A Short Guide for Financial Advisors in Helping their Client’s to Better Understand Common Flaws in Behavioral Investing
1. A Short Guide for
Financial Advisors in
Helping their Client’s
to Better Understand
Common Flaws in
Behavioral Investing
Written by: James Orth
2. A Short Guide for Financial Advisors in Helping their Client’s to Better
Understand Common Flaws in Behavioral Investing
Table of Contents
.....................................................................................................................................................................1
Table of Contents........................................................................................................................................2
Introduction.................................................................................................................................................3
First of all What is Behavioral Finance and Behavioral Investing?...............................................................3
What we Know so far From Advisors’ Experience....................................................................................4
Our “Old” way of Thinking?.........................................................................................................................4
What one of the Best Investor in Modern History has to say About Investing........................................5
Prepare, Plan, and Pre-Commit to a Strategy..............................................................................................5
Why it is Painful for you and your Clients to go Against the Crowd?...........................................................6
Re-Investing When Terrified........................................................................................................................7
Why Being Overly Optimistic is Probably a Bad Thing?...............................................................................8
Overconfidence kills an Investor’s Portfolio?..............................................................................................8
Why Does Anyone Listen to Cramer and the Other so Called “Experts?”....................................................9
Forecasts and how This Leads to Anchoring..............................................................................................10
Uncovering Critical Information from the Cloud of Noise..........................................................................10
How to Overcome your Client’s Views on Sunk Costs and Being Loss Averse...........................................11
Beating the “Status Quo” and the “Endowment” Effect............................................................................12
While you Cannot Control Everything as an Advisor, you can Control the Process of Recommending
Investments to Clients...............................................................................................................................12
Final Words................................................................................................................................................13
Resources..................................................................................................................................................14
A Little bit about your Author of this Article..............................................................................................14
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Introduction
To help understand the psychological behavior of people we will need the help from
James Montier and his book titled The Little Book of Behavioral Investing: How not to be your
own worst enemy. James (I will refer to Mr. Montier by his first name, not to be confused by the
author of this article) currently works with GMO, a global investment management firm
committed to providing sophisticated clients with superior asset management solutions and
services. James gives details into behavioral finance using similar case studies to show
similarities of common biases that also exist when investing. The book references those that
are starting out in investing and those that consider themselves professionals and gives insight
into the often-overlooked aspect of our investment decisions, our self. James also goes on to
reveal some of the most common psychological barriers showing how emotion,
overconfidence, and numerous other biases lead us to making poor investment decisions.
This guide also use articles from the websites of Think Advisor, Adhesion Wealth,
Investopedia, and other example articles have written articles on this important topic for
Financial Advisors. These articles explain how advisors should know their clients innate
tendencies towards investing so that they can maximize their clients returns on their portfolios
while providing confidence that the Financial Advisor has a plan in place for better or for worse.
First of all What is Behavioral Finance and Behavioral
Investing?
Many Advisors have heard of the Efficient Market Hypothesis (EMH) where the theory
assumes, for the most part, that investors behave rationally and predictably. However, there
are times that anomalies in the markets cannot be based on rational behaviors. Investopedia
explains that “the most rudimentary assumptions that conventional economics and finance
makes is that people are rational wealth maximizers who seek to increase their own well-
being.” This explains that there should not be other factors that influence how people make
economic choices.
One irrational decision is those that purchase lottery tickets, with the chance of winning
being “roughly 1 in 146 million, or 0.0000006849%, for the famous Powerball jackpot”
(Investopedia). Yet people still contribute despite the odds not being in their favor.
“That on average IPO’s underperform the benchmark by 21% three years on
because they’re born on excitement. They’re born in irrational exuberance, and
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people tend to do IPOs, of course as we all know, when the market is relatively
elevated or there’s a lot of popular sentiment” (Think Advisor 10).”
Behavioral Finance/Investing can be best explained by academics such as James Montier
who look to psychology to account for the irrational and illogical behaviors which cannot be
explained through the traditional approach from a theory such as EMH, which assumes ever
investor is rational.
What we Know so far From Advisors’ Experience
From the website Think Advisor the two commentators “Widger and Daniel Crosby,
behavioral finance experts, and founders of consulting firm IncBlot and co-authors of the new
book Personal Benchmark: Integrating Behavioral Finance and Investment Management.” They
also conducted a survey and “found out that 77% of financial advisors are talking to their clients
about behavioral finance, which is a great thing.” From Adhesion Wealth, another website
dedicated to financial advisors, they also did a study where “93% of advisors believe that
individual investors make irrational investment decisions” (Adhesion Wealth). Not to say that
these Advisors will not make such mistakes, but it is important for Advisors to know what the
multitude of biases and irrational behaviors exist and incorporate them into their practice so
that they can properly educate and appropriately invest their client’s accounts that suits their
needs.
Our “Old” way of Thinking?
This is where we kick off some of the topics that are covered in James Montier’s book on
Behavioral Investing. First up is the evolution factor that our brains are designed for the
environment that we faced over 150,000 years ago on the African savannah, not the industrial
age of 300 years ago. It takes over thousands or hundreds of thousands of years for species,
especially given our complex nature, to evolve to changes to our environment. Unless we know
how to speed up evolution, which may very well be the case someday, we currently have not
fully adapted to this new modern age and therefore we act as though we are still swinging in
the trees with a banana in hand.
James used the concept of Star Trek to further explore how we think, saying that there
are two different ways of how we process our thoughts. The first is your X-system, the
emotional approach to decision making. The other is the C-system, the more logical approach
to problem solving. Our X-system has engrained emotions into how we think, as James
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describes, that we will still react to a snake snapping at us behind a glass window as a natural
defense mechanism. We know that the window will protect us, our logical C-system thinking,
yet we still jump in fear, our emotional X-system thinking. We ultimately need the X-system to
make quick decisions for if we relied completely on the C-system we would question everything
to the point of impairment. Yet looking at Investing James well go on to say that the most
reasons why investors perform poorly is because they were thinking with their emotions, not
with their logic.
What one of the Best Investor in Modern History has to say About
Investing
Warren Buffett, one of the most prominent “value investors” of our era, said that,
“Investing is simple but not easy” (Behavioral Investing). The simple concept in investing that
you buy assets for less than their intrinsic value and then sell when they are trading at or above
their fair value. If everyone listened to Benjamin Graham and regularly attended Warren
Buffett’s annual shareholder meeting than investment managers would at least earn the same
return on the market. Turns out this is not the case as this excerpt from James’ book discusses.
“Over the last 20 years, the S&P 500 has generated just over 8 percent on
average each year. Active managers have subtracted 1 or 2 percent from this, so
you might be tempted to think that individual investors in equity funds would
have earned a yearly 6 to 7 percent. However, equity fund investors have
managed to reduce this to a paltry 1.9 percent per annum (return)” (Behavioral
Investing).”
Prepare, Plan, and Pre-Commit to a Strategy
Some of us turn out to be bad at imagining how we will react in the “heat of the
moment.” This inability to predict future behavior under emotional strain is a bias called
the empathy gap. After a big hardy meal we could not imagine being hungry again, and
on that same note that you should never go to the grocery store while hungry, as you
tend to over buy. The same would go for investors before the dot.com crises who saw
enormous gains on the NASDAQ and grew hungry for big gains. So thinking falsely that
past performance does guarantee you a lot of money, they invested their life savings.
Then see in a couple months span of all their money going down the bottomless abyss.
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They then saw we are also prone to post-phoning plans as we all have a
tendency to procrastinate. While some like the idea of having everything done at the
last minute, psychologists have found “that imposed deadlines are the most effective”
(B.I.).
Both of these behavioral pitfalls of the empathy gap and procrastination can be
beaten by the power of pre-commitment. After all “Perfect planning and preparation
prevent piss poor performance” (Behavioral Investing). Sir John Templeton, investor and
mutual fund pioneer, used to make his buy decisions well before a sell off occurred. Sir
John knew that it would be impossibly difficult to buy when particular stocks are down
40 percent. With buy orders though it made it easier to buy when faced with massive
sell offs and removed emotions, the X-system, from the situation.
As clients like to be involved in investing, advisors can coordinate companies that
the clients are interested in investing and place buy orders prior to any eventual sell
offs. With 90% or more invested in accordance to a strategic or tactical investing
strategy, and with 10% or less for more speculative investments, that could be a similar
strategy to Sir Johns investing. This way the client that wishes to be engaged in investing
can do so and the advisor can feel safe that he/she did so during a time of irrational
exuberance that should benefit the client.
Why it is Painful for you and your Clients to go Against the
Crowd?
The biggest example of “herd-mentality” was described above as being the
dot.com crises where investors were employing buy and sell strategies in pursuit of the
newest and hottest investment trends. We know this can be a very powerful force as it
contains the social pressure of conformity to be like other investors that are making
gags of money. An Advisor may be pressured by clients to go along with the trend of
either sectors or particular stocks in the hopes of gaining what those investors have
already achieved. Advisors may feel compelled to do so because if the client invests and
makes money, then the client will be happy. If he/she does not, than the Advisor can
justify his/her poor decision making that many other investors and even Advisors were
led astray as well.
“As sir John Templeton put it, that it is impossible to produce superior
performance unless you do something different from the majority. Keynes, world
renown economist, pointed out the central principle of investment is to go
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contrary to the general opinion on the grounds that if everyone agreed about its
merits, the investment is inevitably too clear and therefore unattractive” (B.I.).”
As Advisors we need to not only keep ourselves from this herd-mentality but also
educate them about the irrational exuberance with going with the crowd. As somewhat stated
in the quote above Advisors should invest less in equities in times of exuberance and more in
times when investors cannot click the sell button fast enough. As such recommending more
stable income earning bond funds that perform well even during a crisis would be good
investment advice. Also, when the market topples you can recommend to clients the
importance of moving funds more to equities to take advantage of the once again exuberance
but of those that sell securities below their intrinsic value. This would need to have been
discussed prior to any investing as it is important in teaching clients how the market works and
to think logically when it comes to investing and not with your emotions.
Re-Investing When Terrified
The paragraph above touched on this briefly as Sir Templeton said that “The time of
maximum pessimism is the best time to buy and the time of maximum optimism is the best
time to sell” (Behavioral Investing). Another famous saying coming from Buffett that you should
be fearful when others are greedy and greedy when others are fearful. This notion is that
trouble is opportunity for you and your clients.
From the Behavioral Investing book again, the author shows how a study that has those
with brain damage to parts of their brain where they feel fear have no problem in flipping a
coin when they have a higher probability of earning money than losing money. While this many
hinder them in certain ways in life, in re-investing this plays out well for them. This does not
mean that we should only take on clients that have brain damage to the parts of their brain
where the feel no fear but that we should educate the power of other people’s irrationality and
how you can help in the recovery of companies along with making money along the way.
From (Think Advisor 10) Crosby, mentioned before as a behavioral finance expert,
created a 0-to-100 index of market sentiment called the Irrationality Index. He said that the
index reached its lowest point in history during the recent financial crises where it got down to
5 out of the potential 100. Investors were thinking rationally that their investments were
indeed overvalued. He goes on to say that “if you had gone in at that 5, by this point you would
have about doubled your money” (Think Advisor 10).
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Why Being Overly Optimistic is Probably a Bad Thing?
From Live Science, a website dedicated to science in health, planet Earth, space, and
others, says “that studies suggest optimists live longer and enjoy better health than pessimists”
(Live Science). Even CBS has commented on people’s illusory superiority where “in a classic
1977 study, 94 percent of professors rated themselves above average relative to their peers”
(CBS). Yet if equity investors compared themselves to the S&P 500 benchmark to their portfolio
then they would have vastly underperformed so instead of 8 percent they contributed 1.9
percent, as quoted from the “What one of the Best Investor in Modern History has to say About
Investing” section. Not only would these equity investors be underperforming but they will also
be living long enough to make their mistakes even longer.
Spencer Davidson of General American Investors recalls, “that we’re (wealth managers)
paid to be cynical and that a big part of success in investing is knowing how to say no”
(Behavioral Investing). Think Advisor 10 also comments that if an Advisor or client becomes
excited about an investment, that it’s probably a bad idea. One Advisor was getting phone calls
for his clients about the recent Alibaba debut and whether they should buy it. Have these
clients known that IPO’s underperform the benchmark by 21% consistently over a three year
span, which explained before are being born from excitement.
Advisors, or in this case Wealth Managers, should analyze stocks, mutual funds, ETF’s,
all in the same manner and should let only the logical parts of the brain lead them in
recommending sound advice rather than their biased redden emotions.
Overconfidence kills an Investor’s Portfolio?
James conducted a study of 74% of the 300 professional fund managers and found that
they deliver above average job performance. We all know that only 50% can be above average
and this shows that fund managers seem to believe that they are not only good at their job but
they are also overconfident in their skill set.
Researcher Terrence Odean found that,
“overconfident investors/traders tend to believe they are better than others at
choosing the best stocks and best times to enter/exit a position. Unfortunately,
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Odean also found that traders that conducted the most trades tended, on
average, to receive significantly lower yields than the market” (Investopedia).
Advisors need to know where they get their advice, as in the next section will
cover the so called experts that Advisors or their clients may listen to which may
promote underperforming. We need to follow mutual funds or ETF’s that we know have
reputable managers that have been experience along with a low turnover in their funds.
When it comes to your older investors it is important for Advisors to know that risk is
the probability that you won’t have the money you need to do the things that matter
most to you. Advisors want their clients to fill confident in our skill sets but that does
not mean that you are the best Advisor and should be content with a laissez-faire
investing strategy. What Advisors should be doing is continually learning more and most
importantly, learning from our mistakes.
Why Does Anyone Listen to Cramer and the Other so Called
“Experts?”
Flipping through the channels on the T.V. around many have encountered Jim Cramer
and his style of fast talking and extreme exuberance towards investing, but does he add any
value? According to Wikipedia Cramer’s career from his hedge fund over his 14 years there had
an average annual return of 24%. Yet this is the same “expert” That recommended buying Bear
Sterns, Morgan Stanley, Lehman Brother, and Merrill Lynch, some years before they all went
down in 2008.
From Think Advisor 10 they equate forecasting as a tool that should be left to the
weatherman/weatherwoman as we are not very good at forecasting and what the market is
going to do. Those that do more trades tend to fair worse than those that trade less. From
“1991 -1996 the market returned just under 18 percent annually, yet those that traded
frequently, 21.5% earned a 12% return, and those that traded the least managed to earn close
to the 18% annual return after fees”(Behavioral Investing).
For an Advisor this should be noted in the mutual funds and ETF’s that we recommend,
along with individual stocks for the more hands on and higher net worth clients. We should
focus our strategy to keeping a low turnover rate for the funds that we recommend. During our
client meetings we can focus on other parts of our clients lives such as, changes since the last
meeting. Comparing a benchmark that you set that compares what they are doing now and if
that is on track for their financial goals. Lastly, covering the performance of your client’s
accounts as it pertains to their investment goals and balance only as necessary.
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Forecasts and how This Leads to Anchoring
Analysts are always forecasting numbers on companies but many of these “experts” as
well are wrong with 2 years earnings report, being wrong on average of 94% and a 12 month
time horizon being wrong around 45% according to evidence provided in James’ Behavioral
Investing book. The reason why they can be so off is that a model contains many moving parts
with sales, costs, margins, taxes, and so on that it makes it difficult to predict each one and
their connection to each other. These analysts only make money if their forecast was different
from the consensus adding a new dimension of complexity to the problem.
Yet Advisors and clients want to know what the experts think with their forecasts and
many will find forecasts that best fits our own preconceived notion of how a company will
perform in the future. When given a number we tend to cling to it, even subconsciously, a trait
known as anchoring as James points out. When shopping for an engagement ring many
consider that it should be two months’ worth of salary. Sounds like the jewelry industry
bamboozling young men into spending more than what they want, to the enjoyment of both
their fiancé and the jewelry industry.
Just because a stock of a company has fallen from a high point and your client is calling
and asking whether to invest, does not mean that it automatically is trading at a discount. To
understand if it is below its intrinsic value is to look at the fundamentals of what can cause a
stock to drop so much before thinking of this stock as a door buster deal.
One measure of forecasting that can be more beneficial is doing a reverse Discounted
Cash Flow (DCF) model. For instance James did performed this analysis on Google, Apple, and
RIMM which were all pricing at 40 percent annual growth every year for the next 10 years.
Comparing this to historical distribution of the 10-year growth rates achieved by all firms show
that 99.99% only managed to grow at 22 percent annually over 10 years. So these companies
are expected to do twice as well as any other company in history? That seems unlikely and as
James shows they lost 53, 52, and 63 respectively over the course of 2008. Whenever a client
brings up a company of interest we could then run this reverse DCF to calculate if their
expected growth is too extreme and implausible as James notes in his book.
Uncovering Critical Information from the Cloud of Noise
Is more better? We might all say yes when it comes to Thanksgiving with food and
drinks. Yet as James points out that as more information becomes available, two things happen.
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First, accuracy flat-lines, and Second is the degree of confidence expressed in a given forecasts
increase with more information being provided, which confidence can cloud judgment. From
Advisor 10 comes this sentence that “more importantly than this entire onslaught of
information that they’re getting from financial news networks is how they affect those in
managing their own behavior.”
James is a big proponent of value investing and says that his key measures which I think
every Advisor should note in their valuation is first, is the security undervalued or overvalued?
Second is if their balance sheet shows stability or them going bust? Lastly is the company’s
capital discipline and what the management is doing with the cash I am giving them and if they
are driving up risk.
How to Overcome your Client’s Views on Sunk Costs and Being
Loss Averse
The “sunk cost” fallacy is a tendency to allow past unrecoverable expenses to influence
current decisions. We “tend to hang onto our views too long simply because we spend time and
effort in coming up with those views in the first place” (Behavioral Investing). What is
important about sunk costs is that you should not let this past information affect your decision
in the present. The same can be said about a losing stock and that you want to ride out the
poor performance of the stock in the hopes that it at least comes back to the point that you
originally bought it at so that you can sell it for little to no loss. This would be due to our over
optimism and overconfidence biases that we all have when it comes to investing.
Terry Odean, who was talked about from the section titled “Overconfidence kills an
Investor’s Portfolio?” explored individual habits of 10,000 investors in a brokerage account
from 1987 to 1993. “Investors tend to hold losing stocks for a median of 124 days and winning
stock for 102 days and that investors were 1.7 times as likely to sell a winning stock than a
losing stock” (Behavioral Investing).
This is not just for those individual investors as mutual fund managers were 1.2 times as
likely to sell a winning stock rather than a losing stock. The best performing funds happen to be
those with the highest percentage of losses realized. The disposition effect, selling winner too
early and keeping losers, and also shows signs of investor’s loss aversion. That people strongly
prefer avoiding losses than acquiring gains. Studies suggest that “losses are as much as twice as
psychologically powerful as gains. Loss aversion was first convincingly demonstrated by Amos
Tversky and Daniel Kahneman" (Wiki Loss Aversion).
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One way Advisors can easily sell loser stocks is by having either a “guaranteed stop loss”
or a “put option” that charges a premium but sells losers when the market tanks or individual
securities perform poorly. It can be hard to contact clients with individual holdings of different
funds and individual stocks in time to make a difference from those underperforming funds and
securities. Although, this might be an expensive strategy and time consuming strategy to
constantly be renewing these guaranteed stop losses and put options. This is part of a pre-
commitment strategy that an Advisor can develop with his/her client that is a portfolio
management tool that is based on the principle of risk/return.
Beating the “Status Quo” and the “Endowment” Effect
Now that we know that many are willing to hold onto losers and sell their winners,
James gives a scenario where you are looking at your account where all your stocks have lost 30
percent in value within the last three months. You are so overwhelmed that you take your dog
out to do its business and at the same time your nephew is messing with your computer trying
to find a game but ends up selling all of your positions. Would you buy them back? Most people
though would not buy those loser stocks back, says James from Behavioral Investing.
This scenario shows that investor’s inaction is represented in the status quo bias, that
we are indifferent with the current progress, or we would have sold all our stocks already. The
other is the endowment effect “that once you own something you start to place a higher value
on it than others would” (Behavioral Investing).
For Advisors this is important as some clients hold onto, particularly certain stocks that
sometimes they recommended in buying which the Advisor backed up their decision to buy. If it
has performed poorly the Advisor should know to sell the security given a pre-conceived notion
that if an investment losses X percentage than it should be sold. The Advisor should make it
clear that if a particular stock got down to a certain level than it should be sold so that the
endowment effect does not hinder a client’s decision in whether to sell or hold.
While you Cannot Control Everything as an Advisor, you can
Control the Process of Recommending Investments to Clients
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Good Outcome Bad Outcome
Good Process Deserved success Bad break
Bad Process Dumb luck Poetic justice
This how James breaks down how decisions are based on either a good process or a bad
process, but either one is subject to a different outcome of also good and bad. Advisors want to
be in the far left box where are good process and good outcome lead to our client investment
accounts to do well. There is also the very likelihood that bad process could have a good
outcome which this can be a major downfall for an Advisor. This one time success of a client’s
portfolio many cripple other future clients as eventually our luck will eventually run out. Clients
place their judgment on their outcomes rather than the quality of the decision and the
experience of the Advisor with recommending investment advice, known as outcome bias.
James states that focusing on process frees us up from the worrying about aspects of
investment which we really cannot control, such as return. With a sound process we maximize
our potential to generate consistent long term returns. However, this will not help you in the
short term and during periods of underperformance where clients will be pressuring you to
change your process. To counteract this is the need to educate clients early on about investing
and all that it entails. From not following the crowd, to not chasing the highest return stocks
and funds, to let go of securities when they underperform, amongst many others described in
this book. As Sir John Templeton said, “the time to reflect on your investing methods is when
you are most successful, not when you are making the most mistakes” (Behavioral Investing).
Final Words
Investing is not for those that are prone to biases and irrational thinking. This is
probably why many choose not to invest and why Advisors still have a job. To make this work
for clients though it needs to be tailored to each individual/married/domestic partnership
clients that you serve. As an Advisor you want to maximize your possible usefulness and create
confidence with the client about your skills and the process with how you recommend investing
advice. One of the strongest pieces of advice to Advisors may be that they teach each of their
clients about behavioral investing, that thinking with one’s emotions are the very downfall that
one can be susceptible to when a financial crises comes knocking on the door of their portfolio.
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Resources
Behavioral Investing: The Little Book of Behavioral Investing: How Not to Be Your Own
Worst Enemy
Adhesion Wealth: http://www.adhesionwealth.com/blog/2013/11/22/an-rias-guide-to-
behavioral-investing-webinar/
CBS: http://www.cbsnews.com/news/everyone-thinks-they-are-above-average/
Eric Tyson: http://www.erictyson.com/articles/20080922#.VHs4LYvF-y4
Investopedia Detailed: http://www.investopedia.com/university/behavioral_finance/
Live Science: http://www.livescience.com/32338-is-optimism-good-for-you.html
Seeking Alpha: http://seekingalpha.com/article/586351-book-review-the-little-book-of-
behavioral-investing-how-not-to-be-your-own-worst-enemy
Think Advisor: http://www.thinkadvisor.com/2014/10/30/how-behavioral-finance-can-boost-
goals-based-inves
Think Advisor 10: http://www.thinkadvisor.com/2014/10/06/10-commandments-of-investor-
behavior?page_all=1
Value Walk : http://www.valuewalk.com/james-montier-resource-page/
Wikipedia Loss Aversion: http://en.wikipedia.org/wiki/Loss_aversion
A Little bit about your Author of this Article
Hell everyone this is James Orth, having graduated from the University of
Texas at San Antonio in the year 2015 from the honors college with a
Bachelors of Business Administration in Finance, Magna Cum Laude. I
have been fascinated with finance and in particular personal finance for
years before writing this article. It is amazing how well off some few
individuals are on this ill spoken subject, and others who need a lot of
help but find that it is in their best interest to solve it on their own. That is
why I wish to radically change the field of Financial Advising and give
those I work with knowledge which will become power to change their
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lives, and just as importantly, their loved ones’ lives. I thank my readers for reading this article
on a subject that I am very passionate for and to those advisors I too hope you will radically
change the world of Financial Advising.
(This paper was written to fulfill Business Honor requirements with the help of Professor of
Finance, Ronald Sweet)
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