
But on a deeper level, the Fed also needed the advice that comes from experts knowing how much to buy, when, and where (meaning from which parties) to reach that $160 million target. As a director of ETF and mutual fund research stated in Investment News, “Individual investors should avoid paying commissions on ETFs, because there are platforms available. But if you’re self-directed you’re not getting the benefit of advice. The Fed paid commissions because they are getting advice.”
Advice is key. While many of us may be an expert in our particular fields, most people are not simultaneously experts in their own business and in investing. Even the Federal Reserve and their expert economists were not simultaneously experts in how to trade $160 million worth of bond funds.
Individual investors without financial advice can make mistakes that are common to human nature. These are often called behavioral “biases” and we are all susceptible to them and least likely to recognize them in our own behavior. Having a trusted financial advisor to help mitigate these biases through expertise and a degree of separation (just like it helps to have someone edit a book who didn’t write it themselves) can be well worth “paying” for.
Four Common Biases
There are several common biases that individuals can have in investing and that a financial advisor should be trained to recognize and can help mitigate. We’ll focus on four of them today: confirmation bias, loss aversion, status quo bias, and regret aversion.
Confirmation bias is a cognitive (or “thinking”) bias. Once a person has an idea for an investment, it can be tempting to only absorb information that confirms or proves his or her original idea. Say you decide to purchase Tesla (TSLA) stock because you think the cars produced by the company have great long-term prospects. After the decision, you peruse some more information to decide if Tesla is a good investment. Confirmation bias makes it more likely that you will remember and consider facts that point out how good Tesla is while ignoring or dismissing facts that suggest Tesla might not be such a good idea.
Loss-aversion is an example of an emotional bias. Studies have shown that individual investors are tempted to take more risk to avoid losses than to procure gains. This is the opposite of how investing should work, as the very purpose of taking on risk is to obtain greater reward.
Yet individuals will often keep a stock that they know is not going to recover because they want to avoid “giving up” and selling it for a loss, while at the same time selling a stock that has gone up slightly because they are afraid to lose what gains they have made (thereby frequently missing out on higher returns).
Another common emotional bias is the status quo bias, where individuals are hesitant to take any action unless presented with a problem. As an example, let us imagine that a person has stock investments in Emerging Markets (China & India) at 60% and the United States at 40%. After a year, both are doing well.
A good financial advisor should be consistently monitoring these investments, deciding, well, what is going to happen next? Will recent potential conflict between China and India prove a risk to the investments? Will the United States economy recover from the coronavirus pandemic in a V-shape or a U-shape?
These are questions that we should ask even if nothing is going wrong in the portfolio. But the status quo bias means that many individuals, unless there is a problem, simply do nothing.
One last key bias is regret aversion. It’s an understandable one. Regret is a powerful and negative emotion, and we often are tempted to avoid making a decision that we might later regret. In both daily life and the investment process, however, this can cause us to avoid making important decisions.
A frequent example of regret aversion is when individuals refuse to invest in a stock market if stocks have gone up recently. People fear that they might be getting in “at the top” and that, if they do, they will regret not having waited. So they are tempted to do nothing.
Advice and Process
All of these behavioral biases can crop up when trying to “go it alone” with “free”, do-it-yourself investing. Yet a little advice can go a long way towards avoiding these pitfalls. A strong investment policy statements (IPS), crafted with the help of a financial advisor, lays out the goals, limitations, restrictions, and risk tolerance (how much risk you can take) for a portfolio. This can help mitigate risk aversion and regret aversion. Talking with your financial advisor about the importance of diversification and asset allocation can help with confirmation bias and status quo bias.
Everyone needs advice, particularly in areas where we don’t have expertise. And while “free” is tempting, we should also remember that trusted financial advice, like anything valuable, is worth paying for. If even the experts at the Federal Reserve can use some advice every once in a while and are willing to pay for it, individual investors should consider the importance of financial advice also.
Alex Urpí, CFA®