Many people rely on financial advisors, either independent ones or those employed at banks. The good ones will at least ensure that you have a sensibly diversified portfolio and that it stays that way. However, a recent study indicates that many advisors do not increase the actual investment returns on an ongoing basis.
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What Advisors Do and Don't
An investigation conducted at the University of Frankfurt in Germany reveals that neither portfolios advised by banks nor independent advisors, do any better than those for which no advice was given. Finance professor Andreas Hackethal explains that the main problem is the failure of advisors "to correct systematic investment errors sufficiently, while at the same time, they generate additional costs." (For related reading, see Diversifying Your Portfolio.)
Furthermore, this work almost certainly applies to the United States. According to Hackethal, an investigation by Bergstresser et. al in the U.S., demonstrated that mutual funds sold through U.S. broker channels underperform other mutual funds. They take this as indirect evidence that brokers or advisors do not add value for clients.
The Frankfurt-based study used client data from a large German bank and from an online broker that specializes in providing independent advice. The survey sample that was given advice, performed no better than the execution-only group.
The researchers also confirm that banks (and certain other advisors) have the wrong incentive structures, so that the advisory process all too often helps only the seller and not the investor. (To learn more, read Paying Your Investment Advisor - Fees Or Commissions?)
Investor Reluctance to Obtain and Follow Good Advice
Good advisors are clearly hard to find, but they are indeed out there. However, Hackethal found a widespread client reluctance to use good, skilled advice, "preferring to rely on their own generally mediocre investment skills." A staggering 95% of those questioned were not even interested in free independent advice from an advisor with no incentive, at all, to recommend specific products.
Equally amazing is the fact that of the remaining 5%, only half actually followed the advice that they were given. Of this tiny group, half again followed the advice only half-heartedly, even though the recommendations would have led to substantially better returns.
It seems to be mainly wealthy, experienced investors who really appreciate the value of good advice from the right people. Yet, almost anyone would benefit from a second, objective opinion on what to do with their hard-earned savings.
The Frankfurt researchers do not believe that more governmental regulation is the answer either. In particular, given the above consumer attitudes to advice, purely seller-side regulation seems doomed to fail. For instance, Hackethal doubts that simply providing more information in the form of brochures, for example, will help much. It will take a lot more "to achieve the necessary transparency and learning effects … with respect to investment risks and opportunities."
Clearly, somehow, investor attitudes towards advice need to change and the incentive structures in the industry as well. In addition, investment selling processes at banks may need to be overhauled in a more general sense. There is a compelling need to establish just why, in so many instances, the advisory process fails to work for the investor.
There are undoubtedly independent and bank advisors who can and will help people get more "bang (and bank) for their buck." What is lacking is an understanding of the difference between good, mediocre and really bad advice. Above all, far greater market transparency is essential, so that people are able to draw the appropriate distinctions between a fine investment, a rip-off and the various shades of gray between the two extremes. At present, too many investors just do not know who they are dealing with. As Hackethal puts it "the person sitting opposite them could be excellent or an outright crook. The clients just don't know." (Learn more on how to Find The Right Financial Advisor.)
An Important Benefit Remains - with Genuinely Independent Advisors
Independent financial advice can, however, at least prevent excessively risky, undiversified portfolios. That is, even if an advisor does not lead to better returns, if they can prevent you from having a high risk portfolio that rockets in a boom and plummets in a bear market, that can be worth a lot. This is a separate issue and needs to be kept in mind. The above research dealt with better investment performance, not with avoiding disastrous losses in a crash.
The Bottom Line
Financial advice can be pretty ineffectual for two main reasons. Firstly, when the incentive structures are wrong, the advice benefits mainly or only the bank or broker. Secondly, investors are remarkably reluctant either to seek out or follow objective advice from a third party. Overcoming this highly unsatisfactory situation entails a combination of changed structures and attitudes on both the buyer and seller sides of the market. This is not easy to achieve, and regulation alone will certainly not do it. The industry needs to take a long, hard look at what it is doing, both wrong and right. (For related reading, see Do You Need A Financial Advisor?)
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