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Academic Study Confirms IW Observations

Just as with Congress, staunchly ethical people enter the securities industry and face daily pressure to compromise those ethical principles for the sake of advancement or continued employment.

The securities industry chalks it up to a few bad eggs; advisers and brokers who take advantage of their customers for big commissions and fees. My experience has taught me that the problem is systemic. Brokerage firms are for-profit corporations. They’re bottom line is dependent on their salespeople (brokers) earning every dollar of commission possible. The source of those commission? You. This week, The Wall Street Journal reported the results of an academic study which confirms what I’ve seen from ground level for more than two decades. According to The Wall Street Journal:

[P]erhaps you’ve turned to a financial adviser. The majority of retail investors have. If so, a new study posted this month by the National Bureau of Economic Research has some bad news for you: Financial advisers not only fail to curb investors’ worst habits, they actually tend to reinforce them — especially when those habits generate fees for the advisers.

The study, by Harvard economist Sendhil Mullainathan, Markus Noeth of the University of Hamburg and Antoinette Schoar of the MIT Sloan School of Management, looks at the behavior of typical investment advisers available to the general public through their banks, independent brokerages or investment advisory firms (focusing on the market for those with less than $500,000 to invest). These advisers are typically paid on the fees and commissions they generate by selling stocks, mutual funds, insurance products and the like.

To see what kind of advice was doled out by these advisers in real-life situations, the study’s authors hired and trained actors to make nearly 300 visits to Boston-area financial advisers over a five-month period in 2008. The actors were assigned to one of four fictional investment portfolios: 1) a returns-chasing portfolio, filled with holdings in sectors that had over-performed in recent years; 2) a portfolio heavily invested in company stock; 3) a diversified, low-fee stock/bond portfolio, and 4) an all-cash portfolio.

So, when the actors came into these offices, what happened? Basically, the advisers advised the dummy clients to do a whole lot of things that were in the advisers’ interests, while making some adjustments based on just how much they thought the clients could be persuaded to do.

Most strikingly, the advisers nudged people in low-cost index funds toward high-fee actively managed funds — blatantly making their clients worse off. Presented with the index-fund portfolio, the advisers recommended a change in strategy more than 85% of the time. Meanwhile, advisers largely encouraged returns-chasers to keep chasing returns. And they tried to nudge cash-only and company-stock investors toward active management, too, though they seemed to take things a bit slower with these clients (apparently inferring that they had a lower tolerance for risk).

While the researchers expected that they might find “catering” behavior — that is, advisers telling clients to stay on their current course to avoid alienating them — they largely found that the advisers were willing to recommend big changes fairly quickly (after giving the clients’ original strategies a polite reception in their initial reaction).

Now, in response to a story like this, I expect you to react the way people do when asked to rate Congress as a body, then their individual representatives. Uniformly, people deride the larger group but express satisfaction with their representatives. The problem is the other people, we tend to think. I’ve got a good one. But, you see the inconsistency. Everyone believes this. So, where exactly are the bad representatives? As hard as it is to take on board, they are right in front of you.

Just as with Congress, staunchly ethical people enter the securities industry and face daily pressure to compromise those ethical principles for the sake of advancement or continued employment. You might believe that your broker wants only what is in your best interest. But think of it this way: faced with a choice between doing right by you and continuing to pay his mortgage, which do you think that he will choose?

It’s possible to survive and thrive in spite of the nature of the securities industry. But it takes a clear eye and an ability to face and manage the myriad ways that your hardwired thinking can lead you into trouble. Like a CIA analyst, you need to learn to think about how you think, to critically assess the assumptions that pop into your mind. If you can learn that, the future can be bright. If not, your odds of achieving the retirement you worked and saved for are no better than coming home from Vegas a winner.

1 Response » to “Academic Study Confirms IW Observations”

  1. [...] Huddleston @ Investor’s Watchblog writes Academic Study Confirms IW Observations – Scary information from an academic study possibly about your financial [...]

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