Alternatives to Being an Evidence-Based Financial Advisor

Evidence-basedThere is a new and growing movement in our industry toward so-called evidence-based investing (which has much in common with evidence-based medicine). As Robin Powell puts the problem, “[a]ll too often we base our investment decisions on industry marketing and advertising or on what we read and hear in the media.” Evidence-based investing is the idea that no investment advice should be given unless and until it is adequately supported by good evidence. Thus evidence-based financial advice involves life-long, self-directed learning and faithfully caring for client needs. It requires good information and solutions that are well supported by good research as well as the demonstrated ability of the proffered solutions actually to work in the real world over the long haul (which is why I would prefer to describe this approach as science-based investing, but I digress).

The obvious response to the question about whether one’s financial advice ought to be evidence-based is, “Duh!” But since all too few in the financial world practice evidence-based investing, we ought carefully to look at the possible alternatives to being an evidence-based advisor. Here is a baker’s dozen of them for your thoughtful consideration. If I’ve missed any I’d appreciate your letting me know. Continue reading

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The Advice Business: Make It Personal

res-1015-coverThe October edition of Research magazine is now out and it once again carries my regular column. I hope you will read it and the entire issue. Here’s a quick taste.

We should give our best advice as convincingly and as comprehensively as possible. Yet best practices aren’t always followed. A stellar advisor will recognize when the case for the best approach is lost (but won’t give up too soon) and move on to offer an acceptable alternative. Significantly, a perfect approach, portfolio or product is useless if and when the client refuses to use it or — crucially — stick with it when the going gets rough or when something else comes along. “Pretty good” beats “not at all.”

The Advice Business: Make It Personal

Senior Protection

Al DavisAs part of my Financial Advice: A Top Ten List yesterday, I emphasized the value that an advisor can provide by protecting seniors from making mistakes or being defrauded.  That (summary) point deserves some additional commentary.

As I noted, research confirms what most of us have seen among our families and friends.  Simply put, the ability to make effective financial decisions declines with age, often rapidly.  Continue reading

Advisor Value

Among the benefits that a good financial advisor can offer is some protection from ourselves.  We all suffer from a variety of inherent weaknesses and behavioral biases that conflict with our best financial interests.  This is an underappreciated and vital role.  Unfortunately, it is often better accomplished in theory than in execution.

A recent paper entitled The Market for Financial Advice: An Audit Study, by Sendhil Mullainathan of Harvard, Markus Nöth of the University of Hamburg and Antoinette Schoar of MIT, is as distressing as it is expected. The authors sent trained auditors to meet with financial advisers and presented them with different types of portfolios. These portfolios reflected either biases that were in line with the financial interests of the advisors (e.g., returns-chasing portfolio) or which ran counter to advisor interests (e.g., a portfolio with company stock or very low-fee index funds). They concluded that advisors fail to de-bias their clients and often reinforce biases that are in the interests of the advisor. 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.

There is an implicit bias in these results of the active management bad, index funds good variety, but even so, the results should give every financial advisor pause. We like to think that advisors act in their clients’ best interests.  But, whatever their motives, they clearly do not in far too many cases. Sadly, financial incentives tend to distort advice.  Moreover, the quality of advice is necessarily constrained by the quality of advisors.  Since the barriers to entry in this industry are low and the educational requirements minimal, it should not be surprising that advisors are not be as knowledgeable in finance as necessary or even as expected. The bottom line is clear:  The advice given to the auditors by and large failed to deal with bias and, if anything, may have exaggerated existing biases.

Fee-only of fee-based advisors argue that the nature of their businesses means that they are immune to the lure of incentives. I’m less sanguine on that even though the lesser incentives in such cases ought to help generally.   

In What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?, John Chalmers of the University of Oregon and Jonathan Reuter of Boston College and NBER examined choices and outcomes in the Oregon University System’s Optional Retirement Plan by looking at participants who used an advisor and those who self-directed their choices.  Overall, advisor clients earned net returns that were approximately one percentage point lower per year with much higher volatility. On a risk-adjusted basis, therefore, self-directed investors outperformed their counterparts who used advisors by more than 2 percentage points per year— a difference that is obviously both economically and statistically significant.

Thus there is good evidence to doubt the value of advisors both with respect to what we traditionally think as being at the heart of the profession – money management – as well as with respect to the behavioral aspects thereof.  Some will conclude from this sort of research that advisors are not necessary.  I, on the other hand, conclude that choosing the right advisor is more important than ever.  It’s not easy, but it can make all the difference.