Wall Street has been plagued with stories of large investment banks bilking their clients with complicated products. Former Goldman executive Greg Smith just inked a million dollar book deal to spill his guts about the chicanery that went on at his former firm. But most of us aren’t in the market for the kind of complex derivatives that Goldman sells its bigwig clients. We’re looking for a safe but productive place to park our retirement funds. But are the financial advisers we seek to advise us in this endeavor honest brokers? Or do they consider us all “muppets” too?
Research has shown that individuals aren’t all that great at making rational decisions with their money. Plus the investment world is a pretty complicated and intimidating place. That’s why we need to be able to rely on trustworthy financial advisers. But as economists Sendhil Mullainathan, Markus Noeth, and Antoinette Schoar show in a working paper released this month by the National Bureau of Economic Research, financial advisers are often more likely to give advice that will lead to higher fees for them than higher returns for their customers. These economists sent hundreds of fake clients to financial advisery firms, banks, and brokerages around the Boston area and found that in many cases those advisers actually steered their clients away from more productive investments to less productive ones that produced more fees.
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Time and again, studies have shown that it’s nearly impossible to beat the market over the long term. Sure, portfolio managers can have a good year here and there, but especially when you account for the high fees talented money managers charge, the best bet is almost always to put your money in broad-based index funds of stocks and bonds, and then to allocate between these “risky” assets and cash based on your appetite for risk. If you’re close to retirement you should play it safe by holding more cash, but if you’re a young buck years away from needing to tap into your nest egg, you can afford to go for a higher return by investing in more risky assets.
Of course, these sorts of strategies aren’t the kinds that bring in a lot of fees for money managers, and that’s why many aren’t keen to suggest them to clients. According to the study,
“The market for financial advice does not serve to de-bias clients but in fact exaggerates biases that are in the adviser’s financial interest while leaning against those that do not generate fees. In our index fund scenario, the advisers are even advocating a change in strategy . . . that would make the client worse off than the allocation with which he or she started off.”
If these advisers are actually hurting our portfolios, doesn’t it makes sense to steer clear of professional advice altogether? Maybe not. Remember, individuals are generally pretty bad at making rational investment decisions on their own, too. So what advice do these economists offer to someone who needs to save for retirement? I spoke with one of the authors of the paper, Antoinette Schoar, and she stressed that despite the findings of her study, financial advisers do offer some value added. For instance, they may give someone the confidence to invest their money in risky assets at all. Investing in funds with high fees may be an ineffective strategy, but you’ll do even worse if you let your cash to sit idly in a bank account.
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The poor investing decisions revealed in the study may also partly be result of individual investors themselves being biased towards actively-managed, high-fee funds. “When you talk to advisers many of them will say things like ‘it’s difficult to sell people on strategies that seem so easy,” Schoar told me. “It sounds much sexier when you propose an active strategy.”
So making sure you do your homework before you talk to an adviser and understanding the benefits of passively managed funds is important. At the same time, Schoar argues, the financial advice industry needs to do a better job aligning the incentives of advisers with their clients. Whether through voluntary action or government regulation, she thinks that requiring advisers to have a fiduciary responsibility to their clients would fix many of these problems. “Right now, anyone can just call themselves a financial adviser without any education or fiduciary responsibility,” she says. If there were a fiduciary standard for all financial advisers and brokers, they would be more likely to adopt a ‘percentage of assets’ fee that would reward managers for the size of their fund.
Until the industry reforms itself, however, the best defense for investors is the knowledge that not all investment advisers have your best interests at heart.
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