There are occasions in life when we need to turn to our friends for counsel. “Should I take that job?” is one. “Is she or he worth dating?” might be another.And according to the Survey of Consumer Finances, the Federal Reserve’s once every three-year look at the financial state of the American public which was released on Monday, many of us think we should also look to our pals for investment advice, making them our number one source of information for making financial decisions.
That’s unfortunate. Your friends are just about the last people you should seek financial wisdom from. Unless one of your buddies is named Warren Buffet, the chances are incredible their advice sucks.
Why? Let me count the ways.
First, it’s quite likely your friends don’t know what the heck they are talking about, whether it comes to recommending specific investments or brokers. Need an example? Bernie Madoff was “my guy” to many people. And you couldn’t just invest with Madoff. You needed to be asked, which led to lots of folks telling their friends about the older fellow at the country club with the magic money touch, the guy who earned them 10 per cent year in, year out, market conditions be damned. Many smart, knowledgeable people fell for this scam – and didn’t recognise it for the Ponzi scheme it was til the Federal government stepped in.
However, a financial advisor or broker doesn’t have to be Bernie Madoff for your friend’s advice to suck. The truth is that most of us have no idea if we are receiving good or bad guidance from our chosen advisor.
Take a look at a study entitled The Market for Financial Advice: An Audit Study, released earlier this year by the National Bureau of Economic Research. A group of researchers led by behavioural economist Sendhil Mullainathan at Harvard University recruited men and women to impersonate would-be new investors at several mostly commission-based banks and brokerage houses.
So what happened? Over and over again, the brokers pitched their “clients” on comparatively expensive managed funds, steering them away from lower cost and more fiscally efficient index funds. But the really scary part of this study was not what the brokers did, but how the testers reacted to the advice. The vast majority of the faux investors didn’t think they’d just been had. Instead, they thought they had found “my guy,” so much so that about 70 per cent of them told the researchers that they would return to the financial advisor again – this time with their own real-life investments.
You just know that some of these testers were recommending their new guy to their friends too.
All this points to the fact that our collective financial illiteracy is immense when it comes to what sort of responsibilities our would-be financial consiglieres have toward clients. According to a study performed by a consortium of groups including AARP and the Consumer Federation of America, three out of four of us believe all brokers have to follow something called a fiduciary duty, – that is, they have a responsibility to act in the best interests of their clients.
That, alas, is not true.
Of the nation’s 320,000 financial advisors, a mere 20,000 earned the entirety of their keep as Registered Investment Advisors, and had to follow the fiduciary standard at all times. The rest work at least some of the time to something called the suitability rule, which could be called the “it’s good enough” standard.
I’m not suggesting all non-RIAs give poor advice. The issue is that they’re not required by law to act in the best interest of their clients – a fact that would come as a surprise to many people according to the AARP data.
What’s the risk? It means they can sell all sorts of stuff ranging from less than promising Internet start-ups to active management high fee funds with less than stellar returns. The chances that the pal you’re talking to is one of four investors who possesses the knowledge to ask the right questions of an advisor so that this doesn’t happen to them – or you — is not great.
What about those hot tips your friends hear about, the hot Internet stock sure to be the next Google?
Truly, it doesn’t matter how your friends got the hot lead. A recent review of the investing plays recommended at the 2011 Ira Sohn Investment Conference, a yearly gathering of the stars of the hedge fund world firmament, is instructive. When the website Absolute Return reviewed the presentations one year later, they found the vast majority of suggested moneymaking strategies were actually portfolio losers.
The best financial advice is boring. It doesn’t allow people to boast about their prowess. All that’s required of those who want to invest for the best chances of achieving their goals is to ascertain their risk tolerance, time frame and the amount of money they can afford to put aside. From there, they need to place their monies in a selection of low-cost, tax efficient, indexed exchange traded funds. It’s a strategy that won’t let you do better than the markets — but it won’t let you do worse either.
And that’s advice that doesn’t suck.
Jon Stein is the founder and CEO of Betterment. Passionate about helping people make smart decisions with their money, he founded the online investment product in 2008. Jon is a Chartered Financial Analyst (CFA), a Series 7, 24, and 63 Registered Securities Representative, and a graduate of Harvard University (Economics) and Columbia Business School. His interests lie at the intersection of behaviour, psychology, and economics. What excites him most about his work is making everyday activities and products frictionless, efficient, and more accessible.