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Financial Markets

Want to invest wisely? Check your prior beliefs at the door

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It shouldn’t be hard to convince someone to take good financial advice. After all, everyone wants to have a good return on their investments.

But new research from MIT Sloan suggests otherwise: Some investors cling to their existing beliefs and underestimate good financial advice and, consequently, lose out.

“Sometimes people think they know more than they actually do,” said MIT Sloan professor co-author of a new study that tests how retail investors assess different types of financial advice and update their beliefs based on that advice. “This is particularly problematic because, even if you know some finance, the average person never will know as much finance as the adviser or the firm behind the adviser.”

In the forthcoming paper “Financial Narratives and Investor Beliefs: Experimental Evidence on Active Versus Passive Advice,” the authors discuss an experiment they conducted that focused on advice recommending either an active or passive investment strategy.

Generally speaking, passive strategies that have low fees are a wise approach for retail investors who have limited time and knowledge to monitor their portfolios. Active strategies, on the other hand, aim to outperform a benchmark index through stock selection and market timing. This approach is more involved and requires more sophistication.

“Most academic research suggests that a passive strategy outperforms in the long run,” Schoar said. “The textbook finance recommendation would say that a passive strategy that minimizes fees is right for the average household.” Therefore, in their study, Schoar and co-author Yang Sun of Brandeis University considered a passive strategy to be a smarter investment strategy than active investing.

The authors first assessed participants’ financial literacy levels by asking them eight questions, such as how to calculate compound interest and “If the interest rate rises, what should happen to bond prices?” The researchers also asked subjects to do a self-assessment of their financial literacy. 

The authors then categorized each participant as preferring either an active or passive investment approach, based on their responses to a survey about their beliefs regarding financial markets and the best investment strategies.

Participants were next randomly assigned to watch financial advice videos with either a male or female adviser that confirmed or challenged a participant’s beliefs by emphasizing the benefits of passive investment strategies or those of active strategies. The videos were designed to imitate the type of robo-advice or online consultations that increasingly happen in the real world when individual investors seek retail financial advice.

After watching the video, participants were asked to rate the quality of the advice and the adviser. Lastly, the authors conducted a postvideo survey to measure people’s perceptions of financial advice and any changes in their beliefs about investment strategies.

Here’s what the authors learned:

People who overestimate their financial acumen are most at risk of discounting good financial advice.

On average, the authors found a positive correlation between people who knew more about finance (as indicated by their answers to the eight questions) and those who gave themselves high marks in their self-assessment of financial knowledge. But there was a sizable subgroup of people who scored low in their financial literacy but still ranked their self-assessed knowledge high. In the postvideo survey, this group gave more positive ratings to advisers who recommended an active management strategy.

“These people tend to think that they can do a good job actively managing their portfolio, and they look for advisers who recommend active management. Even when they receive good advice — that is, passive advice — they don’t want to take it,” Schoar said. “This is, to me, the population that is maybe most at risk: the people that overestimate how much they know.”

Less-sophisticated investors need to do their homework and be sure they’re picking a good financial adviser.

Schoar said that financially sophisticated investors — those who scored high in their financial knowledge — generally did well: They were able to assess the quality of advice they saw on the video and update their beliefs accordingly in the postvideo survey if they perceived the video advice as being of high quality.

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“We think it’s a sign that these more financially literate people have read the literature,” Schoar said. “Maybe they’ve even just talked to good advisers and have already absorbed this textbook advice” that a passive approach is smarter.

However, those who were less experienced in finance were unable to accurately evaluate advice quality. They readily adjusted their beliefs according to whichever advice was given in the videos they were shown. In a real-world situation, this would leave an investor susceptible to following potentially unsuitable advice.

“When you look at the financially uneducated people ... they are willing to follow the adviser if the adviser says active is good, and they’re also happy to follow the adviser if the adviser says passive is good,” Schoar said.

Enforcing high standards for fiduciaries continues to be crucial in protecting naïve investors.

These findings have important implications in terms of how the financial advice space is being regulated, Schoar said.

For example, any financial adviser who gives advice on a client’s 401(k) must be a registered fiduciary adviser, but until recently there’s been less protection for those wanting to roll over a 401(k) plan into an individual retirement account. A new U.S. Labor Department fiduciary rule, however, will raise the legal bar for brokers, financial advisers, insurance agents, and others who give retirement investment advice.

“There is really a lot of debate in the U.S. on how to correctly regulate the market for financial advice,” Schoar said. “There’s a lot of heterogeneity in the quality of advice and advisers that people can get, depending on whom they approach, and even, in a way, how good they are in searching for the right person.”

Schoar cautioned investors to be aware of situations where there are fewer protections, such as when clients want to put their money in a brokerage account; perhaps they want to invest their money but have a nest egg that exceeds what they can put into their 401(k).

Sometimes investors are quick to trust a financial adviser who recommends adopting an active investment approach, believing that more hands-on intervention equals success. Schoar said this is often incorrect.

“This is not always the right strategy; it’s often the better strategy just to have a passive portfolio,” Schoar said. “It shows you the conflict that sometimes can happen between how an adviser establishes trust and what’s actually the better advice.”

Read next: Retail investors lose big in options markets, research shows

For more info Tracy Mayor Senior Associate Director, Editorial (617) 253-0065