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Last modified: Thursday, October 20, 2011

Investors who most need financial guidance are least likely to get it, and even less likely to take heed

First study to link advisers' guidance and client behavior; findings question key Dodd-Frank provisions

Oct. 20, 2011

BLOOMINGTON, Ind. -- Despite the rocky economy, relatively few investors seek professional guidance that could keep them on solid financial footing and help them avoid costly investing mistakes. Further, those who do obtain sound advice tend to ignore it -- a pattern even among investors most in need of assistance. Taken together, these realities indicate that key provisions in U.S. and European regulations designed to protect investors are ineffective and waste money.

Bhattacharya image

Utpal Bhattacharya

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These are the primary findings of a study from the Indiana University Kelley School of Business that is believed to be the first to link recommendations of financial advisers to actual client behavior after advice is given.

"Smart people routinely make serious financial mistakes, such as trading too frequently, hanging on to losing stocks too long, or not diversifying. These are moves that financial-education programs and government regulation -- the "supply" side of the equation -- have sought to prevent," said Utpal Bhattacharya, finance professor at the Kelley School and co-author of the study.

"But unbiased professional guidance is useless if isn't accepted or followed, and our study showed that it generally is not. This suggests that remedies coming from the supply side, such as the Dodd-Frank bill, are not working and should be scrapped or re-imagined," he added.

Bhattacharya and his co-authors from the Goethe University of Frankfurt delved into the "demand" side of the equation (i.e., what investors actually do) to better understand the efficacy of supply-side remedies to the financial crisis. They partnered with one of Germany's largest brokerages to offer financial advice to more than 8,000 of its several hundred thousand active retail investors. The advice was free of charge and, since it was generated by an algorithm designed to improve portfolio efficiency, was also free of bias and monetary conflicts of interest of the brokerage.

Given this, the researchers were stunned to find that:

  • Only 5 percent of the investors accepted the offer from their primary brokerage;
  • Those who accepted tended to be male, older, and have a longer relationship with the brokerage;
  • Those who accepted were more financially sophisticated (measured by past investment returns) and so needed the advice less; and, most surprisingly
  • Most of the 5 percent who accepted the advice never followed it

It was not surprising to find that the few who'd accepted and acted on the advice saw their portfolios dramatically improve, in marked contrast to their many counterparts who'd either declined or not implemented the guidance.

"We found ourselves with a modern, financial version of a horse we'd led to water, but we couldn't make it drink," said Bhattacharya. "Investors who could benefit the most from assistance, say, those who are younger or newer to investing, didn't accept advice even though it was free, unbiased and from one of the nation's most trusted firms."

Dodd-Frank wasting money; broad implications for regulators worldwide

The financial-advice business accounts for an estimated $37 billion in the United States alone. However, there might be much bias in this advice, according to the authors, because private information and complexity provide camouflage to advisers to act in their own interests to the detriment of their clients. This is why regulators want to force advisers to provide unbiased advice. But, as this study shows, even this does not work.

The authors believe their study is the first to make clear that government regulations have severe limitations when it comes to dealing with actual investor behavior.

"Our study is a scientific critique of the Dodd-Frank bill and its European equivalents, which are well meaning in the intent to provide investors with unbiased advice by improving disclosure and removing conflicts of interest. The problem is that it may be completely ineffective," said Bhattacharya. "Investors aren't taking the advice anyway, so in persisting to carry out these provisions of Dodd-Frank, the government is wasting untold millions of taxpayer dollars."

Bhattacharya and his co-authors note that in examining the demand side of financial advice, their work raised more questions than it answered. But they believe that doing so was an important first step in further exploration that will help develop creative, effective ways to prevent common investing mistakes.

"Protecting financial consumers from conflicted financial institutions -- the 99 percent from the 1 percent -- is at the top of regulatory agendas worldwide, but the success of such initiatives will rest entirely on our ability to get inside the minds of retail investors and figure out what makes them tick," said Bhattacharya. "We must unlock the secret of what will make the horse drink."

Bhattacharya's co-authors include Andreas Hackethal, Simone Kaesler, Benjamin Loos and Steffen Meyer, all of whom are members of the finance faculty at Goethe University of Frankfurt. The study is forthcoming in the Review of Financial Studies.