Retail Financial Advice: Does One Size Fit All?

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Retail Financial Advice: Does One Size Fit All?

Stephen R. Foerster

University of Western Ontario – Richard Ivey School of Business

Juhani T. Linnainmaa

University of Chicago – Booth School of Business; National Bureau of Economic Research (NBER)

Brian Melzer

Northwestern University – Kellogg School of Management – Department of Finance

Alessandro Previtero

University of Western Ontario – Richard Ivey School of Business

Chicago Booth Research Paper No. 14-38

Fama-Miller Working Paper


Using unique data on Canadian households, we assess the impact of financial advisors on their clients’ portfolios. We find that advisors induce their clients to take more risk, thereby raising expected returns. On the other hand, we find limited evidence of customization: advisors direct clients into similar portfolios independent of their clients’ risk preferences and stage in the life cycle. An advisor’s own portfolio is a good predictor of the client’s portfolio even after controlling for the client’s characteristics. This one-size-fits-all advice does not come cheap. The average client pays more than 2.7% each year in fees and thus gives up all of the equity premium gained through increased risk-taking.

Retail Financial Advice: Does One Size Fit All? – Introduction

The life-cycle asset allocation problem is complex. Choosing how to allocate savings across risky assets requires, among other things, an understanding of risk preferences, investment horizon, and the joint dynamics of asset returns and labor income. To help solve this problem, many households turn to investment advisors. In the United States more than half of households owning mutual funds made purchases through an investment professional (Investment Company Institute 2013). Likewise, nearly half of Canadian households report using financial advisors (The Investment Funds Institute of Canada 2012), and roughly 80% of the $876 billion in retail investment assets in Canada reside in advisor-directed accounts (Canadian Securities Administrators 2012).

Despite widespread use of financial advisors, relatively little is known about how advisors shape their clients’ investment portfolios. Recent studies highlight underperformance and return chasing by advisor-directed investments and provide suggestive evidence that agency con icts contribute to underperformance.1 An opposing view is that financial advisors nevertheless add value by building portfolios suited to each investor’s unique characteristics, an approach described as “interior decoration” by Bernstein (1992) and Campbell and Viceira (2002). In this paper, we use unique data on Canadian households to explore two dimensions through which advisors may add value: first, by inducing clients to take investment risk and, second, by tailoring investment risk to clients’ particular circumstances as opposed to delivering one-size-fits-all portfolios.

Our analysis begins by using a regulatory shock to the supply of Canadian financial advisors to measure advisors’ impact on risk-taking. Household survey data show a strong correlation between portfolio risk and use of an advisor in Canada|advised households allocate more of their portfolio to risky financial assets. However, these data also indicate substantial sample selection. Clients of advisors are more educated, wealthier, and earn higher salaries than their unadvised peers. Thus, the disparity in portfolio risk between advised and unadvised households likely provides a biased measure of advisors’ impact, one that is confounded by unobserved differences in, for example, risk tolerance.

To resolve this selection problem, we study a 2001 regulatory change that imposed licensing, financial reporting and capital requirements on Canadian financial advisors operating outside of Quebec. This change provides a shock to the supply of financial advisors that is plausibly unrelated to demand for advice. Using a differences-in-differences model to compare affected households to those in Quebec, we find that the change reduced households’ likelihood of using an advisor by roughly 10%. Exploiting this variation within an instrumental variables model, we estimate that financial advisors increase the marginal households’ risky asset share by 30 percentage points, which exceeds the estimate from a least squares regression that controls for household characteristics. This finding suggests that advisors facilitate substantially greater financial market participation and risk-taking, perhaps by reducing households’ uncertainty about future returns or by relieving households’ anxiety when taking financial risk (Gennaioli, Shleifer, and Vishny 2014).


Retail Financial Advice

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