Category Archives: Wealth Volatililty

Zeta: Measuring the Value of Financial Planning

The field of financial planning has grown exponentially in the last 15 years based on the premise that a person can expect better financial outcomes by hiring a financial planner. Is this assumption, in fact, true? Surprisingly, very little research has been focused on answering this question—until recently.

Researchers working in the Financial Planning Performance Lab are focused on answering the following question: “What is the ultimate purpose and value of financial planning?” This question is at the core of all research efforts at the Lab. This lead Drs. Grable and Chatterjee to develop a measure of financial planning value called Zeta.

Zeta is a measure of the relative volatility of wealth at the household level. Some might wonder how measuring wealth volatility is relevant in the context of determining the ultimate purpose and value of financial planning.

In the past, Alpha was the primary tool investment managers used to measure the value of their advice. Alpha captures how much an investment has outperformed a comparable investment, such as a benchmark index. Investors expect higher potential returns when a portfolio is exposed to greater risk and uncertainty. They also expect two investments with similar levels of risk to provide similar levels of return. Some of the excess in the expected performance of a portfolio can be attributed to the skill of the investment manager.

The problem, of course, is that few investment managers actually outperform relevant indexes. Most underperform. Using alpha and similar portfolio measures, it would appear that the value of financial advice is lacking. However, is this actually correct? The reality is that comprehensive financial planners do much more than manage client portfolios. Among other things, financial planners provide recommendations related to cash flow, tax-efficiency, insurance, estate, and retirement planning. Researchers working at Morningstar (Blanchett and Kaplan) noted that alpha fails to account for the value of this type of advice. They developed a measure called gamma to estimate how much value these types of planning activities create. Although the development of this measure took a great step toward discovering how much value professionals create by following the financial planning process, gamma, as originally conceptualized, did not take into account the value created by wealth management skills provided by most financial planners.

Zeta was developed as a more comprehensive measure of well-being by combing the best of alpha and gamma. At its core, Zeta shows that financial planners create value by reducing wealth volatility (risk) in times of financial stress such as the Great Recession. Rather than measure portfolio returns or gains from topic specific recommendations, Zeta attempts to estimate value created by minimizing the change (volatility) in total wealth over time.

Based on data from the Great Recession, it was determined that people who met with a financial advisor accumulated more wealth with less wealth volatility. This was true holding other relevant factors constant. Clients of financial planners exhibited 6.25% greater performance on a risk-adjusted basis than people who did not meet with a financial advisor.

While there is certainly more work to be done, initial results do suggest that financial planners are helping their clients in meaningful ways. Lab studies demonstrate that financial planning creates better financial outcomes through a combination of financial planning advice and skilled investment management.

Fantastic Morningstar Paper Just Published

A very important strategic planning article was just published in Morningstar Magazine. It is worth reading. The paper’s author—Hal Ratner—lays out what he and Morningstar are calling Total Wealth, which is a move to quantify a household’s total assets and liabilities. With this information, Morningstar hopes to develop strategies that will provide financial planners (and consumers) with tools to help clients maximize the “probability of meeting a set of consumption goals at some level of risk preference and futurity preference” (p. 52).

Essentially, Morningstar is advocating a position long held by faculty teaching financial planning at the University of Georgia; namely, financial planners add value by helping clients manage their entire “portfolio” rather than a single aspect of wealth. Total wealth—using Morningstar’s definition—includes financial capital, human capital, housing wealth, and pension wealth.

Those working in the Financial Planning Performance Lab would add other forms of wealth to the equation, including business wealth, collectibles, hobby assets, and use assets. All of this may sound familiar to those following the development of zeta. Zeta is a measurement of financial planner value. Zeta can be used to assess how well a financial planner helps his or her clients manage the volatility of total household wealth.

It is quite exciting to see how quickly the financial planning landscape is changing and evolving. If you get a chance, read: “A New Chapter in Investing: The Total Wealth Framework Considers an Investor’s Financial Life” in Morningstar Magazine, February/March 2015, pp. 52-54.

Latest Zeta Paper Posted

The latest paper on zeta from the Financial Planning Performance Lab is now posted on SSRN:

The intention of this study was to document how closely households follow normative descriptions of financial behavior in relation to their financial planning horizon. Modern Portfolio Theory predicts that households, in general, exhibit risk aversion. Aversion to wealth volatility should correspondingly be highest among those households with the shortest planning horizons. This study estimated percentage changes in wealth and wealth volatility over time categorized by financial planning horizon using data from the 2002 through 2010 waves of Health and Retirement Study. Modigliani ratios were computed for the entire population and by planning horizon. Zeta estimates were made by calculating the difference between the Modigliani ratios for each planning horizon and the ratio for the short-term horizon. Contrary to the conceptualized relationship between planning horizon and financial wealth volatility, results from this study show that respondents with the shortest financial planning horizons experienced lower risk-adjusted returns and greater wealth volatility. The findings of this study underscore an unmet and perhaps unrealized need for professionally provided financial planning.