Thursday, 24 September 2009
Do financial advisors aid their clients in making wise investments? This column shows that investors who delegate their portfolio management achieve better results. But that’s due to the fact that advisors tend to be matched with richer, older investors. In fact, financial advisors tend to lower returns and raise risk relative to clients who manage their own investment.
The recent stock market crash makes clear the dangers of financial risk exposure, particularly for households lacking financial sophistication and the means to handle market downturns. Household exposure to financial risks has been promoted in the last decade, partly as a deliberate move towards greater investment in the stock market and partly through policy shifts aimed at promoting retirement financing through individual retirement accounts. These developments may have important distributional consequences, as unsophisticated investors become more exposed to financial market fluctuations and less able than others to buffer financial risks.
Trusting the professionals
In principle, financial advisors could ameliorate consequences of differential ability to handle finances by improving returns and ensuring greater risk diversification among less sophisticated investors. Indeed, delegation of portfolio decisions to advisors opens up economies of scale in portfolio management, because advisors can spread information acquisition costs among many investors. Such economies of scale, as well as possibly superior financial practices of advisors, create the potential for individual investors to improve their portfolio performance by delegating financial decisions.
Well trained financial advisors might also be able to ameliorate behavioural biases of their clients and moderate trading activity. Barber and Odean (2000) show that some investors trade excessively in brokerage accounts, suffering transactions costs that result in significantly lower returns; such behaviour is often attributed to overconfidence. Other behavioural biases have been found to influence some individual investors, such as trading on the basis of past returns, reference prices, or the size of gain or loss over the holding period (Grinblatt and Keloharju, 2001). But delegation entails costs in terms of commissions and fees and gives rise to conflicts of interest between advisors and customers, as shown by Inderst and Ottaviani (forthcoming). On the one hand, financial advisors need to sell financial products, and, on the other, they need to advise customers on what is best for them to do.
New evidence on advisors’ impact
The budding literature on financial advice and its regulation is usually based on the premise that advisors know what is good for individual customers but have an incentive to misrepresent this and take advantage of their typically uninformed customers. In recent research (Hacketal, Haliasso, and Jappelli, 2009), we ask:
* How do brokerage accounts run by individuals without financial advisors actually perform compared to accounts run by (or in consultation with) financial advisors?
* Are financial advisors are indeed matched with poorer, uninformed investors or with richer, experienced but presumably busy investors?
* Is the contribution of financial advisors to the accounts that they do run actually positive relative to what investors with the characteristics of their clients tend to obtain on their own?
Our analysis is made possible by a unique administrative data set from a large German brokerage firm that allows its clients to choose whether to run their accounts themselves or with the guidance of an independent financial advisor. The answers we obtain provide quite a different perspective on financial advice. We track accounts of 32,751 randomly selected individual customers over six years.
Our unconditional findings would likely find their way into marketing brochures and to shape perceptions of the public – they paint a very positive picture. Investors who delegate portfolio management to a financial advisor achieve on average greater returns, lower risk, lower probabilities of losses and of substantial losses, and greater diversification through investments in mutual funds.
However, one cannot view the advisor-investor pairing as random. Our econometric analysis suggests that advisors tend to be matched with richer, older investors rather than with poorer, younger ones. Taking account of this sample selection bias yields the opposite result. Once we control for different characteristics of investors using financial advisors, we discover that advisors actually tend to lower returns, raise portfolio risk, increase the probabilities of losses, and increase trading frequency and portfolio turnover relative to what account owners of given characteristics tend to achieve on their own.
These results provide a new perspective on the role of financial advisors that could prompt further scientific research and policy analysis of their conflicting incentives, their likely effects, and the need to regulate them.
Based on the findings, it should not be taken for granted that financial advisors provide their services to small, young investors typically identified as in need of investment guidance. Indeed, the opposite is true. Even if advisors add value to the account, they collect more in fees and commissions than they contribute.
Policy issues
One interpretation could be that advisors overcharge for their services. If they do, should they be regulated? Or should we be content with the idea that they do not tend to serve those lacking sophistication but those lacking time to make money on the market? But then, why do rich, older people pay so much for advice? Could part of it arise because these individuals would not have undertaken the investment themselves if it were not for the help of advisors?
A further policy issue is whether, in light of varying financial sophistication across households, financial advice can be used to ameliorate the consequences of such differences. The findings suggest that we are two steps removed from such a conclusion. First, we have not found financial advice to actually improve performance relative to what households tend to achieve on their own. Second, we have not found that the naďve and unsophisticated are those who tend to use financial advisors. Other alternatives, such as simpler products and carefully designed default options, may be more promising than financial advice in averting negative distributional consequences.
Finally, the analysis raises some issues for evaluating the recent implementation of the EU’s Markets in Financial Instruments Directive aimed at increasing financial markets transparency and competition. The directive requires financial institutions to elicit and rate investors' financial abilities through simple questionnaires that ask investors to report knowledge of specific assets (such as stocks or mutual funds) or whether they consider themselves financially sophisticated. The directive seeks to reduce conflicts of interest between individual investors and financial institutions and advisors. But ensuring high investor quality does not necessarily eliminate the need to monitor quality of services by financial advisors, especially since there are negative performance effects even for older clients with larger accounts.
References
Barber, Brad M. and Terrance Odean (2000). “Trading Is Hazardous To Your Wealth: The Common Stock Investment Performance of Individual Investors”, Journal of Finance, 55, No. 2, 773-806.
Grinblatt, Mark and Matti Keloharju (2001). “What Makes Investors Trade?”, Journal of Finance, 56, No. 2, 589-616.
Inderst, Roman and Marco Ottaviani (forthcoming). “Misselling Through Agents”, American Economic Review.
Hackethal, Andrea, Michalis Haliassos, and Tullio Jappelli, "Financial Advisors: A Case of Babysitters?", CEPR Discussion Paper 7235, March 2009.
Andreas Hackethal Michalis Haliassos Tullio Jappelli
