Filed under: Investing Basics, Financial Services, Financial Advisors, Investing
When I initially asserted this view more than a decade ago, it was derided as representative of a fringe position. Over time, the trend toward passive investing (which I prefer to call "evidence-based investing") has markedly accelerated.
Nevertheless, most financial advisers don't follow basic principles of evidence-based investing when making recommendations to their clients. Until now, it was difficult to evaluate the quality of the counsel such advisers do provide. However, thanks to a study co-authored in March 2012 by professors at Harvard, the MIT Sloan School of Management and the University of Hamburg, we now have some insight on the competence of financial advisers. It is not a pretty picture.
This Study Was a Sting
You consult with a physician when you are sick, and expect that the advice you receive will be legitimate, science-based medical information. According to the study, the vast majority of individuals consult with financial advisers before purchasing shares of stock or mutual funds. Presumably, they believe the advice they receive will be sound, and that it will assist them in making intelligent, responsible choices. While this expectation seems reasonable, the harsh reality indicates such confidence in many advisers is misplaced.
The study's methodology included an interesting sting operation. The authors set up meetings with retail advisers that the average citizen would be able to access through their bank, independent brokerage firm or investment advisory firm. The advisers interviewed were typically paid based on fees generated rather than on assets under management or performance of the portfolio. The study did not include advisers who provide estate planning services or wealth management services.
The researchers interviewing the advisers (who are called "auditors") claimed to have either investments between $45,050 and $55,000 or between $95,000 and $105,000. They presented advisers with different portfolios and asked for advice. Two portfolios reflected a poor investment behavior best described as chasing fund returns. This type of behavior involves the discredited notion of assuming past performance of a particular fund or sector is predictive of future performance and is likely to continue in the future.
In the third scenario, the auditor presented a well-diversified, low-fee portfolio consisting of index and bond funds. This portfolio was deemed by the authors of the study to be "an efficient U.S. portfolio" similar to those recommended in most finance textbooks. It was consistent with the principles of evidence-based investing. A competent adviser would have congratulated the prospect for having such a portfolio. The fourth portfolio consisted solely of cash.
Activity Encouraged
The results were disheartening. Instead of dissuading prospects from chasing past returns, advisers were "broadly supportive" of this strategy. But here's the most shocking part: Advisers weren't supportive of the efficient index portfolio. Instead, they suggested a change to actively managed funds. In almost 50 percent of the visits, the adviser encouraged investing in an actively managed fund. In only 7.5 percent of the advice sessions, advisers encouraged investing in an index fund.
The authors of the study believe these results indicate flaws in the market for financial advice. Advisers focused on the best interest of a prospect would explain (as the SEC mandates) that past performance is not indicative of future returns. They would also explain the difficulty in identifying prospectively which mutual funds are likely to repeat past stellar performance.
The study pulled no punches in reaching these conclusions:
- The market for financial advice works "very imperfectly."
- The advice given may exaggerate existing biases or even make prospects "worse off."
- Advisers often act in their own self-interest and provide advice that is contrary to the best interest of their clients.
Daniel Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."
