The Cold, Hard Truth About Brokers and Financial Advisors
Mar 20th 2012 1:21PM
Updated Mar 20th 2012 2:32PM
The case against stock brokers and financial advisors isn't just all hot air. Today, I have proof that when you use a financial advisor or full-service broker, you may find yourself with lower returns than if you'd handled your investing yourself. Read on and I'll share the details of recent research that shows just how costly professional financial advice can be.
To Germany we go!
I'm referring to a paper titled "Financial Advisors: A Case of Babysitters?" that comes to us from Andreas Hackethal and Michael Haliassos of Goethe University in Frankfurt, Germany, and Tullio Jappelli of the University of Naples Federico II in Italy. The trio of researchers got their hands on a couple of very cool datasets -- one is from a German online brokerage and includes 32,751 randomly selected customers, while the other is 4,447 clients of a large German bank.
In both the online brokerage and the bank, customers were offered the option to manage the accounts themselves or employ an advisor. That choice provided the perfect opportunity to do a side-by-side study of advisor-assisted and individually managed accounts.
Let's get right to those results. Here are the researchers summing up their findings:
Involvement of financial advisors is found to lower portfolio returns net of direct cost, to worsen risk-return profiles, as measured by the Sharpe ratio; and to increase account turnover and investment in mutual funds, consistent with incentives built into the commission structure of both types of financial advisors.
That may be a lot to digest all at once, so let me break this down a little further. There are three very crucial points that the researchers highlighted:
- Lower performance. Bottom line, the research showed that the accounts that used financial advisors had lower returns (net of fees) than the accounts that did not. How much lower? A whopping five percentage points lower. That smarts. But just how much does that hurt? Starting with a $100,000 portfolio, over the course of 30 years, getting 7% returns instead of 12% means a difference of a cool $2.2 million, or having a $761,226 account value instead of nearly $3 million.
- Lower risk-adjusted performance. A potentially reasonable explanation for No. 1 above is that advisors are serving their clients by creating safer portfolios that produce lower returns but also have lower risk. But that doesn't appear to be the case with this dataset. The researchers found that advisor-assisted accounts also had lower Sharpe ratios. The Sharpe ratio is a measure of performance that adjusts for risk, so the findings suggest that investors using advisors were getting less compensated for the risk they were taking as opposed to investors who weren't using advisors.
- Padding their bottom line. Finally, the results suggest that, on the whole, advisors in this dataset were focused on padding their own bottom lines. Accounts that used advisors had higher turnover and were more heavily invested in mutual funds -- both outcomes that would (conveniently!) earn higher commissions for the advisors.
What have you done for me... ever?
Take a moment to think about what it means to pay a professional for their services. I've had problems with scorpions in my house, so I hired a pest professional. Evaluating that service has been simple -- I've been happy because I'm not seeing poisonous arthropods running around anymore. Which, mind you, is an outcome I was woefully unsuccessful at achieving on my own.
Likewise, you could hire a plumber to fix a leaky faucet or a doctor to treat an infection with the expectation that either could do a better job at remedying the problem than you could.
With all of that in mind, consider this: What is a financial advisor worth if you end up with lower investment returns?
Say it ain't so!
I'm sure there are holes that could be poked in this research, and I'd be overreaching if I were to suggest that this one study of a couple of financial outlets in Germany is enough to condemn the entire financial advisory industry worldwide.
At the same time, if I'm Bank of America's (NYS: BAC) Merrill Lynch, Morgan Stanley Smith Barney (a Citigroup (NYS: C) / Morgan Stanley (NYS: MS) joint venture), Wells Fargo (NYS: WFC) , Charles Schwab (NAS: SCHW) , or any of the many other players in this multitrillion-dollar business, it's got to be a bit uncomfortable that research like this is coming out. For decades, brokers and financial advisors were very much like the great and powerful Oz, hiding out behind a comfortable and profitable shroud of secrecy. In the age of the Internet, it's becoming much easier to find out the value -- or lack thereof -- that brokers and financial advisors actually offer their customers.
But I'm not writing this to simply crucify the industry. I want to hear what you have to say. Whether you're a financial advisor or broker client or you're a financial advisor or broker yourself, I want to hear why you think this research hits the nail on the head or why it misses the point. Share your thoughts in the comments section below or send us an email at email@example.com.
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