The Market for Financial Advice: An Audit Study. Sendhil Mullainathan, Harvard University Markus Nöth, University of Hamburg Antoinette Schoar, MIT

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1 The Market for Financial Advice: An Audit Study Sendhil Mullainathan, Harvard University Markus Nöth, University of Hamburg Antoinette Schoar, MIT

2 Motivation past two decades: enormous proliferation of mutual funds and other investment vehicles for retail investors recent demographic and political trends: increasing reliance on individual investment accounts increasing importance of individual decision making for retirement/financial planning potentially less reliance on social security in future many firms move from defined benefit to defined contribution plans

accounts increasing importance of individual decision making for retirement/financial planning

3 Motivation numerous studies: individual investors are prone to make biased decisions e.g. Benartzi & Thaler (2007); Barber & Odean (2000) 1/n heuristic excessive trading individual decision biases bad investments? not necessarily: intermediation mechanisms may ameliorate biases Main Research Question Does the market for financial advice provide a private solution to improve the decision of retail investors or do advisers exploit the biases of individual investors for their own purposes?

not necessarily: intermediation mechanisms may ameliorate biases Main Research Question Does the market for financial

4 Research Questions 1. How does the market for financial advice work? What is the quality/type of advice that is offered? Do advisers adhere to basic recommendations of portfolio theory? 2. Do advisers de bias investors? Or do they exploit the biases for sales purposes? How do biases interact with the incentives of the adviser? 3. Are advisers constraint in the advice they can give by the client s preexisting biases (catering)?

Do advisers adhere to basic recommendations of portfolio theory? 2. Do advisers de bias investors?

5 Research Design: Audit Study (supply side) Sent trained auditors as clients to receive financial advice (April August 2008) Initially planned for 480 auditors balanced across 4 different treatment and control groups, But had to stop at 284, since banks started reducing the number of advisers (onset of financial crisis) Target 100 financial advisory firms in the Boston and Cambridge area banks and non bank advisers just investment advice; no retirement planning

to stop at 284, since banks started reducing the number of advisers (onset of financial crisis) Target 100

6 Mechanics of the Audit Study Mystery shopping is common for financial service firms to audit the quality of branches Logistics: Hired a mystery shopping firm Auditor recruitment from a pool of trained mystery shoppers with relevant demographics Auditor training via training materials, video conference, online testing, and mock visits Auditors set up meeting, meet adviser Data collection: online questionnaire had to be filled out within 24 hours after visit to receive payment double blind: neither auditors nor banks know our specific research questions

materials, video conference, online testing, and mock visits Auditors set up meeting, meet adviser Data collection: online questionnaire

7 Treatments Treatment 1 Chasing past returns: Auditor was assigned a portfolio that has 30% of the funds invested in sectors with high past returns. The auditor asked the adviser s opinion investing a large fraction of the money in those sectors which had high returns in the past. Treatment 2 Company stock: Auditor had a portfolio that has 30% of the funds invested in company stock (stocks of the company s/he is assigned to say s/he works at). Auditor will ask the adviser s opinion investing a large fraction of the money in his/her company stock. Treatment 3 Index portfolio Treatment 4 Cash Treatment (Control Group)

$works at). Auditor will ask the adviser s opinion investing a large fraction of the money in his/her company stock.$

8 Treatments Treatment 1 Chasing past returns Treatment 2 Company stock Treatment 3 Index portfolio: Auditor had an efficient portfolio invested in index funds. Auditor asked the adviser s opinion about investing in index funds. Treatment 4 Cash Treatment (Control Group) Mystery shopper was assigned a portfolio of cash and CDs. Auditor asked the adviser for general advice on portfolio investing.

Auditor asked the adviser s opinion about investing in index funds.

9 Research Set Up auditors were assigned background characteristics to match their own ones: Clients (auditors) are college educated, men and women. Two age/ investable funds groups will be clearly identified: early 30s with investable funds around US$ 50,000 late 40s with investable funds around US$ 100,000 Auditors get home ownership status and occupation assigned other characteristics: marital status, children, etc. shoppers own characteristics auditors were assigned portfolios to reflect their biases

Two age/ investable funds groups will be clearly identified: early 30s with investable funds around US$ 50,000 late 40s with

10 Outcomes Quantitative Compare change in asset allocation relative to starting portfolio Qualitative Detailed description of the discussion with the adviser How do adviser explain or enforce biases? Are fees mentioned without being prompted?

description of the discussion with the adviser How do

11 Descriptive Stats: Do Advisers Mention? VARIABLES Yes No Total Advisors encourage more of current strategy? Advisors suggest change of current strategy? Initial Reaction Positive Initial Reaction Negative Recommend Index Funds Recommend Actively Managed Funds Spontaneously mention fees Ask about age Ask about current occupation Ask about annual income Ask about 401k Ask about number of children Auditor would go back to this advisor with own money

139 67 206 Initial Reaction Positive 35 171 206 Initial Reaction Negative 82 124 206 Recommend Index Funds 21 263 284 Recommend Actively Managed

12 How do Advisers Respond to Clients with different investment biases? Are advisers supportive or discouraging toward current investment strategy? Measure whether advisers suggest to scale up or reduce reliance on the current investment strategy. Also code if advisers make positive of negative comments about the current portfolio. Regression remarks here: clustered at individual level no differences with random effects or probit regression no bank fixed effects

Measure whether advisers suggest to scale up or reduce reliance on the current investment strategy.

13 How do Advisers Respond to VARIABLES (1) (2) (3) (4) (5) (6) (7) (8) adviser encouraged client to invest more in adviser discouraged client to invest more in the existing strategy the existing strategy Investment Amount $100k $50k $100k $50k Company Stock PF 0.165** 0.185** * ** (0.0807) (0.0780) (0.154) (0.102) (0.0908) (0.111) (0.179) (0.117) Index Funds PF 0.284** 0.304** 0.418* 0.300** 0.397*** 0.438*** 0.476** 0.521*** (0.111) (0.116) (0.210) (0.108) (0.0989) (0.109) (0.176) (0.147) log(auditor's Age) ** (0.152) (0.396) (0.732) (0.489) (0.181) (0.485) (0.481) (0.775) log(annual Income) *** ** (0.228) (0.260) (0.349) (0.166) (0.252) (0.262) (0.390) (0.275) log(investment Amount) (0.258) (0.293) Marital Status (0.0355) (0.0924) Children 0.125* (0.0682) (0.119) Gender (0.108) (0.127) Constant *** *** (2.273) (2.185) (3.556) (2.984) (2.781) (3.039) (3.308) (4.765) Observations R squared

117) Index Funds PF 0.284** 0.304** 0.418* 0.300** 0.397*** 0.438*** 0.476** 0.521*** (0.111) (0.116) (0.210) (0.108) (0.0989) (0.109) (0.176) (0.147) log(auditor's Age) 0.0965 0.0121 0.991 0.681 0.

14 How do Advisors Respond to VARIABLES Investment Amount (9) (10) positive initial reaction negative initial reaction Company Stock PF * (0.0766) (0.125) Index Funds PF 0.199** (0.0884) (0.167) log(auditor's Age) 0.327* (0.181) (0.275) log(annual Income) (0.357) (0.353) log(investment Amount) Marital Status Children Gender Constant (4.006) (3.494) Observations R squared

167) log(auditor's Age) 0.327* 0.265 (0.181) (0.275) log(annual Income) 0.194 0.0901 (0.357) (0.

15 VARIABLES (1) (2) (5) (6) advisor recommends index funds advisor recommends actively managed funds Company Stock PF ** 0.149* (0.0540) (0.0567) (0.0906) (0.0737) Index Funds PF * 0.308** (0.0354) (0.0415) (0.138) (0.119) All Cash PF 0.183** 0.168** 0.318*** 0.292*** (0.0827) (0.0697) (0.104) (0.105) log(auditor's Age) ** (0.120) (0.110) (0.172) (0.193) log(annual Income) (0.141) (0.126) (0.291) (0.273) log(investment Amount) 0.109*** *** (0.0110) (0.0220) Marital Status (0.0365) (0.0623) Children *** (0.0518) (0.0913) Gender * (0.0490) (0.0744) Constant (1.349) (1.285) (3.311) (2.968) Observations R squared

110) (0.172) (0.193) log(annual Income) 0.0313 0.0292 0.170 0.267 (0.141) (0.126) (0.291) (0.273) log(investment Amount) 0.109*** 0.0783*** (0.0110) (0.0220) Marital Status 0.0271 0.00512 (0.0365) (0.

16 Key Findings Advisers seem to support biases that are in their own economic interest Lean strongly against investing in index funds Less strongly against investing in own company stock (relative to trend chasing) Advisers seem to have dramatic preferences for actively managed funds over index funds Push actively managed funds even for index portfolio More likely to offer index funds for cash treatment But: initial reaction to the client s portfolio is less negative. Could be indicative of a need to cater

preferences for actively managed funds over index funds Push actively managed funds even for index portfolio More likely to

17 Investor Characteristics How do advisers take the characteristics of the auditor into account Age Income Investment Amount Children How did adviser advice vary?

18 (1) (2) (3) (4) VARIABLES advisor recommends advisor advice index funds actively managed funds mentions fees after money transfer only log(auditor's Age) *** 0.527** (0.118) (0.217) (0.197) (0.811) log(annual Income) (0.120) (0.272) (0.219) (0.350) Marital Status (0.0366) (0.0876) (0.0804) (0.105) Children *** (0.0438) (0.0813) (0.101) (0.151) Gender ** *** (0.0417) (0.0979) (0.101) (0.116) Constant ** (1.248) (3.068) (2.688) (4.488) Observations R squared

107 0.130 0.124 (0.0366) (0.0876) (0.0804) (0.105) Children 0.0203 0.320*** 0.0471 0.138 (0.0438) (0.0813) (0.101) (0.151) Gender 0.0194 0.209** 0.0146 0.

19 Key Findings: Mixed Bag Older auditors are told spontaneously about fees and are given more detailed advice upfront, which might suggest that they are taken more seriously but are also more likely to be pushed into actively managed funds Women are advised.. not to put their money in actively managed funds, which might suggest they are seen as more risk averse.. to put the money with the adviser before given advice, which might suggest that they are seen as more gullible

20 Conclusion Advisers generally fail to de bias their clients, but seem to exaggerate existing biases. Advisers self interest plays a role in generating lowquality advice Some evidence that advisers cater to clients preexisting biases Advisers tend to tailor advice according to the demographic groups, which broadly matches portfolio theory.

Advisers self interest plays a role in generating lowquality advice Some evidence

The Market for Financial Advice: An Audit Study

The Market for Financial Advice: An Audit Study Sendhil Mullainathan (Harvard University) Markus Nöth (University of Hamburg) Antoinette Schoar (Massachusetts Institute of Technology) April, 2011 A growing