Financial Advisers Flunk Undercover Sting

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wall streetThis article was published by Smart Money on April 2nd 2012.  To see this article and other related articles on Smart Money website, please click here

Sager: A new study finds advisers often put client interests second to their own.

By now, you may have realized that you aren’t always the most rational manager of your money. Chasing returns. Buying into bubbles. Selling into troughs. Keeping too much in cash or company stock. Heck, even if you keep a textbook, well-diversified portfolio of low-fee index funds, you’ve still probably felt tempted over the last month or so to buy Apple at $600. (You may turn out to be right in retrospect; that won’t make it rational.)

To keep yourself in check, perhaps you’ve turned to a financial adviser. The majority of retail investors have. If so, a new study posted this month by the National Bureau of Economic Research has some bad news for you: Financial advisers not only fail to curb investors’ worst habits, they actually tend to reinforce them — especially when those habits generate fees for the advisers.

The study, by Harvard economist Sendhil Mullainathan, Markus Noeth of the University of Hamburg and Antoinette Schoar of the MIT Sloan School of Management, looks at the behavior of typical investment advisers available to the general public through their banks, independent brokerages or investment advisory firms (focusing on the market for those with less than $500,000 to invest). These advisers are typically paid on the fees and commissions they generate by selling stocks, mutual funds, insurance products and the like.

To see what kind of advice was doled out by these advisers in real-life situations, the study’s authors hired and trained actors to make nearly 300 visits to Boston-area financial advisers over a five-month period in 2008. The actors were assigned to one of four fictional investment portfolios: 1) a returns-chasing portfolio, filled with holdings in sectors that had over-performed in recent years; 2) a portfolio heavily invested in company stock; 3) a diversified, low-fee stock/bond portfolio, and 4) an all-cash portfolio.

So, when the actors came into these offices, what happened? Basically, the advisers advised the dummy clients to do a whole lot of things that were in the advisers’ interests, while making some adjustments based on just how much they thought the clients could be persuaded to do.

Most strikingly, the advisers nudged people in low-cost index funds toward high-fee actively managed funds — blatantly making their clients worse off. Presented with the index-fund portfolio, the advisers recommended a change in strategy more than 85% of the time. Meanwhile, advisers largely encouraged returns-chasers to keep chasing returns. And they tried to nudge cash-only and company-stock investors toward active management, too, though they seemed to take things a bit slower with these clients (apparently inferring that they had a lower tolerance for risk).

While the researchers expected that they might find “catering” behavior — that is, advisers telling clients to stay on their current course to avoid alienating them — they largely found that the advisers were willing to recommend big changes fairly quickly (after giving the clients’ original strategies a polite reception in their initial reaction).

So, should investors ditch financial advisers entirely? “I wouldn’t say that people shouldn’t use financial advisers,” says Ms. Schoar of MIT. Many people, without an adviser, are too timid to enter the market at all, which isn’t good for their financial health. The best advice in the experiment, she said, was given to those who came in without a strategy (that is, those with the cash-only portfolio). While the advice given to these clients wasn’t perfect, it was relatively conservative and well-matched to a client’s income, age, marital situation and perceived risk tolerance.

The most important thing, she said, was simply to understand how your financial adviser is getting paid. Some charge based on how much capital they’re managing, and thus their incentives line up much better with their clients. Some even charge by the hour, which eliminates most conflicts of interest — though it does leave the client with the vast majority of the work.

In the end, the quality of advice you get from a financial adviser is likely to be tied directly to your financial literacy — and your willingness to hear advice that doesn’t conform to your preconceptions. Individuals who are bad at making financial decisions might also be bad at picking advisers,” says Ms. Schoar.

That certainly seems to be the case. A 2008 RAND study of investors’ understanding of the roles of investment advisers and stock brokers found that investors have little understanding of how much responsibility either type of service provider has to them (advisers generally have a much greater duty to look out for their clients’ interests) or of what types of fees they are paying. Nonetheless, the majority of investors were happy with their financial-service providers.

Just how bad is the gap between the quality of service and people’s contentment? Well, despite the abysmal advice offered by the advisers surveyed in the Harvard-MIT study, the actors were willing to go back to 70% of the advisers they visited. This time with their own money.

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