Think twice about that financial advisor

What’s a financial advisor to do? 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. An audit study finds predictably depressign results

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 returns‐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 returns‐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.

Author: Harold Pollack

Harold Pollack is Helen Ross Professor of Social Service Administration at the University of Chicago. He has served on three expert committees of the National Academies of Science. His recent research appears in such journals as Addiction, Journal of the American Medical Association, and American Journal of Public Health. He writes regularly on HIV prevention, crime and drug policy, health reform, and disability policy for American Prospect,, and other news outlets. His essay, "Lessons from an Emergency Room Nightmare" was selected for the collection The Best American Medical Writing, 2009. He recently participated, with zero critical acclaim, in the University of Chicago's annual Latke-Hamentaschen debate.

25 thoughts on “Think twice about that financial advisor”

  1. You really hit the nail here, Harold. We have recently gone through a similar process, doing some retirement planning and asking for investment advice from a variety of sources. One thing have learned is that you want your investment advisor to have NO stake in whether or not you buy one type of stock over another, whether you have a managed portfolio or simply mutual funds. Once you know how your advisor is paid, you can figure out what advice is being offered! But it really is a scandal that this type of advice is so hard to figure out.

    1. Interestingly enough, the people most likely to be affected by this are those with the most money, not those with the least, or so I would guess. At least with Bank of America/Merrill Lynch, there was a recent proposal to stop paying advisors on accounts with less than $250,000 in them. (This doesn’t mean that they won’t take your funds, only that the chance of an advisor spending time with you goes down unless you already have a lot of money.) If other companies follow BOA/ML’s lead, would it be a good or bad thing? For the vast majority of people, it will be some time before they get a few hundred thousand dollars in an investment or retirement account. If they simply invest in the broadest securities possible when starting out, will they ever change?

  2. Q: When will our brave elected representatives and our honest top-tier journalists trumpet this vital news, crying out, “The Scammers are coming, the Scammers are coming!”?

    A: never

    We’re on our own, folks.

  3. This is very true. And yet there appears here as elsewhere to be different worlds for the truly rich and the rest of us. Most of us will get returns that are not significantly different from the market average, and we may well pay an advisor too much in the false belief they’ll do better than that. And then there’s people like Willard Mitt Romney …

    Romney claims to be making about $25 million a year, on assets he claims are about $250 million. We can assume Romney isn’t the type to take big risks with his nest egg. This leaves a few possibilities, all of them quite disturbing: (1) Romney has massively understated the value of his assets, in particular his stake in Bain; (2) a big part of the money is laundering repatriation of assets previously hidden from the tax authorities overseas; or (3) rich, well-connected folks like Romney can genuinely expect to get low-risk returns in the 10% range. I think possibility (3) is quite plausible, and it’s the possibility that poses the greatest long-term risk for our society, because of the way it makes our elites fundamentally distinct and unaccountable.

    1. Romney claims to be making about $25 million a year, on assets he claims are about $250 million.

      Warren: The 25 is his income. 250, net worth. No?

      To keep it simple, lets say Mitt was awarded $250 million dollars of stock options from Bain. Thats his net worth but he still hasn’t paid taxes on it since its in an illiquid form.

      Then one fine day he exercises $25 million worth of those options. Thats his income, but its not really a return on the 250.

      You appear to be looking at the situation as if Mitt had a net worth of $250M, threw it in a retirement fund, and the fund threw back 25…giving him a 10% return.

      But a good chunk of his income could’ve been him just selling assets that were previously not reported as income.

      1. This is conceivable, but I’ll point out that he left Bain just over 13 years ago, meaning he’d have been gone more than 10 years when the first of the two years I’m describing started. I therefore doubt he’s still cashing out equity from Bain. Apparently he is still receiving income from Bain, from a passive partnership – a situation I referred to in my first comment here. But that passive partnership has a value relevant to his net worth: are you saying he’s massively underreported that net worth? I don’t think that would be a crime (you don’t report your net worth to the tax authorities, just your income), but it would be interesting.

  4. Warren Terra: at least part of that (not clear how much) is liquidity and risk premium. Mutual funds are highly regulated and only in the most transparent, liquid, and relatively low-risk assets. That’s probably as it should be. But returns are necessarily lower. Especially since you have to be able to get your money out at any time; hedge funds and P/E funds have long lockups. That doesn’t dismiss the “connected” theorem, but complicates it and makes it very hard to prove.

    1. Ms. McArdle,
      I’m not sure I understand your response – but to the extent I do, I am sure I’m not really satisfied with it.

      You talk about liquidity, but most people have a big part (most?) of their investments in IRAs, which are designed are not to be very accessible. And if this is an issue of liquidity, doesn’t the problem get bigger? It is my (fairly ignorant) impression that you pay taxes on investments that pay off, when you cash out; if he’s got a lot of illiquid investments cooking untaxably in the background someplace his actual, eventual rate of return might be considerably higher.

      You talk about risk premium, but do you really think Romney is playing fast and loose with his fortune? Whatever would give you the impression he’s the type to risk his own money.

      Transparency is an issue – but if a reputable (or “reputable”) firm were offering safe 10% returns, don’t you think a lot of people would jump to buy a piece of it, even if it were not at all transparent, even if they had to pay a broker/fund manager a percent or two to bundle their money together to qualify? And wouldn’t this mean that the proprietors of such a fund could claim bigger profits for themselves by marketing to this eager (if hypothetical) crowd?

      In fact, we’ve already done this experiment: it was called Bernie Madoff. Madoff sold his clients – and through his clients, a huge number of people bundled together by his clients – the idea of a safe, reliable 10% return on their investments. It was wildly popular and successful – even though as we all now know it was a fraud, and many were lucky to get a 10% return of their investments. Note that the 10% that proved such a draw for Madoff’s customers is precisely the rate Romney claims to be getting. So, assuming Romney is too savvy to be a victim like those Madoff scammed, what resources are available to Romney and to people like him that Madoff only pretended were available to the rest of us?

      1. Warren,

        I think what Megan is referring to is higher risk tolerance. According to financial theory higher risk is necessary (but not sufficient) to achieve higher returns. Note that in these discussions risk means something slightly different than it ordinarily does. It refers to the variability of expected returns, not simply the dangers of the investment. A man with $250 million or so can afford to make riskier (higher variance) investments than those of us with a few dollars less. If those investments are wisely chosen, risk notwithstanding, he may well earn a higher return than a sensibly more risk-averse individual.

        That’s not to say that 10% is achievable. It’s an awfully high number.

        1. It seems to me that this is to a significant degree another version of the liquidity dodge – with his resources, Romney can afford to have investments that do poorly, or do poorly for a time, balanced by others that do well. But this is true not just for wealthy individuals, but also for the collected assets of people subscribing to a fund, especially those saving for the long term with eventual retirement as their object. People like this would happily pay a couple extra percent to get 7 or 8% returns, instead of the 10% Romney claims – a huge profit for the money manager. Doesn’t the whole idea of the market dictate that if Romney’s reported returns are real, the opportunities should be eroded by such underbidding? I admit I’m very much a financial ignoramus, but I still maintain that either there’s something hinky about the numbers, Romney is assuming levels of risk that seem extremely uncharacteristic – or else he genuinely has access to privileged investment opportunities unavailable to the common investor, even at a price. And I still maintain that the last of those options suggests a very disturbing potential for a self-maintaining plutocracy.

          1. But this is true not just for wealthy individuals, but also for the collected assets of people subscribing to a fund,

            This is not quite true. The individuals whose assets are collected may still be considerably more risk-averse than Romney, meaning they either will not subscribe to a high-risk high-(expected)-return fund to begin with, or that they are more likely to withdraw money when things go badly over a short period.

            Another legitimate possibility is that Romney’s income comes from illiquid investments which he carries at their original cost, but are in fact worth much more than that. A simple example would be a puny $1 million investment made some years ago in a risky venture which has turned out well, and now generates $100K a year in dividends. Such an investment probably has a legitimate value higher than $1 million, but if it is in a private company, where the market value is difficult to ascertain, it would not be surprising if it were still carried on his, or Bain’s, books at the purchase price. In that sense he has underreported his net worth, but only sort of, and only by following a fairly common practice.

            I’m frankly much more suspicious of his pre-2010 tax situation. I’d bet those returns contain some information that would be very unpleasant for Romney if it became known.

  5. This post is do very true. But there is a twist.

    You can’t beat the market. But the reason you can’t beat it is because its so efficient (all the known information about a stock is built into the price). Even if you do manage to beat it, once you take away fees, you are likely to underperform.

    So Index Funds are the way to go.

    But if everyone invested in Index Funds, the market wouldn’t move. It would then become inefficient and stock-picking would suddenly become the wiser route.

    The truth is Index Funds have a parasitic relationship with the market. They are seemingly morally superior, but they depend on the very evil they condemn.

    1. Not true. In a perfectly efficient market, the value of index funds would increase when the value of the shares they hold increases, which would happen when the companies in which those shares represent part ownership became more profitable. In simpler terms, real economic growth would drive increase in share value, and the opposite would of course be true as well.

      1. …the value of index funds would increase when the value of the shares they hold increases…

        In order for share prices to increase, someone has to be buying and selling actual shares. But if everyone were in Index Funds, no one would be doing that.

        …which would happen when the companies in which those shares represent part ownership became more profitable.

        In the hypothetical all Index Fund market, as companies become more profitable, their share prices would remain the same.

        Ergo, the market would suddenly become inefficient, since share prices are not properly reflecting earnings. Since market inefficiencies create value opportunities, the smart money would go stock-picking.

        Index Funds depend on the very act they warn against.

        1. The Smart Money would find inefficiencies. But most of us are dumb money; the non-professionals. and it turns out we are better off going with the index.

          1. agorabum,

            You say, dumb $$ = non-pros. Presumably, smart $$ = pros.

            Then you say dumb money is “better off going with the index”, presumably because they can’t pick stocks themselves…i.e, find inefficiencies in the market to exploit.

            But the point is that either can Smart $$. Thats why its better for Dumb to go Index than it is for them to allow Smart to manage their money for them (usually in the form of a mutual fund).

            Thats the basic point of this post.

            But my point is that if everyone did go index, Smart would be able to find inefficiencies, since the very act of everyone going Index creates inefficiencies.

            In such a scenario, Dumb would indeed be better of in an actively managed fund as opposed to an Index.

    2. Although my point is academic…I mean, we are never going to have an actual scenario where all individuals with a stake in the market are invested there only by way of Index Funds…it’s important to understanding what’s really going on here.

      A scam, like say a pyramid scheme as in Bernie Madoff, is something that if eliminated would make make markets better. But eliminating actively managed funds and their enablers, ie advisors who steer money toward them because they pay out sales fees, would actually result in the market collapsing.

  6. Think of this in evolutionary terms. Insofar as the financial advisor is paid directly by you, the fees they can charge up front are way too small to cover researching anything other than “go buy a mutual fund”, yet the average person isn’t going to pay at all for “go buy a mutual fund”. So the advisor is going to have to be paid at least in part by other people. And the other people are going to pay the advisor according to a) how much money they can trouser by getting to hold your money, and b) how unlikely you would be to place your money with them absent the advisor’s recommendation.

    Run any kind of simulation with these rules forward a few cycles, and you’ll see that the advisors who give the simple advice have either starved or gone into other lines of work, and the advisors who give complicated, anti-customer advice are the ones who are left. With the most opaque advisors tending to survive longest because customers are less likely to figure the scam out.

    This is, not surprisingly, the same kind of pattern that we saw with the MBS bubble, where anyone who thought it was a really bad idea was no longer managing significant amounts of assets.

  7. Financial Advisor is such an important but so frequently ignored consultant especially in India. Some points i really dont agree to on this blog for that reason as I think that the financial advisor can really make a difference when it comes to savings required at various junctures in life.

  8. A financial advisor does with your money and how this professional decides on the best investments and course of action for you.This money professional has a detailed plan and system to help you construct your life today and tomorrow as well as how to grow your wealth.

  9. Mark Rotstein prides himself in building strong relationships with the families he serves. This is accomplished through spending a great amount of time with the family in order to determine goals and identify specific financial needs so they can be met.

  10. Hi all,

    It takes time for people to realize that financial advisors aren't valuable and that's saying it kindly. Way to high a percentage push poor investments including loaded mutual funds and insurance products.

    At first it just seems like you need "Expert" advice since planning for your financial success is so important. It isnt intuitive that "Experts" aren't "Experts" and wont do what is in your best interest. Most want you to believe that if they weren't doing whats best that they would be out of business.

    Later you realize they aren't bringing value to the table, it isnt so hard to do on your own, and you likely will do better on your own even with a few mistakes. They are never going to be able to enforce fiduciary standards on all these sales people. Permanent life insurance would practically go out of business.


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