Financial advisers are those people, who provide financial guidance to customers for getting the maximum compensation from the buyer. Investment management, income tax preparation and estate planning, etc all are the possible jobs of financial advisers.
How much We can rely on Financial Advisers
In U.S.A. 75% of investors consult some type of financial adviser before making an investment. In Spain, banks and cash sales tables perform this function with their clients, and operate in parallel with other independent advisers. At my entrance last month we saw an example of the incentives that the tables of placement of the banks and boxes to sell those products with higher commissions even if these are not very good. Given these premises we can ask how well are the advice received by financial advisers. Are they tips interested? Do advisers excessively react to their own incentives? Do they tend to tell us what we want to hear to secure a sale?
While it is reasonable to suspect that some of these biases are present, it is important to measure and confirm them empirically. For this purpose Mullainathan, Nöth and Schoar performed the following experiment. They hired and trained a group of auditors whose mission was to visit independent financial advisers. In the visits the auditors pretended to be clients looking for an investment product for their savings.
The auditors acted as false clients with different demographic characteristics (marital status, age), and financial (amount to invest and portfolio in which it is currently invested). More than one auditor is dispatched by financial adviser.
The results of the study are as follows. Financial advisers take into account the demographic conditions of the clients. They recommend more conservative portfolios for clients with lower income and greater risk aversion. Secondly a negative result. Financial advisers have an excessive bias toward actively managed products, structured products and in general those with higher commissions.
They tend not to recommend passive investment products that replicate an index and carry lower commissions. Basically, financial advisers recommend those products that bring them higher revenue even when they are not customer-friendly.
This second result may not be surprising (once again agents react to incentives), But it is not so obvious in an environment where reputation and repeated interaction are important. Finally, another result is not encouraging. Financial advisers tend to tell the client what they want to hear. For example, investors whose portfolio consists solely of shares of the company in which they work (generally it is not a good idea to put all the eggs in the same basket) do not receive advice on diversification.
Angol, Cole and Sharkar perform a similar experiment. They send auditors to life insurance vendors in India. Two types of insurance coexist in India. Insurance in which an annual premium is paid for annual coverage (in which the premium is lost if no death occurs) and insurance in which an annual premium is paid which is capitalized and received upon death or upon reaching 80 years. The authors argue that given the current premiums the first contract becomes up to 70% cheaper than the second and has additional benefits. The advantage of one contract over another depends, among other things, on age and preference for client liquidity. Again the authors sent auditors, camouflaged from buyers, who asked insurance salesmen.
The results again are not conducive to sellers. Firstly, between 60% and 80% of visits end with a recommendation of insurance that is strictly dominated by another available. That is, insurance less appropriate and with a higher commission for the seller than other insurance to which the seller has access.
Secondly, again sellers react to the initial predisposition of buyers even though this is clearly erroneous. If a customer begins the meeting requesting a type of insurance that, because of its demographic characteristics, is not appropriate, the insurance salesman tends to recommend it. This result is maintained even when the ideal product has a higher commission than the less convenient product.
In general, both studies acknowledge that financial advisers provide certain information that is valuable to the client but also determine that advisers generally react too much to their own incentives and tend to emphasize customer biases, even if they are manifestly incorrect. As always, the results are not necessarily applicable to each and every one of the consultants or contexts; but if they teach us that we must be careful with the investment advice received when these may be interested.
However have other results that are more hopeful. Insurance sellers are more likely to recommend the right product the greater the competition and when there are laws that require you to inform the customer about which is the integral commission that the seller takes for the sale. From the regulator’s point of view, increasing information and competition seems to be the way forward.
And from the individual point of view what message should we draw from this type of study? Personally I do not think the answer is that we should ignore the advice of financial advisors, but we must change the way we interact with them. There is a final result in Angol, Cole and Sharkar that I have not yet mentioned and I think it is very important.
The buyer tends to receive the right recommendation if he demonstrates (or simply expresses) having basic financial knowledge. I think here is the key. It is not necessarily all about doing it yourself but having enough financial knowledge to understand the pros and cons of each financial decision and to induce us to offer the right products.