Investor Biases and the Role of Financial Advisers Antoinette Schoar, MIT and NBER September 18 th, 2015 Hutchins Center Event “The Power of the Nudge”

Motivation Recent demographic and regulatory trends have increased the reliance on individual decision making for retirement and financial planning – Move from defined-benefit to defined contribution plans – Potentially less reliance on social security in future Numerous studies have shown that individual investors are prone to make biased decisions – Bernartzi & Thaler (2007); Odean (2002) But individual decision biases might not necessarily lead to bad investments if there are good intermediaries

Overarching Question Do financial intermediaries such as brokers and financial advisers provide a private solution to improve the decision of retail investors? – Do advisers adhere to basic recommendations of portfolio theory? – Do advisers exploit the biases of individual investors based on their personal objectives Do advisers “de-bias” investors? – How do biases interact with the advisers’ incentives? – Are advisers constraint in their advice by the client’s preexisting biases (catering)?

Research Design: Audit Study of the Market for Financial Advice How do advisers react to clients with different investment biases (Mullainathan, Noeth, Schoar, 2012) – How good is the quality of advice given – Compare biases that either work in the advisers interest to those that would reduce fees to advisers – Compare brokers and ‘fiduciary’ advisers Sent auditors (‘clients’) to receive financial advice – Target financial advisory firms in the Boston and NYC area, combined more than 600 visits – Auditors were assigned background characteristics to match their own: College educated men and women – Two age/ investable funds groups will be clearly identified: Early 30s with investable funds around $50,000 Late 40s with investable funds around $100,000

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 advisor’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 advisor’s opinion investing a large fraction of the money in his/her company stock. Treatment 3 – Index portfolio: Auditor had an efficient portfolio invested in index funds. Auditor asked the advisor’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 advisor for general advice on portfolio investing.

Key Findings Advisers 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) – Effect is stronger for brokers than fiduciary advisers Advisers show strong 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

What Do Advisers Mention? VARIABLESYesNoTotal Advisors encourage more of current strategy?13%87%206 Advisors suggest change of current strategy?66%34%206 initial reaction positive83%17%206 initial reaction negative40%60%206 Recommend Index Funds7%93%284 Recommend Actively Managed Funds50% 284 Auditor would go back to this advisor with own money70%30%284

(1)(2) (5)(6) VARIABLESadvisor encouraged client to invest more in the existing strategy advisor discouraged client to invest more in the existing strategy Company Stock PF-0.165**-0.185** (0.0807)(0.0780)(0.0908)(0.111) Index Funds PF-0.284**-0.304**0.397***0.438*** (0.111)(0.116)(0.0989)(0.109) log(Auditor's Age) (0.152)(0.396)(0.181)(0.485) log(Annual Income) (0.228)(0.260)(0.252)(0.262) Observations R-squared

Conclusion Advisers overall fail to de-bias their clients but seem to exaggerate existing biases – Adviser self-interest and incentives seem to play a role in generating advice – Some evidence that advisors cater to clients pre-existing biases at the initial stage (sales process) Ongoing Research – Supply Side: Test advisers’ own biases and knowledge – Demand Side: Understand how consumers select and evaluate advisers and how it affects the type of advice that is provided