Suppose you are in business offering people advice about some important products. You have a problem, though. The correct advice pretty much fits on a single sheet of paper that is available for free at the public library. Moreover, the products one should recommend buying are inexpensive, and are widely-available at leading websites.
Thus the predicament of the modern financial advisor. Thus also the predicament of her unsophisticated customers. If the right advice is simple and free, at-best the expensive and complicated advice she will sell you will be overpriced, and probably more than a little wrong. Moreover, if the correct products to buy are cheap, no-load index funds that generate little sales commission, your advisor has obvious incentives to offer you something riskier or fundamentally more costly.
Thus, we have the results of an important, if cosmically unsurprising experiment: “The Market for Financial Advice: An Audit Study,” by Sendhil Mullainathan, Marcus North, and Antionette Schoar.
These respected authors used an audit methodology in which trained auditors met with different Boston-area financial advisors and claimed to have different existing investment portfolios and different personal strategies for retirement savings. Some came loaded with stock in their employer’s firm. Others arrived with low-cost mutual investments that were basically fine. Still others arrived with a mix of return-chasing investments in sectors that had recently outperformed the overall market. (The average under-performance of these sectors, compared with the S&P 500, 1.5 years after the audit study was 6.5 percent. So ex post these strategies happened to turn out even worse than basic portfolio theory would lead one to generally expect.)
Given the reality that tens of millions of people make very poor financial decisions, one might hope that the financial advice industry would “de-bias” its customers in a more sensible direction, encourage people to diversify their portfolios through low-cost index funds. Instead, the advisors audited in this study pushed their customers towards costly, actively-managed funds that happen to generate lucrative fees. In gauging advisors’ reactions to consumers’ existing investment strategies,
… The likelihood of a supportive response was 19.4% for the returnsâ€chasing portfolio, against the sample mean of 13.1%, but only 9.7% for the company stock portfolio and a remarkably low 2.4% in the case of the index portfolio. When we measure whether the adviser proactively encouraged the client to change the current investment strategy, we see a parallel pattern. The incident of a negative response is significantly below the mean for the returnsâ€chasing portfolio but significantly above the mean for the index fund portfolio: in 59.2% of cases, an adviser suggested a change in the current strategy. In contrast, if the client had an index portfolio, the adviser suggested changing the current investment strategy in 85.4% of the cases.
These disgraceful findings are not the result of a few bad apples blighting the name of their industry. Rather, the majority of audited advisors are following a predatory business model that harms many of their customers.
When Steve Jobs passed away, I was struck by how many people genuinely mourned him. He made a ton of money by offering consumers a genuinely valuable product. iPads and the rest aren’t cheap (and the circumstances of their production aren’t always admirable—another story). Yet Apple’s basic business model is to generate a beneficial experience that earns repeat customers. That’s sadly refreshing when one scans the landscape of goods and services marketed to the American consumer.
[Cross-posted at The Reality-Based Community]
