Addressing advisors’ misguided beliefs

We need to contemplate something uncomfortable that has gone unaddressed for too long and that many financial advisors do not want to contemplate: their own misguided beliefs.

A research paper originally published in 2016 and entitled “The Misguided Beliefs of Financial Advisors” included evidence that Canadian mutual fund advisors chase past performance, are too concentrated in their recommendations, and pay little or no attention to product cost — behaviours long recognized as demonstrably incorrect and harmful to investors.

The unexpected twist was that the advisors engaged in these harmful activities in their own accounts, even after they retired from the business.

Why did the advisors do this?

Before the Misguided Beliefs paper, it was easy to assume that advisor recommendations were based on self-interest and misplaced agency. The thinking was that advisors gamed the system to maximize their personal revenue: specifically, they recommended high-cost, actively managed products that had performed well in the past to get their clients to buy more of them. Plus, it was easier and more profitable to recommend products with embedded compensation, and these products were often among the most expensive.

Yet, the advisors in the paper were not trying to swindle their clients; they believed what they were doing was appropriate. They themselves could have saved money by avoiding products with embedded commissions but chose not to. The original abstract even came with a warning that regulatory changes aimed at eliminating compensation-based biases would not solve the misguided beliefs problem. That was the research’s counterintuitive finding.

Misguided beliefs and why they persist

Examples of misguided beliefs in action include recommending:

• a fund based on its one-, three-, five- or 10-year performance;
• more than one product for a specific mandate (whether it’s Canadian stocks, American bonds or a niche sector, there’s simply no need to add more names to make things look more diversified than they really are); and
• high-cost products when low-cost alternatives exist.

Note that the client-focused reforms address cost, as do the FP Canada Projection Assumption Guidelines, where planners are instructed to lower expected returns by both product and advice costs.

The interests of ordinary investors are best protected by building customized portfolios that are cheap, diversified and agnostic toward past performance. In John Bogle’s immortal words, when it comes to investing, “you get what you don’t pay for.” The more a product costs, the less it is likely to return to the investor.

The Misguided Beliefs paper reflects groupthink rooted in the social psychology research of Stanley Milgram, Leon Festinger and Solomon Asch. These trailblazers showed how easy it is for people to conform when there is group pressure to do so. Most advisors understandably want to fit in and, as a result, do what everyone else in their shop does. Once a pattern of routinely recommending actively managed funds that have done well in the recent past is seen as being appropriate (even laudable) behaviour, it soon becomes the norm. Once a norm is established, it becomes difficult to dislodge. In-group favouritism and belief congruence take hold. Misinformation is normalized and questionable conduct follows.

Ideas to counteract misguided beliefs

Here are three actionable steps to address advisors’ misguided beliefs. I’m interested in hearing others.

• Institute mandatory disclosures as a precondition of opening an account. Have a generic, industry-wide disclaimer that has the client acknowledge, in writing, that diversification and keeping costs low are important and that past performance may not persist and should not be relied on.
• Retrain advisors, perhaps through a course that challenges misguided beliefs.
• Nip the problem in the bud. The mutual fund licensing course could provide evidence that counteracts misguided beliefs.

Conclusion

Any industry should quite properly seek to maximize profit, but allowing misguided beliefs to stand is wrong. And how can anyone be serious about investor education when the trusted advisors doing the educating are misinformed?

The problem before us is entrenched, presumptive and, judging by the overall lack of industry action, seemingly innocuous. But it is costing Canadians billions of dollars annually in the form of excess costs and forgone returns.

John De Goey is a portfolio manager with Designed Securities Ltd. He can be reached at jdegoey@designedsecurities.ca.