Why you might be overpaying for financial advice
Financial advisers may not be providing the customized portfolio advice the industry advertises
- Rather than crafting portfolios to conform to clients’ specific characteristics, such as risk tolerance and income, financial advisers are more likely to build generic portfolios reflecting their own investment preferences, according to research by Chicago Booth’s Juhani Linnainmaa, with Stephen Foerster of the University of Western Ontario, Brian T. Melzer of Northwestern University, and University of Western Ontario’s Alessandro Previtero.
- Using data from 1999 to 2012 from four large Canadian financial firms, the researchers find that client characteristics explain only 13 percent of the variation in the portions invested in equities across portfolios. But when advisers’ risk preferences are taken into account, the two factors explain up to 32 percent of the variation in equity portions. The importance of adviser preferences is even more apparent when the researchers examine investment allocations between domestic and foreign equities (see chart).
- This one-size-fits-all advice does not come cheap. Financial advice increased client investment returns by 1.8 percent per year, by inducing clients to buy riskier assets. Compared with life-cycle funds that are not actively managed and cost about 1 percent per year, clients paid an extra 1.7 percent per year in fees, on average, for this advice. The added cost of the advice wipes out any gains collected from risk-taking.
- The researchers speculate that financial advisers may be adding value beyond portfolio choices, such as advice on saving for college and retirement, tax planning and estate planning, and, perhaps, reduced anxiety about investing generally.