ANALYZING FINANCIAL ADVICE

The possibility that financial advice can sometimes be worse than nothing needs no explanation these days. Think Bernie Madoff. That was extreme, of course, but how wary should investors be when it comes to more prosaic counsel from, say, the local financial planner? As with everything else in finance, the answer boils down to a gray area. In short, it depends.


It’s a given that in the grand scheme of financial advisory, most of it will end up as mediocre; a small slice of it will bring stellar gains; and a bit of it will be a disaster. That’s simply a twist on what Professor Bill Sharpe described as The Arithmetic of Active Management. Returns, in other words, are a zero sum game and the winning hands are financed by the losers. In the end, most invetsment decisions end up in the middle. That's not necessarily bad news. For most investors, sound advice that delivers reasonable if middling results will suffice. And compared with what happens with many portfolios, middling represents progress. But expectations are still important.

Sharpe's law of active investing has been demonstrated many times, and it has a habit of explaining the ebb and flow of performance in a single asset class as well as the rules for asset allocation. In a recent issue of The Beta Investment Report, for instance, I looked at how a passive mix of all major asset classes fared relative to 900-plus actively managed multi-asset class mutual funds over the past 10 years, courtesy of data crunching with Morningstar’s Principia software. The result wasn’t terribly surprising: the passive mix delivered a modestly above-average return.

Is it reasonable to expect something similar when it comes to hiring a financial advisor? Perhaps. Everyone can’t be above average. But can they at least do no harm? Not necessarily, or so a recent study of financial advisory suggests.

A paper penned by two researchers at Goethe University Frankfurt (“Financial Advice: An Improvement for Worse?) asks three key questions:
1. Does the consultation of financial advisors improve portfolio performance?

2. Do financial advisors ameliorate their clients investment mistakes?

3. Do advisor recommendations improve asset allocation?

The answers aren’t encouraging, according to the paper, which explains:

Firstly, involving financial advisors results in lower portfolio returns, higher risk, and thus, in lower risk-adjusted returns. Second, advisors correct for some but not all investment mistakes. Third, advisors do not generally improve the asset allocation in client portfolios. Overall, our analysis provides evidence that the advice offered by the sample bank lacks quality in some tangible dimensions. This implies that conventional types of financial advice may not be the best remedy for the widespread financial illiteracy of households.

Critics will rightly point out that the study examines one large German financial institution, and so it can be said that this unnamed “German universal bank” is the problem rather than financial advice per se. In addition, one could take issue with the paper’s methodology, which draws on the traditional mean-variance optimization process for reaching conclusions. There are other assumptions that could conceivably skew results, such as that deciding that all transactions take place in the middle of the month.

The study, which analyzes "10,434 randomly selected customers for the 34-month period from January 2003 to October 2005," is hardly definitive, and so reasonable minds can differ about its relevance. But at the very least this research is a timely reminder that investors who hire advisors to manage money and/or dispense financial recommendations need to have a clear idea of what they’re paying for and who they're dealing with.

Suffice to say, different advisors offer different services and come with different skills. When it comes to straight investment advisory, it’s crucial to develop reasonable expectations and decide if you’re paying a fair price. That’s a complicated subject, of course, although no investor can afford to dismiss the necessary work to gain a reaosnable comfort level with a hired financial gun. The details, in short, can get messy when it comes to weighing the pros and cons of advisors.

Meantime, some of the usual caveats still apply. That starts with the recognition that the odds that any one advisor is going to deliver stellar performance results is probably expecting too much. Of course, everyone likes to focus on the outliers. The difference between Bernie Madoff’s results vs. Warren Buffett’s are the proverbial night-and-day outcomes. But for most investors, the middle ground is probably destiny.
Impressive investment returns are still dependent on three factors: skill, luck and asset/factor allocation. Quite often, a mix of all three is often relevant when analyzing results. For obvious reasons, advisors and money managers prefer to emphasize one of these variables over the other two.

There are no short cuts for intelligently choosing a financial planner, but you can start by asking prudent questions. The Certified Financial Planner Board of Standards, for instance, recommends 10 Questions to Ask When Choosing a Financial Planner. The Financial Planning Association publishes useful resources on the topic as well, including this primer.

Ultimately, many of the hazards that infect investing choices apply to choosing an advisor. Indeed, the decision may be as much art as it is science.

Even if you do everything right and choose a great planner, you’ll still need to monitor and assess through time. Expecting to fully transfer responsibility to an advisor and assuming that everything he or she recommends is exactly correct is asking for trouble. Yes, minding assets is time consuming and requires hard work. But you’re going to be involved one way or another. After all, it’s still your money.