How to Fix What Advisers and Investors Are Doing Wrong

Financial advisor talking to couple on sofa
By Hal M. Bundrick

Many Americans are struggling to save an adequate amount for retirement –- or for other long-term goals. Is it just our fault? Are we simply too inept to set aside the money and invest it prudently to meet our financial needs? It's quite possible, according to new research by State Street's Center for Applied Research, that our financial advisers are also to blame.

%"The models for success in the investment management industry are broken," says the report, called "The Folklore of Finance." Gathering input from 3,744 investors, investment providers, government officials and regulators in 19 countries, the study finds that opportunities for producing out-performing investments are rare. In other words, what clients are seeking -- and advisors are promising -- is nearly impossible to deliver.

Investors pay about $600 billion per year in fees for investments that promise to deliver returns above that of a passive index. In 2006, only 0.6 percent of some 2000 equity mutual funds outperformed their respective benchmarks. This quest for "alpha" -– investment outperformance -– is futile, according to the report.

The Alpha Dog

"Despite overwhelming evidence that alpha is increasingly difficult to obtain, the investment management industry continues to hold alpha as its primary measure of success -– to its peril," the center concludes.

Investors nurture this behavior by shopping for money managers based on past performance, rather than on attaining financial goals. Instead of considering risk and downside protection, as well as income and liability management, consumers are fixated on finding the portfolio manager with the "magic touch."

Meanwhile, distrust of the financial services industry is fueling increasing dissatisfaction among investors. A whopping 93 percent of individual investors believe they would be better off just making their own financial decisions, the survey says. Two thirds think the best investment they ever made was "entirely their own decision," and 65 percent believe technology will do better at meeting their needs than humans. Here come the robo advisers.

A Fractured Relationship

"Many asset managers focus relentlessly on new product launches to grow their assets under management and associated fee base," the study says. "Similarly, focusing on maintaining accounts, some financial advisers seek to shield clients from bad news by telling clients what they want to hear, not what they need to hear. This only makes the distrust and dissatisfaction worse."

To fix a broken system, the researchers offer these suggestions, applicable to investors and investment professionals alike:

  • Keep records of decisions. Documenting past choices will help eliminate "hindsight bias" – the tendency to credit ourselves for successes but outside forces for failures.
  • Encourage feedback from others –- as well as a "devil's advocate" -– to help recognize and address mistakes.
  • Create investment rules that mandate buying, sizing and selling decisions.
  • Reduce portfolio complexity by limiting investment choices.
In addition, the report urges the industry to find a way to revise compensation structures. Rather than incentives based on assets-under-management or investment performance, compensation should be based on meeting organizational and investor goals.

Hal M. Bundrick is a certified financial planner.
Read Full Story