When I first started investing years ago, I didn’t really know what I was doing. I wanted to play around with stocks, but I didn’t want to risk losing all my money. For that reason, I decided to place some of my money under management by financial professionals. I figured that the experts would know best how to grow my money. However, that turned out to be a mistake. My managed portfolio consistently underperformed the benchmark both over the short term (monthly, quarterly, and yearly) and over the long term (3-5 years). When I realized that I was earning 3.5% less than the benchmark per year without including fees and 4.5% less per year with fees, I knew it was time for a change. I closed my professionally-managed account and transferred all the money into my personally-managed account, and my returns have been much better ever since.
This is evidently a common story according to a 2021 study published in The Journal of Finance titled “The Misguided Beliefs of Financial Advisors” by Juhani T. Linnainmaa, Brian T. Melzer, and Alessandro Previtero. Based on a large sample of Canadian financial advisors and their clients from January 1999 to December 2013, the authors found that both the advisors and their clients underperformed a passive benchmark by about 3% per year on average. The authors claimed that this is because the advisors had misguided beliefs about optimal investing practices, exhibiting the following problematic behaviors:
- Trading frequently
- Chasing returns
- Preferring expensive and actively managed funds
Regardless of their clients’ goals, the advisors’ preferences resulted in their clients’ accounts looking quite similar to their own. I will go into more detail about each of these problematic behaviors below.
Frequent trading, or high turnover, occurs when an investor buys and sells securities often. This can negatively affect returns because the investor may be buying or selling at inopportune times (see Why Emotions And Investing Don’t Mix) or simply because they may have to pay higher taxes on short-term sales. Linnainmaa et al. found that advisors actually trade more frequently than their clients and both trade more often in general-purpose accounts than in tax-advantaged retirement accounts. Average turnover for advisors was 66% in general-purpose accounts compared to 39% in retirement accounts, while turnover for clients was 40% in general-purpose accounts compared to 32% in retirement accounts. While anyone aiming for long-term returns should attempt to limit frequent trading as much as possible, trading more in general-purpose accounts is particularly problematic. This is because frequent turnover results in higher taxes, which can be avoided if the turnover occurs in a tax-advantaged account.
I, too, have made this mistake. I opened my retirement account much more recently than my general purpose account, and due to the contribution limits, I have much less money in that account. Since the account balance is so much smaller, it feels like there is less trading I can do with it. However, this is apparently a problem for the general population as well, so it is doubtful that it is only due to account balances. More likely, people tend to trade less in retirement accounts because they view them as long-term accounts. Since you generally can’t take your profits out until near retirement age without penalties, people are more likely to have a longer time horizon. There are also a number of retirement accounts where you have limited control over your investments aside from picking a plan, which would prevent high turnover. On the contrary, general purpose accounts allow people to feel like they have more direct control over their money, and this usually encourages people to think more short-term and thus results in higher turnover.
Return chasing is when an investor purchases a security because it has performed well in the past. Generally, people think that a security that has done well previously will continue to do just as well in the future. However, as is often said, past performance is no guarantee of future results. Linnainmaa et al. found that clients purchased funds in the 56th percentile of prior-year performance on average, while advisors purchased funds in the 59th percentile, slightly higher. The authors claim that this means the advisors and their clients make the mistake of chasing returns. However, as the 50th percentile would be funds with the median prior-year performance, 56th percentile and 59th percentile are not really that high.
That said, this is a mistake that I am definitely guilty of making. I tend to be a momentum investor, preferring securities that are currently growing because I feel like they should probably keep growing, barring any issues with the companies, their competitors, or the financial environment as a whole. Thankfully, my wife tends be a value investor, buying securities she believes are trading at a discount and have room to grow. This difference in our trading strategies helps our overall investments to be more balanced.
Preferring expensive and actively managed funds
Funds have varying costs to own and can be either actively managed or passive. Actively managed funds try to outperform the market, while passive funds try to capture the performance of the market as a whole or a segment of it. Actively managed funds tend to have higher fees than passive funds. In general, investors should look for low cost funds since fees can eat a large portion of your return. They also would often generally be better served with passive funds rather than actively managed funds. According to the SPIVA Scorecard by the S&P Dow Jones Indices, 75% of large-cap funds in the U.S. underperformed the S&P 500 Index over the last 5 years as of December 2020. For Canada, where the data for this study was collected, a whopping 97% of equity funds underperformed the S&P/TSX Composite Index over the last 5 years.
Despite these facts, Linnainmaa et al. found that there was a huge preference for actively managed funds. For both advisors and their clients, 99% of the funds they invested in were actively managed, suggesting that they were trying to chase down the 3% of funds that beat the passive index. As for fees, although the authors claimed advisors preferred expensive funds, their data indicates that both advisors and their clients actually bought funds with costs below the median for their asset classes, at the 46th and 43rd percentile, respectively.
Diversification is a measure of how varied your assets are in terms of asset class, sector, and size. Generally, the more diversified your portfolio is, the lower the overall risk since different assets and sectors are affected by market events in different ways. For instance, stock prices are not correlated with gold prices, so gold prices may not decrease in the event of a stock market downturn (see What Assets Are Correlated With Gold?). However, greater diversification can also result in lower returns since some assets grow much more slowly at times than others.
Linnainmaa et al. found that clients were underdiversified relative to the Canadian index by 6.9% and by 7.3% relative to the MSCI World index. Advisors were slightly more underdiversified at 7.4% relative to the Canadian index and 8.0% relative to the MSCI World index. I have no idea how diversified the typical investor’s portfolio is, so it is hard for me to put those numbers in context. However, 7-8% underdiversification doesn’t seem like that much to me, considering many people these days seem only to invest in either tech stocks and cryptocurrencies or dividend stocks.
Personally, my portfolio is not particularly diversified, although I have been working on improving that. As of the end of 2020, my wife and I had 81% of our assets in stocks, mutual funds, and ETFs, 3% in Worthy Bonds, 13% in cash (we’re planning to buy a house in the near future, so we want to have cash on hand), and 3% in our two cars. Recently I’ve moved about 3% from stocks into Fundrise to diversify into real estate, so we’ll see how that pans out. My wife and I are still young, so most experts say to keep the majority of our assets in the stock market. I have tried to diversify in terms of large-cap, mid-cap, and small-cap stocks as well as investing in different sectors, but the bulk of my investments are still in tech since I believe it will continue to advance at a rapid pace.
Why do financial advisors tend to make these mistakes?
While the degree to which advisors exhibit the above behaviors is up for debate, it is clear that financial advisors more strongly exhibit the behaviors than their clients, suggesting that they believe this is beneficial. Basically, they believe they can beat the market. Why? Linnainmaa et al. suggested that it is either because they are overconfident or ignorant about optimal investing strategies. I would guess the former explanation is more likely. These are people who received formal training on how to invest and earn their living doing it for others. I’m sure they were exposed to the theory and fundamentals. However, due to their education and experience, they likely believe they know how to beat the system better than others, making them overconfident. You wouldn’t be hired as a financial advisor if you weren’t confident in your investing skills.
In their article, Linnainmaa et al. claimed that financial advisors make four main investing mistakes which result in lower returns for themselves and their clients: trading frequently, chasing returns, preferring expensive and actively managed funds, and underdiversifying. Based on the data they report, I find several of these claims tenuous at best. They do appear to trade frequently, particularly in general-purpose accounts rather than retirement accounts, the opposite of what you should do. They also strongly prefer actively managed funds to the tune of 99:1. However, there is no context to compare underdiversification, and 7-8% underdiversification does not seem particularly large without context. They do chase returns, but only slightly more than the median. And they actually buy funds with costs slightly below the median. Altogether, I would say that they do make some mistakes, but how this compares to the behaviors of non-financial advisors is unknown. If the general population tends to exhibit these behaviors even more severely, then perhaps the advisor is actually helping. Otherwise, they appear to be a waste of money. Without that context, it’s impossible to say.
You may be wondering if the results would be different for fiduciaries, financial advisors who are legally required to act in the best interests of their clients. The authors do address this point, even though none of the financial advisors they studied were fiduciaries. They suggested that since they found that the advisors managed the clients’ accounts as they would their own, it is unlikely that a fiduciary would provide better service. They already believe that they are acting in the best interest of their clients and themselves.
While the article unfortunately does not provide any concrete advice about whether to entrust your money to a financial advisor, it does bring up some good points about investing. The best way to generate optimal long-term returns is to invest passively in low-fee funds, trade infrequently (don’t chase returns), and diversify.