Undercover Economist

Valuable advice on investment advisers

Be careful whose interests the expert is serving…

Don’t try this at home: seek professional advice. A sound maxim, one might think. Unless you know something about electrical wiring, get an electrician in; go to a doctor rather than diagnosing yourself. And, since you are a fallible investor, choose your financial portfolio with the help of an investment adviser.

But do typical investment advisers give good investment advice? Three economists recently published research exploring this question in an intriguing fashion – they mixed the experimental methods of a double-blind controlled trial with the latest behavioural economics, all seasoned with a dash of tabloid sting.

The researchers recruited professional mystery shoppers and asked them to seek advice from a variety of financial advisers in Massachusetts. Each mystery shopper was equipped with one of four imaginary portfolios.

The first portfolio exhibited the classic investor bias of buying whatever did well last year. This is likely to destroy value partly because it leads to excessive trading, which is expensive, and partly because, as the small print says, past performance is no guarantee of future results. Mystery shoppers with this portfolio were instructed to ask the financial adviser to recommend further hot stocks.

The second portfolio demonstrated a different bias: 30 per cent of its value was invested in the imaginary investor’s employer. This is common, but unwise: it reduces diversification for no good reason, and exposes people to the risk that they lose both job and savings if the employer seeks bankruptcy.

These portfolios were artfully designed, because if a financial adviser is paid on commission – and everyone in this experiment was – he will have an incentive to exaggerate the first bias and to discourage the second one, in both cases to create the opportunity for earning a slice of the resulting trades.

The third portfolio was close to perfect, at least from the point of view of the economists, Sendhil Mullainathan, Markus Noeth and Antoinette Schoar. It was diversified and packed full of US bonds and low-cost index funds invested in US equities. Good investment advice would be not to touch it; at a push, a financial adviser might suggest purchasing some index funds invested outside the US.

The final portfolio was the control: a blank slate, invested entirely in cash. The mystery shoppers holding this were told simply to ask for advice, and to state they were willing to take more risks if necessary to earn a higher return.

What I love about this experiment is the way it was done. It was double-blind: not only did the financial advisers not know what was going on, but the mystery shoppers weren’t told why they had been given a particular portfolio, nor that there were three other “treatments” doing the rounds.

Nor did the researchers know which advisers had been visited by which mystery shoppers – the logistics were outsourced to an audit firm.

And the results? Advisers made flattering remarks about the clients’ portfolios and then proceeded to try to change them in exactly the way that would tend to generate commissions. The gap between flattery and action was particularly stark in the case of the diversified low-cost portfolio; advisers were more likely to praise it, but more than 85 per cent of them tried to change the strategy.

Almost a third of advisers refused to give any advice at all until the client agreed to transfer control of their portfolio to the adviser, which makes it almost impossible to rate the quality of the advice. And a curiosity: this behaviour was substantially more common when the mystery shopper was a woman.

My financial advice? If you’re looking for investment advice, be careful whose interests your adviser is serving. And if you’re a financial adviser, beware economists bearing randomised trials.

Also published at ft.com.