Investors Are Too Optimistic. No Financial Advisors. – Center for Retirement Research

But Do Counselors Help Their Clients See the Bright Side?

I’ll admit, I’ve always been skeptical of the financial advisory industry. In fairness, it might be because throughout my 20s I was living on graduate student money in the not-so-cheap city of Boston. And I spent most of my 30s in recovery. Questions like “how many packets of Ramen can one safely eat in a week?” and “how much is the rent!?” rarely making a financial profit. But now that I’m older and have more money to spare, I tend to rely on index funds and my experience. And, as I’ve written before, target date and inertia funds do a great job of getting most people on the right glide path as they near the end of their careers.

So, when I saw a recent study from colleagues at Boston College’s Center for Retirement Research on financial advice, I tried to keep an open mind. The study examined two questions. First, what stocks are recommended by financial advisors? Second, does this advice affect their clients’ investment behavior? (This study is part of a broader program conducted in partnership with Jackson National Life Insurance Company.) These questions are important – market risk is an important consideration for people who rely on financial assets in retirement. And even though perhaps a quarter of Americans use financial advisors, the academic literature is still unclear about advisors’ propositions about risk and how they affect their clients.

As a skeptic, I saw the answer to the first question is that advisors recommend assets with large commissions. And as a teacher, I realized that the answer to the second question was that few customers listen to the advice and most ignore it. Sigh. But, with my open mind, I continued to read. To answer those two questions, researchers surveyed both financial advisors and investors. On the advisor side, the sample included 400 advisors with at least 3 years of experience, $30 million in assets under management, and 75 clients. For investors, the sample includes 1,016 people aged 48-78 with at least $100,000 in invested assets. Unfortunately, the surveys did not include advisors and clients, but the researchers attempted a measurement method to compare the advisors’ advice with the investors’ decisions.

On the first question, a survey of advisors showed a wide variation in recommended stock allocations and thus risk. For the base client, the average recommendation was a share of 48 percent of the stock, but with a large standard deviation – 18 percent. So, the researchers wondered what makes this different. One of the things they discovered at the beginning caused my doubts even more – advisors who rely on fees calculated as a percentage of assets that recommend a high allocation to stocks. This makes sense if advisors are just trying to maximize their fees, as stocks will have a higher average return but more risk. Again, I reminded myself – I try to keep that open mind – an advisor only gets those high fees if they make their clients more money. As long as the advisor respects their clients’ wishes regarding risk, seeking a higher return is not a bad thing.

So, my skepticism eased when I realized that the advisors were actually very sensitive to their clients’ risk preferences – they didn’t just recommend multiple stocks all the time. For clients with a low risk tolerance, advisors recommend only 30 percent of assets be allocated to stocks, more than one standard deviation below the baseline. Advisors’ decisions were also influenced by their preferred strategy – those looking to maximize total return chose more stocks while those targeting income recommended fewer. Obviously there’s a lot more going on here than simple self-centered advice.

OK, so how does this advice affect customers? However, it turns out that many investors would prefer to hold fewer stocks than an optimal portfolio, especially before retirement. A survey of investors found that for pre-retirement savers, their preferred stock allocation has fallen below even the recommended sliding scale based on economic theory. Essentially, investors want to accept very little risk and, in doing so, forego returns. Counselors seem to help offset this effect. Of the investors who said their advisors’ advice changed their behavior, 60 percent said it moved them to take greater risks. This change is probably a good thing, as many investors are more tolerant of low risk than high risk and sound advisor opinions.

Finally, learning from my colleagues lessened my reluctance to advise. Given how risk-averse many investors are, it seems that having someone to provide a helpful nudge about a slightly higher stock allocation helps. Maybe as I move on from my Ramen days and get closer to retirement, I’ll think about getting some help too.