07 March 2013

Study Reveals: Financial Advisers are Biased but Still Wanted

Financial advice and financial advisers became accessible to the so-called middle-class back in 1940s when Charles Merrill, the cofounder of Merrill Lynch (now the wealth management arm of Bank of America), famously coined and made real the phrase “Bring Wall Street to Main Street”. Differently from the other brokerage houses that kept the “best” information only for their wealthiest customers and tried to lure others with exaggerated claims and deceptive promises of profits, Merrill provided accurate figures and honest information tailored to the needs of average Americans. He stated that: “The interests of our customers MUST come first.” *

Since then, the market for financial advice has developed to a multi-billion dollar business. Oddly enough, there seems to be not much left from the original ideas of accurate information and putting the interests of the customers first... Instead, one of the few independent audit studies about this important market, “The Market for Financial Advice: An Audit Study” conducted by the National Bureau of Economic Research and published in March 2012, concludes:

“...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.”

I thought it would be interesting to summarize the facts and figures of this study. Formulations, comments based on the data as well as other add-ons are my own unless they are exact quotes from the original text and, as such, within the quotation marks. My interpretations may differ from those of the original authors due to subjectivity involved.

Background information: study design

Format: audit study with trained (more precisely, moderately trained, so that they’d know the investment basics and understand the suggestions of the advisers), professional auditors impersonating regular customers who are seeking advice on how to invest their retirement savings outside their 401k plan.

Audit focus: retail advisers at the lower end of the wealth spectrum working either for a bank or retail investment firm, or conducting their own operations; most typically being paid on commission based on the fees and volumes that they generate.

Audit time frame: between April and August 2008.

Geographical location: US, Greater Boston and Cambridge area.

284 observations (one observation = one audit visit) presenting two wealth ranges (USD 45,000-55,000 and USD 95,000-105,000) in two age groups (about 30 and 45 years old), and one of the following four scenarios as a starting point (click on the image to enlarge it):



Finding no. 1:

Advisers are well aware that the initial interaction with the client is a sales situation as implied by the fact that in the experiment they were much more often positive about the client’s portfolio initially than supportive at the end: 

(Remember the basic “Sandwich Method” of giving feedback? Well, if you don’t, it’s more-like this:
Step 1: Start off with positive feedback.
Step 2: Provide your criticism.
Step 3: End on a positive note.)

Anyway, what’s interesting about the above Figure is that the most efficient portfolio, the portfolio of index funds, first got more positive reactions than any other portfolio (in 24.4% of cases vs 17.0% in overall sample) but at the end found the least support from the advisers (only in 2.4% of cases the test client was encouraged to continue investing into this strategy).

Finding no. 2:

“Some advisers (84 visits, or roughly 30%) refused to offer any specific advice until the auditor transferred resources to the adviser.” In other words, we are not talking just about a small proportion of advisers; this finding reveals that in almost one third of the cases, the customer would have had to buy a “pig in the bag” before accessing any valuable piece of information:

Finding no. 3:

Advisers had a much higher propensity to suggest more expensive actively managed mutual funds than low-fee index funds (see Figure 3 below). It may be that some of them indeed believed the suggested actively managed funds to be a better choice for the client (even if this belief is not supported by the vast majority of the investment literature). But: it’s rather unlikely that “some advisers” means this high proportion as observed, unless advisers by themselves had been thoroughly brain-washed by their employers, which of course may also be the case…**

Notably, none of the test clients that started out with the portfolio of index funds was later recommended index funds even though the initial reaction to the portfolio had been rather positive in comparison (compare Figure 3 to Figure 1 above).

Did they mention fees spontaneously? Yes, they did (especially when the client was supposed to ask anyway; according to the study: “Advisers tend to explain the fee structure of funds much more to older clients than to younger ones.”) – in a way that downplayed fees, but doing so without lying. You know, using expressions like “not much above industry average” when taking 2% of your invested assets each year, no matter the performance of the fund concerned.

Finding no. 4:

Financial advisers do not tailor their portfolio advice when it comes to the client’s starting portfolio and his/her aims as a small investor. This despite that they at least seem to be considering certain other pre-defined characteristics such as client’s income, other savings, occupation, gender, marital status, number of children etc.

Here are some stereotypical observations from the study:
 * “Female clients were asked to hold more liquidity, advised to hold less international exposure, and pushed less frequently to invest in actively managed funds.” (Women are assumed to be more conservative and sensitive to fees.)
* “Married clients were told to hold less in liquid assets.” (Married people are assumed to be able for taking more risks.)
* “Older clients were more often encouraged to invest in actively managed funds. Similarly, people with children were encouraged to invest in actively managed funds.” (The first group has more money for paying fees. The second group is probably looking for higher returns, supposedly being provided by the actively managed funds.)

And here is a depiction of the not-that-different suggested asset allocations for the test clients with considerably different starting portfolios and previous investment experience (remember the four scenarios in Table 1 above):

Extract from the research report:
“…advisers did not seem to tailor the asset allocation according to the scenario that auditors come in with, since none of the comparisons are even close to being significant. The one exception is that auditors who came in with an index portfolio seem to have received a higher suggested allocation to bonds…”
The research did not provide any much better explanation than a spurious correlation, i.e. just a random coincidence, to the highlighted exception.
The other exception that I see from the data is somewhat lower suggested allocation to stocks for the clients with no previous investment strategy at all (strategy no. 4, All Cash); again, the exact reason is unclear and may well be just a statistical discrepancy.

A few crucial points are reflected in this finding:
* Certain characteristics of the client have to be asked by law and/or asking them is necessary for gaining the trust of the client.
* Advisers are interested in figuring out how profitable the customer could possibly be for them and/or for their employers (i.e. how much time and effort to spend for a particular client).
* Advisers are coming in with a pre-defined set of standard solutions for the typical customer profiles with not much bothering to tailor the advice.
* Clients are not specifically asking for the tailored advice, either.

Related to the above, it is further concluded in the study, that: “…advisers who are interested in providing better advice might be unable to gain a market share if biased retail investors are unable to differentiate good from bad advice.” So it comes that far too often bad advice is “crowding out” the good one: the “production cost” of a good customized advice is apparently much higher than presenting a standardized solution. Furthermore, the adviser may get awarded for selling certain groups of actively managed funds; in that case, consultation from customer’s point of view means answering some rather formal questions and listening to a sales pitch thereafter (which is often the problem with the “free” advice for which the client pays later in the form of higher fund management fees, for example).

Finding no. 5:

Despite of all the discussed problems, financial advice is still being sought and people seem to have no better ideas than hiring a biased adviser: “In this audit study, auditors were willing to go back to about 70% of the advisers they visited but now with their own money. […] In other words, most advisers succeeded in convincing their potential clients and thus they have no need to change their advice giving.”

As ironical as it may sound: an aspiring financial advisor doesn’t need to learn much about finance and specific investments (just enough to sound a bit smarter than an average customer); what he or she needs to master, is sales techniques. Once again: bad advice is “crowding out” the good one.

The final conclusion of the study is actually pretty scary when it comes to the big picture: “Overall our findings suggest that the market for financial advice does not debias retail investors and if anything may exaggerate existing biases. […] While in times of normal economic activity these biases might be arbitraged away…

It clearly implies that someone (read: institutional investors) are explicitly benefitting from the inefficient portfolios of the “average” retail investors that are not being corrected but rather reinforced by the advisers. The three dots in the end of the quote are indicating something even worse, when the arbitrage capital is drying up.

My notes***

Even though the number of observations in the study was limited and the same goes for the observation period as well as the geographical coverage, it very much sounds like we have a massive problem of conflicting interests here… This is true despite of the fact that every experiment and analytical exercise like this one has its own methodical issues by definition. Public entities that are supposed to protect customers, are unlikely to correct the issue of bad advice crowding out the good one if the customers themselves are not able to differentiate between the advisers before it is too late already. 
The bad news is that (I think I have mentioned this before when discussing the inefficiencies on the financial knowledge market) finding a good advisor is at least as difficult as finding a good long-term investment. An adviser and an investment, both may serve you well and both may destroy your wealth. The ex post difference of making a bad choice is that a bad investment doesn’t argue if you want to get rid of it, but a bad advisor most probably does everything to stay with you as long as possible (given that he/she is able to make money on you, of course).

In other words, I’m a strong believer of self-directed investing, independent research and knowing what you are doing. It’s a bit like with the doctors: a financial adviser is the doctor of your financial health. Some people need the doctor and sometimes you and I may need as well, but better if we stayed healthy. Note, however, that this comparison as well as the above discussed research findings are first of all applicable to the so-called middle-class and retail investors covered in the study. People, who can afford having good personal advisers and, perhaps even more importantly, know how to use their knowledge, most probably greatly benefit from their skills by discussing relevant issues and asking right questions.

* You can read more about Charles Merrill here:
** I remember my own training for selling certain retirement funds in the very beginning of my career. But memorizing and delivering sales speeches is not quite my topic. So one day I just started to ask too many questions, purely because I was curious if these particular funds actually were better than the others…
*** Disclosure: I’m neither a financial adviser nor can I add anything from the alphabet soup of financial certifications (such as CFA, CFP, CFS, ChFC, CIC, CIMA, CPA and others) to my name; I just have a MA in economics with the specialization to banking, and the practical working experience in the financial industry since 2004. I’m developing an online marketplace called FRXmarket.com for the independent financial research.


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