As investors panic over the prospect of another recession, advisors might consider whether their clients could benefit from signing a "Ulysses" contract.
Behavioral finance expert Shlomo Benartzi thinks advisors should make written agreements with clients to keep them from doing things they might regret in volatile markets.
While it is widely accepted that one should buy low and sell high, investors often do just the opposite. A commitment contract makes it easier to avoid getting carried away with one's emotions.
Just as Ulysses had his crew tie him down so he could resist the Sirens' deadly song, Benartzi would have investors promise, in writing, not to overreact to sharp market moves in either direction.
These agreements would help advisors do a better job, Benartzi argues. Data from the online discount brokerage TD Ameritrade Holding Corp. shows that its custody platform customers — independent, fee-only fiduciaries with discretion over clients' investments — tend to follow the herd.
When the S&P 500 was at its all-time high in October 2007, these advisors had only 26% of their clients' money in conservative holdings like cash and fixed income.
By early March 2009, with the S&P 500 at a 13-year low, they had nearly doubled their load of low-risk holdings, to 51%.
The data shows the advisors were following trends instead of maintaining all-weather portfolios.
Such tendencies can be costly because market changes, especially those to the downside, are apt to come suddenly and hit hard.
Benartzi hasn't tested his idea, and he doesn't know any advisors who have. But the concept makes sense to John Longo, chief investment officer for MDE Group, registered investment advisor with about $1.3 billion under management. Longo's firm makes similar agreements with its clients as part of their investment policy statements, not in separate documents.
"In our view it's important to have an investment policy, one that includes risk tolerance, and stick to it," Longo says. "It's about taking Warren Buffett's advice to be 'fearful when others are greedy and greedy when others are fearful.'"
That said, MDE doesn't accept investors' first-blush assessment of their appetite for risk. If a client says he can tolerate a 15% drop in his portfolio's value before repositioning, Longo will suggest that he commit to a portfolio review before things get to that stage.
"We suggest that they be a bit more conservative because people often overstate their risk tolerance," he says.
Allan Roth, who often writes about behavioral finance, likes the strategy, but he doesn't see the need for a written contract. The owner of Wealth Logic LLC, an hourly fee registered investment advisor, Roth advises on about $1 billion in private-client assets without assuming discretion over the money.
Roth thinks documenting risk tolerance is window dressing. "These are essentially contracts between investors and their money: you can't hold them to it," he laughs. "What I say is, 'If you don't take my advice, I'll guilt you to death.' "
