The Value of Financial Advice

One of the consistent conclusions drawn from the recent recession and financial crisis is that finance has gotten too large.  Consider that the economic role for finance is shuttling capital into useful projects.  Finance in itself doesn’t create value, it merely allocates capital more efficiently and it’s hard to believe that it does so at a rate justifying 8% of GDP.  I have heard grumbling from businesses that dealings with banks were increasingly expensive, but I haven’t seen any studies on that side and it’s hard to separate that from businesses grumbling about anything that costs them money.  But on the individual side we have lots of evidence that financial advice is at best useless and at worst harmful.

If you don’t know this already, you should be investing in an index fund and the lower the management fees the better.  Other considerations are far less important.  Sadly, most people and pension funds and other institutions don’t know this.  Unless you are managing unimaginable amounts of money (like Harvard, say) you can’t afford the expertise needed to beat the market consistently.  Even most professionals can’t beat the market and they spend their entire working lives on the problem of how to beat the market.  Paying someone to manage your money just means that they have to beat the market by even more for you to make more money.  Many studies show that this pretty much never happens.  If you are actively trading it is almost guaranteed you are doing it wrong.  It is much better to lock in the near guaranteed and often higher returns of an index fund than to trade yourself or pay higher management fees.

Even rich people who have a lot more at stake and can afford better financial advice often fall victim to this.  Studies have shown that they mostly want an adviser that confirms their already chosen strategy.  Furthermore, it’s really easy to see the illusion of skill in fund managers.  There is a lot of variability in fund performance so that a manager might get a few years of great returns, accruing an aura of mastery, before falling below average.  This is the typical human failing of apophenia, seeing patterns in random chance.  In actuality they will fail to beat the market for you in the long run, especially after he takes his management fee.  In reality, picking a good manager has the same or worse odds than picking a good stock.

Finally, money managers have different incentives than you.  They often get paid well whether they beat the market or not.  One study found that insurance brokers matched their clients to insurance policies worse than if the client had purchased their own policy directly.  I have seen similar studies on real estate brokers.  Maybe that suggests aligning incentives better, but if that were easy I don’t think the underperformance of brokers would persist.  The bottomline is that they are making money for themselves, not for you.  It may make sense for them to assuage your ego with bad advice than actually provide good advice if it keeps you as a client.

In conclusion, I reiterate the benefits of an index fund: low management fees, low risk due to diversification, known exposures and higher returns in many cases.

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