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Behavioral Finance and Fiduciary Discipline

Wednesday, October 12, 2016 Eastern Time

2:00 p.m.–3:30 p.m. Central Time

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American Bankers Association Behavioral Finance and Fiduciary Discipline Wednesday, October 12, 2016 ▪ 2:00 p.m. – 3:30 p.m. ET

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II

Table of Contents

TABLE OF CONTENTS ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . II

SPEAKER & ABA STAFF LISTING ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . III

SPEAKER BIOGRAPHY ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . IV

PROGRAM OUTLINE ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . V

CONTINUING EDUCATION CREDITS INFORMATION ... . . . . . . . . . . . . . . . . . . . . . . . . VI

CPA SIGN-IN/SIGN-OUT SHEET ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . VII

INSTRUCTIONS FOR RECEIVING CERTIFICATES OF COMPLETION .. VIII

CFP INSTRUCTIONS AND SIGN-IN SHEET ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . IX

PROGRAM INFORMATION ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ENCLOSED

PLEASE READ ALL ENCLOSED MATERIAL PRIOR TO BRIEFING. THANK YOU.

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III

Speaker and ABA Staff Listing

Speaker Ronald M. Florance, CFA Advisory Board Member Robertson Stephens Advisors RMF Consulting, LLC Scottsdale, AZ 85018 LinkedIn@Ron Florance

ABA Briefing Staff Cari Hearn Senior Manager (202) 663-5393 [email protected] Linda M. Shepard Senior Manager (202) 663-5499 [email protected]

American Bankers Association 1120 Connecticut Avenue, NW Washington, DC 20036 www.aba.com

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IV

Speaker Biography

RONALD M. FLORANCE, CFA Ron Florance is a private investment consultant and financial educator with over 30 years of experience in the investment field. Ron is the founder of RMF Consulting LLC., and he is the Senior Strategic Advisor and member of the Advisory Board of Robertson Stephens. He retired from Wells Fargo where he was the Deputy Chief Investment Officer for Wealth Management. At Wells Fargo, Ron was responsible for developing key investment strategy guidance for high-net-worth individuals, families and philanthropic entities. His prior corporate experience included roles at The Vanguard Group, Wells Fargo Nikko Investment Advisors, and The Private Bank at Bank of America. Ron’s expertise includes Global Asset Allocation, Equity Research, Fixed Income Research and portfolio design and management. He earned his Bachelor of Science degree in Applied Mathematics and Economics from Brown University and was awarded a Chartered Financial Analyst designation in 1995. Ron is a frequent speaker at industry conferences and is quoted nationally and internationally both in print and broadcast media. Ron meets with individuals, foundations, and endowments to evaluate investment needs and strategies.


V

Program Outline

TIMES SESSION & SPEAKERS 2:00 – 2:03 p.m. ET

Introduction Overview of Program, Welcome Introduction of Speakers

1Source International

2:03 – 2:20 p.m.

The Academic Approach

Ron Florance, CFA

2:20 – 2:35 p.m.

The Investor Realities

2:35 – 2:40 p.m.

Questions and Answers

2:40 – 2:50 p.m.

Balancing Fiduciary and Behavioral concepts

2:50 – 2:55 p.m.


2:55 – 3:20 p.m.

Review of 2016 Forecasts and Themes

3:20 – 3:30 p.m.

Questions & Answers, Wrap-up


VI

Continuing Education Credits Information

The Institute of Certified Bankers™ (ICB) is dedicated to promoting the highest standards of performance and ethics within the financial services industry.

The ABA Briefing, “Behavioral Finance and Fiduciary Discipline” has been approved for 2.0

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VII

CPA Required Sign-in/Sign-out Sheet

CPAs may receive up to 1.5 hours of Continuing Professional Education (CPE) credit for participating in this group-live Briefing.

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VIII

Instructions for Receiving Certificates of Completion

CPA/CPE Certificate of Completion

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IX

ATTENTION: PROCESS FOR CFPs

Certified Financial Planner Sign-In Sheet Program ID #: 223989

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10/6/2016

1

Behavioral Finance & Fiduciary Discipline

Ron Florance, CFA

RMF Consulting, LLC

Robertson Stephen Advisory Board member

ABA Briefing/WebinarOctober 12, 20162:00 – 3:30 p.m.

aba.com 1-800-BANKERS

Disclaimer

This Briefing will be recorded with permission and isfurnished for informational use only. Neither the speakers,contributors nor ABA is engaged in rendering legal norother expert professional services, for which outsidecompetent professionals should be sought.

All statements and opinions contained herein are the soleopinion of the speakers and subject to change withoutnotice. Receipt of this information constitutes youracceptance of these terms and conditions.

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Today’s Agenda

The Academic ApproachThe Investor RealitiesBalancing Fiduciary and Behavioral conceptsReview of 2016 Forecasts and Themes

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The Academic Approach

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The Theoretical Investor

• All investors are risk adverse

• Risk must be rewarded

• Reward comes in the form of return

• Maximize return for each level of risk

5

The History of Modern Portfolio Theory

• Market Efficiency

– Random Walk:

•Prices between intervals are unrelated, hence unpredictable

– True Value:

•Prices reflect all information as consensus of all market participants

• No opportunity to systematically exploit market inefficiencies

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The Efficient Markets Hypothesis

• Because market prices are set by the interactions of many knowledgeable players, prices are fair and are based on the fundamental investment attributes of each company.

• Since by definition nobody knows new information that has not yet been made public (except insiders, who are not supposed to trade on that information), it is impossible for anyone to have an information edge that consistently beats “the market”.

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The Efficient Frontier

The “Optimal Portfolios”

Risk

Reward

Sample Optimal Portfolio

Sample Client Portfolio

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• Indifference curves

• Equal Utility of Return Compensating Risk

What Makes Investors Happy?

I1

I3

I2

Risk

Reward

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• Optimal Portfolio

• On Efficient Frontier

• On Highest Indifference Curve That is Tangent to Efficient Frontier

How Does This All Work?

I1

I3

I2

Risk

Rewardefficient frontier

Optimal Portfolio

CAPM Line

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Real Life vs. Academic Finance Theory

• Real investors are not rational all the time• Real investors are not always risk-averse• Real investors do not always have the same

return expectations• There are taxes and other costs associated with

investing—and real investors have reactions to those costs

• Real investors generally do not define risk as variability—they define it as loss

• Real investors do not have an infinite time horizon • Interim returns—not just long-term returns—matter to

real investors

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What is Reward to an Investor?

• Total Return

• Cash flow

• Net Worth goal – have at least $1 million

• Paying as little tax as possible – minimizing taxes vs. maximizing wealth

• Doing better than my neighbor

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How Does Your Client Define Risk?

• Risk of losing money—Downside Risk

• Risk of under performing benchmark—Benchmark Risk

• Risk of not achieving wealth goal—Wealth Risk

• Risk of unpredictability—Volatility Risk, Uncertainty

• Risk that “it is all coming to an end”

• Something else that we don’t anticipate

“Clients are loss averse rather than risk averse”

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Investor Realities

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Press *1 on your Telephone Keypad

15

How do you feel about money?

FEAR VS. GREED

SCARED

GUILTY

IN CONTROL

ASHAMEDSTUPID

WORRIEDTAKEN

CARE OF

PUMPED

NEVER THINK

ABOUT IT

EXPERT

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How do you feel about the market?

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What is Behavioral Finance?

Behavioral finance is the study of how psychology affects financial behavior.

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The Basic Problem

The basic problem is that investors want to trust their intuition instead of focusing on

critical thinking.

This problem manifests itself when the client is forced to make a decision such as when, where,

or how much to invest. Stress causes even worse decisions.

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Intuition vs. Critical Thinking

● An investor looking at this chart may go with his or her gut (intuition) and say that he or she only wants large and small cap stocks because the returns on international stocks are too low

● However, a little critical thinking and investigation would show that in some periods international does better and always diversifies!

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NET WORTH SELF-WORTH

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Task of Advisors

● The task of advisors is to…..– Focus on CRITICAL THINKING

– Help investors understand the pitfalls of relying on INTUITION

– Recognize situations where investors are likely to make significant errors due to intuition

● To be successful, advisors must understand client behavior!

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Risk and Risk Aversion

EXAMPLE ONE:

You have a choice between a 100% chance at $90,000 ora 10% chance at $0 and a 90% chance at $100,000.

Which would you take?

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EXAMPLE ONE:

Given a choice between a 100% chance at $90,000 ora 10% chance at $0 and a 90% chance at $100,000studies have shown that most investors will take thesure bet even though, statistically speaking, theexpected returns are the same under both scenarios.

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EXAMPLE TWO:

You have a choice between a 100% chance at losing $90,000 ora 10% chance of losing $0 and a 90% chanceof losing $100,000.

Which would you take?

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EXAMPLE TWO: Given a choice between a 100% chance at losing$90,000 or a 10% chance of losing $0 and a 90% chanceof losing $100,000 studies have shown that mostinvestors will now choose the latter.

Why? When it comes to losing, clients will (unknowingly) pursue risky behavior to avoid loss.

Both expected returns are the same, but the latter has more risk because of the variability of outcomes.

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Biases and Investment Behavior

• Heuristics-driven biases– Practical methodology

– May not be “optimal”, but is “sufficient”

– Trial and error

• Frame-dependence biases– Not all realities look the same depending on

where you are

– Theory of relativity

– Historical perspective

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Heuristics-driven Biases

• Availability bias– If more information is available, it must be a good

thing

– Home country bias

• Gambler’s fallacy– Finding patterns where none exist

– Tossing a coin and getting 10 heads in a row, what’s next?

• Overconfidence and expert judgment– Confusing “smarter than” with “luckier than”

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Heuristics-driven Biases

• Anchoring– First piece of information is the most important

– Setting levels of return expectations

– “when I get back to even, then I will….”

• Aversion to ambiguity– Prefer known over unknown

– Known loss over unknown gain

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Frame-dependence Biases

• Loss aversion– Preference to avoid loss over

acquiring gain

– The pain of losing a dollar is greater then the joy of making one

• Mental accounting– Buckets of money for purposes

– Source of wealth, found, earned, inherited

– Type of currency, cash, casino chips, credit card

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Frame-dependence Biases

• Money illusion– Real vs. nominal view of money

– Purchasing power

– A million dollars

– $3.99 vs. $4.00

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Behavioral Finance Cheat Sheet

Source: Scott Welch, Unconsrainedthought.com, Dynasty Financil Partners

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Balancing Fiduciary and Behavioral Concepts

33






OR


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Fiduciary Responsibility

Individual savers are even less likely than trustees to make sensible investment decisions. They tend to be motivated by greed and fear, which the fund-management industry plays on. Because its customers have a limited understanding of financial products, the industry has always faced a dilemma. Should it sell people what they think they want, or should it offer them the conservative investments that may be more appropriate for their future needs?

From the Economist – “A Survey of Asset Management”

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Ethical Standard for Financial Services

• Suitability Standard Regulator: FINRA, Financial Industry Regulatory Authority

Regulated: Broker-Dealers

Reasonably believe that any recommendations made are suitable for clients

• Fiduciary Standard Regulator: SEC, Security and Exchange Commission, or State Regulators

Regulated: Investment Advisors, RIA’s

Must act in the best interest of his or her client

Source: Investopedia, 2015

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Suitability Standard

• Know your customer– customer’s financial status– customer’s tax status– customer’s investment objectives– other information used or considered to be reasonable by such

member or registered representative in making recommendations to the customer

• Know the security– Risks– Fees– Tax

The investment is appropriate in terms of an investor's willingness and ability (personal circumstances) to take on a certain level of risk.

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Suitability Standard

• Broker can place his or her interests above that of the client

• Broker's duty is to the broker-dealer he or she works for, not necessarily the client served

• The need to disclose potential conflicts of interest is not as strict a requirement

• Examples

– Index fund

– Annuity

– Robo Advisor

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Fiduciary Standard

• Know your customer– customer’s financial status– customer’s tax status– customer’s investment objectives– other information used or considered to be reasonable by such

member or registered representative in making recommendations to the customer

• Know the security– Risks– Fees– Tax

The Fiduciary Standard requires that advisors put their client's interests above their own

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Fiduciary Standard

• Must choose MOST appropriate/suitable investment

• Must disclose conflict of interest

• Cannot buy securities for his or her account prior to buying them for a client

• Prohibited from making trades that may result in higher commissions for the advisor or the investment firm

• Examples

– Proprietary products

– Dealer transactions

– Hitting sales targets

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Ethical Standard for Financial Services

• “We must treat others as we wish others to treat us”

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Not Traditional Asset Allocation

Volatility10%

Growth25%

Inflation15%

Liquidity15%

Income25%

Catastrophe10%

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Helps to provide asset growth for future financial needs

50% Global Equity

Growth Segment

Silver 5%

Technology Sector 10%

Biotech Sector 10%

Frontier Markets 5%

High Yield Bonds 20%

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Helps to maintain cash flow for lifestyle expenses

30% Investment Grade Bonds

Income Segment

15% High Yield Bonds

Dividend Equity 30%

REIT’s 10%

10% Non-US Bonds

Utilities 5%

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Helps to maintain liquidity for opportunistic investments


Liquidity Segment

15% Developed Mkts Bonds

Large Cap Equity 35%

Developed Mkts Equity 15%10% Short Term Bonds

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Helps to protect against the corrosive impact of inflation

15% Short-Intermediate Bonds

Inflation Segment

25% TIPSREIT’s 5%

Commodities 20%

30% Domestic Equity

Gold 5%

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Helps to maintain portfolio value during heighten market volatility

10% Short Term Bonds

Volatility Segment


Target Date Funds 25%

Min Vol Strategy 30%

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Helps to maintain value and liquidity in market disruptions

30% Ultra Short Term Bonds

Catastrophe Segment


Gold 20%

Silver 15%

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Liquidity Keeps You on Track1

Balancing Behavioral and Fiduciary

Match time horizons with investments2

Manage risk beyond volatility4

Rebalancing makes Asset Allocation work5

Aim for consistent returns3

It’s a big world6

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Liquidity keeps you on track

Adequate liquidity keeps your investment plan on track and provides flexibility.

Source: “The Life of John Maynard Keynes”, R.F. Harrod, 1951

1

“The market can stay irrational longer than you can stay solvent.”

~ John Maynard Keynes

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Match time horizon with investments

Uncertainty about returns generally diminishes over time.2

51

Aim for Consistent Returns

$700,000

$800,000

$900,000

$1,000,000

$1,100,000

$1,200,000

$1,300,000

$1,400,000

$1,500,000

Initial Value Year 1 Year 2 Year 3

Portfolio A

Portfolio B

Portfolio C

Volatility does matter in the long run.Performance of Three Hypothetical Portfolios

3

Portfolio A Portfolio B Portfolio C

Year 1 10% 5% 20%

Year 2 10% -25% 20%

Year 3 10% 50% -10%

Total Arithmetic Return 30% 30% 30%

Ending Value $1,331,000 $1,181,250 $1,296,000

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Manage Risk Beyond Volatility

Goals based risk perspectives:4

Risk of losing money Risk of not having enough money

Risk of missing outRisk of personal/familysecurity

53

Rebalancing makes Asset Allocation work

5 Not rebalancing can cost a portfolio dearly.

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Are you invested by geography or demography.

IT’S A BIG WORLD

6

Each color represents 1 billion people

Are you invested by geography or demography.6

IT’S A BIG WORLD

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2106 FORECASTS AND THEMES

DOMESTIC EQUITIES

• 2016 has been a bumpy ride

Source: Bloomberg

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INTERNATIONAL EQUITIES

• Seeing improvement, even in parts of Europe

Source: Bloomberg

INTEREST RATES

• Aren’t they suppose to be going up?

Source: US Department of the Treasury

10/6/2016

31

COMMODITIES

• Continue to struggle, not helping inflation

Source: Bloomberg

US DOLLAR

• Stabilizing in second half of year

Source: FX Street

10/6/2016

32

2016 FORECASTS

Low expectation can lead to positive surprises…

Federal Reserve makes 2 interest hikes in 2016 to 0.75%Long end of the curve won’t behave.

US Dollar stabilizesHelps US multinationals and commodities

US GDP growth doesn’t surprise anybodyGlobal GDP growth does surprise to the upside, but not from China

US Equity earnings growth: 5.5%You’ll be happy with that as a total return

Volatility across all asset classes will continueActive rebalancing will be the key to successful asset allocation

2016 POLITICS

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2016 THEMES

Interest rates rising by 50bp1

The US economy will survive rate hikes, barely2

Election will be interesting, but not impact markets3

Energy prices will stabilize near $40, but painfully4

The US dollar holds steady5

The Environment takes center stage6






OR


66

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inflation adjustments to the amounts Installment sales GRATs Use of limited partnerships and LLCs as family

investment vehicles Partnership and LLC freezes Portability Planning versus A / B planning at the first

spouse’s death Split interest charitable gifts Loans

Trustee Liability for Investments – A Review of the Current State of the Prudent Investor Rule; Delegation; and Direction – April 6, 2017 2.5 CTFA (INV); 2.0 CPEs for CPAs (Regulatory Ethics) One of the most significant areas of potential fiduciary liability will be discussed in this session. The fiduciary standards applicable to trustees regarding investments and the ability to avoid liability by serving a more limited role will be the focus of this briefing. Prudent Investor Rule Diversification Waiver of Diversification Passive versus active management Delegation of investment responsibility The do’s and don’ts of being a directed trustee Trust protectors and trust directors Fiduciary Litigation Roundtable – May 4, 2017 2.5 CTFA (FID); 2.5 CRSP; 2.0 CPEs for CPAs (Business Law) A panel of attorneys will discuss current trends in trust disputes and fiduciary litigation, and steps for minimizing a trustee’s exposure to liability. Topics will include: Defenses and limitations Trustee compensation Jurisdiction and standing Construction and modification Trust distributions Settlements and arbitration Trust investments Power of attorney Planning in Illiquid Estates – June 1, 2017 2.5 CTFA (FP); 2.5 CISP; 2.5 CRSP; 2.0 CPEs for CPAs (Taxes) An estate with a large interest in closely-held business or other illiquid asset provides numerous challenges from a planning and tax payment standpoint. This briefing will review the pre-death and post-death planning options available to help avoid a crisis. Topics to be covered include:

Closely held assets and illiquidity Impact of limits on valuation discounts Lifetime planning to fund estate tax payments Deferral of payment of estate tax Post-death loan options Section 303 stock redemptions Funding marital and charitable trusts with

illiquid assets Charitable issues

Retirement Benefits – September 7, 2017 2.5 CTFA (FP); 2.5 CISP; 2.5 CRSP; 2.0 CPEs for CPAs (Taxes) The often complex rules for payments of benefits from tax advantaged accounts, and planning options available will be reviewed during this session. Minimum distributions Payments elections after participant’s death Corrective actions after participant’s death Trusts as beneficiaries Qualifying for the marital deduction Advantages and disadvantages of different beneficiaries Inherited IRAs Gifts to charity A New Look at Distribution Standards – October 5, 2017 2.5 CTFA (FP); 2.5 CISP; 2.5 CRSP; 2.0 CPEs for CPAs (Admin. Practice) Both trustees and beneficiaries struggle with applying the distributions standards that exist in documents. Our speakers will discuss the current law on distributions and the tax implications of standards. Topics to be included: Different distribution standards and what do they mean Tax consequences of distribution standards Ascertainable versus non-ascertainable standards Case studies of distribution standards

Planning for the Elderly. What Can and Should Be Done for an Increasingly Aging Population – November 2, 2017 2.5 CTFA (FP); 2.0 CPEs for CPAs (Behavioral Ethics) This session will provide a fresh look at the challenges of planning for and protecting elderly clients. Topics will include: Increasing importance of planning for elderly Avoiding abuse of elderly How to recognize undue influence Use of power of attorney and medical directives Importance of revocable trusts Planning when the client is incompetent Medicare and Medicaid planning Social Security planning Recent Developments in Estate and Trust Administration – December 7, 2017 2.5 CTFA (TAX); 2.5 CISP; 2.5 CRSP; 2.0 CPEs for CPAs (Taxes) A review of recent legislation, regulatory developments, cases and rulings in the estate, gift, generation-skipping tax,

fiduciary income tax, and charitable giving areas will be provided. Some of the subjects to be discussed include: Legislative and regulatory developments Gifts Valuation including the 2704 regulations Generation-skipping planning Life insurance, including split-dollar plans Charitable planning Tax Liens State Death Taxes

Who Should Attend? Trust Officers Estate Planners Trust Counsel Trust Dept. Managers Wealth Managers

Private Bankers Trust Tax Professionals Financial Planners CTFAs, CISPs, CRSPs,

CPAs and CFPs

Registration/Site License Fee PER Briefing Purchased ABA/ICB Member/Service Member: $265

Non-Member: $395

These ABA Briefings include streaming audio over the Internet, where an unlimited number of listeners can participate at one location. Audio over the telephone can be provided as an alternative. Any transmission, retransmission or publishing of these briefings is strictly prohibited. Register Today! Register online at www.aba.com/trustbriefings or call 1-800-BANKERS (1-800-226-5377).

Need Continuing Education Credits? The Institute of Certified Bankers (ICB) has approved each of the 2017 programs listed for a variety of continuing education credits. These programs have also been approved for CPE credits for CPAs. This information is printed after the title of the program. In addition, these programs are being reviewed for Certified Financial Planners (CFP) Board continuing education credits.

Questions? Contact Linda Shepard at [email protected]. Or, call 1-800-BANKERS (1-800-226-5377).

American Bankers Association is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional educational on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: learningmarket.org.

http://www.aba.com/trustbriefings


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