Do financial advisors undo or reinforce the behavioral biases and misconceptions of their clients? It’s a question that receives no shortage of attention in an industry that wrestles with behavioral economics, a fiduciary standard and an overall effort to do right by clients. And it’s a question most recently asked by three top economists in an undercover audit of Boston-area financial advisors.
You won’t like the answer.
“We document that advisors fail to ‘de-bias’ their clients and often reinforce biases that are in their interests,” the authors found. “Advisors encourage returns-chasing behavior and push for actively managed funds that have higher fees, even if the client starts with a well-diversified, low-fee portfolio.”
The National Bureau of Economic Research sponsored the study by Harvard economist Sendhil Mullainathan, Markus Noeth of the University of Hamburg and Antoinette Schoar of the MIT Sloan School of Management.
The authors hired actors to pose as clients displaying signs of the worst self-defeating investment behavior. In each of the 300 appointments, the actors were given one of the following investment portfolios to take in with them: 1) a portfolio that chased returns; 2) a portfolio with a heavy concentration of company stock; 3) a low-cost, diversified stock and bond portfolio, and 4) a portfolio invested in cash.
The wealth ranges varied for the “clients,” either between $45,000 and $55,000 or between $95,000 and $ 105,000; those ranges were picked to mimic the savings of average households in different age ranges.
While specific firms and advisors were not named, the study focused on retail advisors at the lower end of the wealth spectrum, and did not include private wealth managers or hedge funds. The typical advisor in the study worked either for a bank, retail investment firm or their own independent operation.
Most advisors in the study are paid on commission based on the fees and volumes that they generate. Only a small subset of the advisors are independent and would be paid based on capital under management.
The study found advisors’ reactions to different portfolios or investment scenarios varied significantly. They were broadly supportive of the trend‐chasing portfolio but much less supportive of the company stock portfolio. Most strikingly, according to the authors, advisors were “unsupportive of the index portfolio and suggested a change to actively managed funds. Overall, advisors had a significant bias towards active management.”
“In nearly 50% of the visits, the advisor encouraged investing in an actively managed fund; by contrast, in only 7.5% of the advice sessions (21 visits), advisors encouraged investing in an index fund.”
When advisors mentioned fees, they did so in a way that “downplayed them without lying.”
For example, the actors often heard arguments like, “This fund has 2% fee but that is not much above industry average.”
A bit of good news; consistent with portfolio theory, most (75%) did ask clients about their demographic characteristics to determine risk preferences and investment time horizons.
“The recommended investment in stocks and domestic assets significantly increased with annual income, a fact that may be explained by an assumed higher risk or loss tolerance for the well‐off,” according to the authors.
The bad news? In many cases, the information did not get used in the way predicted by portfolio theory: the recommended exposure to equities decreased with the amount invested.
“Female clients were asked to hold more liquidity, advised to hold less international exposure, and pushed less frequently to invest in actively managed funds. At the same time, advisors did not seem to tailor portfolio advice with the age of the client at hand.”
The authors also found evidence of “catering,” a term they used to describe advisors that initially supported their client’s existing strategies in an attempt to establish credibility and not alienate a potential client. However, the initial reaction to a client’s strategy varied significantly from the later recommended course of action.