The Cold, Hard Truth About Brokers and Financial Advisors

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:

  1. 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.
  2. 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.
  3. 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 tips@fool.com.

At the time this article was published The Motley Fool owns shares of Citigroup and Bank of America. The Fool owns shares of and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Charles Schwab. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer owns shares of Morgan Stanley and Bank of America, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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7 Comments

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mingster04

Investors Beware! The Morgan Stanley and Janney Montgomery brokers of the world are there to meet their bottom line - meet their monthly quotas and thus, make commissions. Their rhetoric to clients is to say they are there to help you build your retirement future but the BOTTOM LINE is - it is their JOB to make money for their Wall Street firm. And the ONLY way to make money is to make TRADES (the more the merrier) on your accounts. The more trades they make, the more commission they will get. Their daily 9-to-5 operation is to go thru their client list, contact them and see what trades they can offer to their clients and hope they say yes.
Of course a broker's dream come true would be if their clients would call them (everyday) and say buy this or sell that. There is no liability against the broker if the client initiates the trade.
Some trades can be ideal or possibly necessary for your portfolio. But most (that I have experienced) have been unscrupulous. The ones I've experienced is - there is currently nothing wrong with your portfolio but your broker keeps calling you and highly recommends that you sell all or some of your current stock or buy something new. Your portfolio is not in jeopardy but your broker tries to persuade you to make some activity. This churning activity achieves the brokers bottom line - making a commission. They really don't care about your retirement future, they are there to make money for themselves.

May 22 2012 at 10:26 PM Report abuse rate up rate down Reply
jlenri2561

I tend to agree with some of the comments mentioned about how some advisors just care about their bottom line, but this is not always the truth. I am currently an advisor for Primerica and prior to that with the former Wachovia Bank. I always based my recomendations on the clients well being and never on my wallet, in fact i always as i do now look out for the client's best interest by first and foremost educating the client about the different investments available to them. Whether i get paid $1.00 dollar or $1,000.00 is of no concern to me since i am always looking for the client's best interest. To me for them is all about choices that they make, i just lay it all on the table and let them choose. I do however make a very strong recomendation for life insurance (income protection) as well call it, because there is no other way to replace someones income if the unfortunate happens. So there you have for others to share. Check out Primerica you'll be impressed.

March 21 2012 at 1:46 PM Report abuse rate up rate down Reply
Chris Barber

I'm not totally convinced that advisors don't provide value. Sure, you may be able to outperform advisor recommendations (more than likely by taking on more risk), but at what cost? With the abundance of information available now, who has time to evaluate it all and keep up with market movements daily? I may be able to kill spiders better than an exterminator, but it doesn't mean that's how I want to spend my valuable time. Advisors may or may not be the most savvy of investors, but I think they save their clients in opportunity costs, ease of mind, and being an objective (rather than emotional) investor. I use www.fipath.com to do both research for financial planning and to be connected to expert advice, so it's really the best of both worlds.

March 21 2012 at 8:29 AM Report abuse rate up rate down Reply
ajorgen000

I agree. We've had 2 financial advisors.And never again.It's true they put you in loaded funds and pad their pockets big time.I now do my own investing and am doing 100% better than with the advisor.Wish I had know then what I know now!!

March 20 2012 at 11:57 PM Report abuse rate up rate down Reply
jiharris53

Financial advisors are only interested in how to advise how to use your money to make themselves a buck.

March 20 2012 at 9:28 PM Report abuse rate up rate down Reply
clcruse

So what do you think of Ameriprise?

March 20 2012 at 9:17 PM Report abuse rate up rate down Reply
1 reply to clcruse's comment
jlenri2561

I have a former buddy rep of mine that works as an independant broker for them and he is very happy there. I used to recomend their products and i never had any problems with them.

March 21 2012 at 1:49 PM Report abuse rate up rate down Reply