One way your financial advisor could help you (but probably isn’t)

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Saturday, April 7, 2012
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Recently, we’ve been pretty critical of the financial advisory industry. While it might seem like we’re sounding off simply because we have a bone to pick with financial advisors, that’s actually far from the truth.

In fact, I think that financial advisors have the potential to create significant value for investors. In that regard, I’m very much in line with Robert Shiller in his recent book Finance and the Good Society, where he writes:

Increasing access to legal and financial advice – access that affords people a patient and sympathetic advisor — is one of the key factors in developing a truly responsive financial capitalism for the future. If people have good legal and financial advisors who really represent them, who are committed to nothing more than helping them, they will make better decisions.

However, for an industry that has the potential to add so much value, it pains me that brokers and financial advisors so often fail to live up to this potential.

Investors behaving badly
Berkeley professor Terrance Odean knows a thing or two about the mistakes that investors tend to make. His work on behavioural finance goes back to the mid-1990s, and he’s widely considered one of the leading lights in the field.

When I asked him about the potential value of financial advisors for individual investors in general, his answer was unequivocal: “You need to ask: Is there room for improvement for the behaviour of individual investors on their own? Yes, of course there is. Could someone that’s well trained help them? Sure!”

While there were a number of specific ways that professor Odean suggested that advisors can add value, it’s that behavioural aspect that seems to be one of the keys. Or as Odean summed it up, it’s a matter of advisors keeping clients from “shooting themselves in the foot.”

Odean’s extensive collection of research papers details many of the most damaging behaviour quirks among individual investors, including:

  1. Excessive trading – Some of Odean’s most compelling research has shown that human beings’ natural tendency toward overconfidence often leads to excessive trading and worse investment outcomes.
  2. The disposition effect – Investors have a tendency to sell investments that have gone up while holding onto those that have gone down. It’s a way to avoid regret, but also a great way to reduce investment performance.
  3. Unwillingness to repurchase – In another effort to avoid regret, Odean and his co-authors recently showed that we tend to avoid repurchasing stocks that we previously lost money in or ones that had gone up since we sold them. This is an inefficient way to invest and another prime way we shoot ourselves in the foot.

This list barely scratches the surface, but what’s clear is that there are plenty of ways that an advisor can potentially help their clients invest better.

But here’s the rub
A National Bureau of Economic Research paper that’s made headlines recently suggests that not only do financial advisors often fail at curbing the behavioral biases of their clients, but in many cases they may exaggerate those biases. Authors Sendhil Mullainathan, Markus Noth, and Antoinette Schoar sum up their findings:

Overall the audits suggest that the market for advice works imperfectly. The advice by and large fails to debias and if anything may exaggerate existing biases. … The evidence further suggests that advisor self-interest plays a role in generating the low-quality advice even when incentives of both the advisor and the client are aligned…

Research that we’ve previously highlighted from Goethe University Business School Dean Andreas Hackethal similarly suggests that advisor self-interest appears to lead to higher portfolio turnover and lower returns for clients:

Trading costs and associated commissions earned by both IFAs and banks certainly contribute to these outcomes [of lower returns], since we find that advised accounts feature higher portfolio turnover … relative to self-managed accounts. … Our findings imply that many financial advisors end up collecting more in fees and commissions than any monetary value they add to the account.

In other words, many of the industry’s built-in incentives prevent advisors from delivering what their clients most sorely need.

Get it together!
There is some hope. US bank Wells Fargo is reportedly trying to help customers get a handle on the big picture through its financial-planning platform. Maybe even more encouraging is Deutsche Bank‘s ”Fair Share” program, which “considers customer satisfaction and the quality of advice given in performance assessments of branches. It’s also hired a chief client officer to help in this approach.

We can only hope that Australian banks and advisory firms follow this lead (and preferably surpass it). In the meantime, take control for yourself – check out The Motley Fool’s ‘Your 13 Steps to Financial Freedom’ and encourage your friends and family to do the same.

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This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article was originally published on fool.com

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