By Jason Zweig | June 9, 2017 2:13 pm ET
Image credit: Photo of scene from Dumb and Dumber by “Insomnia Cured Here,” Flickr
Do all financial advisers turn their clients into better investors, or do some make their clients’ behavior even worse?
My latest column looks at this question. There isn’t any doubt that many financial advisers keep their clients from getting too greedy as markets go up, while also inspiring them with hope during dark times — helping investors stay the course through good times and bad.
But ultimately this question boils down to whether you believe that there is such a thing as “smart money” and “dumb money.”
For decades (centuries?), Wall Street has mocked individual investors for buying and selling the wrong things at the wrong times. And there is plenty of truth to that criticism. Individual investors do chase performance, buying more and more of whatever is hot until they get burned, then selling once it gets cold (or as soon as it gets them back to “breakeven”). That’s what they did with bond funds and emerging-market funds in the early 1990s, Internet stocks in 1999 and 2000, and so on.
But the great investing writer “Adam Smith” (George J.W. Goodman), who died in 2014, turned the mockery around, showing how absurd the idea of dumb money becomes when you take it to its logical extreme:
“In more polite circles, John Jerk and his brother are called ‘the little fellows’ or ‘the odd-lotters’ or ‘the small investors.’ I wish I knew Mr. Jerk and his brother. They live in some place called the Hinterlands, and everything they do is wrong. They buy when the smart people sell, they sell when the smart people buy, and they panic at exactly the wrong time. There are services that make a very good living out of charting the activity of Mr. J. and his poor brother. If I knew them I would give them room and board and consult them…. I would push the pheasant and champagne through the little hatch of his cell and ask Mr. J. what he was going to do that morning, and if he said, ‘buy,’ I would know to sell, and so on.”
The behavior gap — the difference between the performance of an investment and the returns of the investors who own it — has historically been cited by stockbrokers as evidence that investors do poorly without financial advice. Brokers are fond of citing reports from Dalbar, a Boston financial-services firm, contending that investors in U.S. stock funds have underperformed the funds they own by an astounding margin of nearly seven percentage points annually for the past three decades.
If you think about this for a moment, though, it makes no sense. Decades ago, many investors did act in isolation, without the counsel of a financial adviser. But today, 80% of investors who hold mutual funds outside employer-sponsored retirement plans own them through an adviser.
So the contention that investors are shooting themselves in the foot is nonsensical. Four out of five investors are using financial advisers when they invest in mutual funds. They might be getting shot in the foot, but if so, it must have been a financial adviser who pulled the trigger!
Either investors are behaving badly and their advisers aren’t stopping them, or advisers are giving bad advice and investors are following it. Researchers using “mystery shoppers” masquerading as prospective clients have found that some financial advisers tend to tell investors what they want to hear — throwing fuel on the emotional fire instead of damping it.
It’s discouragingly easy to see that the “smart money” — financial advisers, investment consultants and the institutions counseled by them — isn’t as smart as it likes to fancy itself:
- The money managers hired by corporate pension plans underperform the managers fired by the same plans; just as individual investors buy high and sell low, these big investors hire high and fire low.
- Even the funds that corporate-pension plans favor the most underperform the ones they like the least.
- Investment officers at the largest pension funds in Australia admit they rely heavily on hunches and “subjective” beliefs, rather than quantitative analysis, to pick external managers to run their funds.
- Buyers of hedge funds — who like to style themselves among the most sophisticated of all investors — put the most money into the funds with the hottest recent returns.
- As a result, they underperform the hedge funds themselves by an average of three to seven percentage points annually.
Finally, let’s not forget that professional hedge-fund analysts, fund-of-fund managers and other such purportedly expert advisers put thousands of investors into Bernard Madoff’s Ponzi scheme.
Nor should we forget that among the eager clients of the Foundation for New Era Philanthropy, one of the most notorious fraudulent investment schemes of the 1990s, were such billionaires and eminent financiers as Laurance Rockefeller, former Goldman Sachs co-chairman John C. Whitehead and ex-U.S. Treasury Secretary William E. Simon.
So some financial advisers surely do help their clients control the greed and fear that can lead to buying high and selling low. But other advisers may well succumb to the same kind of behavior themselves. They might serve their clients better by spending more time on financial planning and less on investment management.
Taking all the evidence into account, it seems only fair for everyone to recognize that there is no “smart money” or “dumb money.” There is only money.
Source: WSJ.com, MoneyBeat blog, http://on.wsj.com/2rV1TBT
Resources:
Definitions of FINANCIAL ADVISOR, INDIVIDUAL INVESTOR, RETAIL INVESTOR, SMART MONEY, and SOPHISTICATED INVESTOR in The Devil’s Financial Dictionary
John C. Bogle, “The Arithmetic of “All-In” Investment Expenses”
Donald G. Bennyhoff and Francis M. Kinniry Jr., “Vanguard Advisor’s Alpha“: hypothetical measures of the ways advice can benefit investors
David Blanchett and Paul Kaplan, “Alpha, Beta and Now…Gamma“: how financial planning can make retirement richer; see also “Moving Beyond the Efficient Frontier: Gamma, Anyone?” and “Morningstar Tries to Quantify the Value of Financial Planning”
David Blanchett, “Testing Dalbar’s Claims About Mutual Fund Investors”
Wade Pfau, “A Warning to the Advisory Profession: Dalbar’s Math Is Wrong”