Financial Advice Can Be Dangerous Too

It’s widely recognized that actively managed investing strategies generally face an uphill battle vs. indexing. The evidence at this late date, after countless studies of real world track records, is persausive if not overwhelming. And the empirical clues keep adding up, as The Wall Street Journal reminds. What’s true for individual asset classes tends to apply with multi-asset class strategies too. That alone is enough consider indexing in a strategic context, but there are other incentives. Looking for financial guidance from certain professionals can also eat away at your wealth, warns a study that analyzed recommendations by advisors

“The Market for Financial Advice: An Audit Study,” a new working paper from the National Bureau of Economic Research, finds that there’s considerable risk in assuming that you’ll always find good advice for managing your portfolio from among so-called financial professionals. The paper starts out with a simple question: “Do financial advisers undo or reinforce the behavioral biases and misconceptions of their clients?” In search of an answer,

We use an audit methodology where trained auditors meet with financial advisers and present different types of portfolios. These portfolios reflect either biases that are in line with the financial interests of the advisers (e.g., returns-chasing portfolio) or run counter to their interests (e.g., a portfolio with company stock or very low-fee index funds). We document that advisers fail to de-bias their clients and often reinforce biases that are in their interests. Advisers 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.

Perhaps the main lesson here is that you must do your homework when picking a financial advisor. Barriers to entry are laughably low for getting the regulatory green light for feeding investors portfolio advice. The hurdles to, say, selling residential real estate are higher compared with doling out opinions on asset allocation for fees and/or commissions.
Money, of course, changes everything, and it compels some advisors to dispense poor investment recommendations. As Financial Advisor magazine summarizes the NBER paper’s findings, “Financial advisors often work against the interests of their clients if it means the advisor can earn more in fees.”
Not exactly a shocking disclosure, but a relevant one now and forever. One of the problems of evaluating advice, even for sophisticated investors, is that portfolio benchmarks should be customized to match each client’s objectives, risk tolerance, net worth, and so on. Alas, that’s a tough assignment under the best of circumstances. As the NBER study suggests, it’s also a task that’s all too often ignored in the financial industry. All the more reason to start with the default portfolio that’s optimal for the average investor with an infinite time horizon: a passively allocated portfolio of all the major asset classes.
This default mix of assets is an obvious place to start for several reasons. Why? The long answer is found in decades of research. The short answer: this portfolio has, in theory, the highest risk-adjusted expected return. That may not be true in practice, but the actual results over the past decade—one of the more stress-tested periods in recent history—are certainly competitive. Another plus is that you can inexpensively replicate a passively allocated mix of the major asset classes with ETFs. It doesn’t hurt that the strategy is fully transparent with and requires no forecasts or special investing skills.
The main question, of course, is how to customize this asset allocation benchmark for your investment needs? That’s a good question for your advisor to ponder. His answer may tell you a lot about whether it’s even worth asking him a second question.