** Special to the Just Word Blog from Robin Powell, the UK based editor of The Evidence-Based Investor and consultant to investors, planners & advisors **
“It is difficult to get a man to understand something when his salary depends on his not understanding it.”
Upton Sinclair, American writer & social reformer, 1935
If you want to know how to invest and which stocks or funds to invest in, who do you look to for help? The obvious answer, you might assume, is to ask an expert professional. After all, you would probably consult a doctor if you were worried about your health, or a lawyer if you faced a pressing legal issue.
But it’s not that simple with investing. The problem is that, although there’s no shortage of professionals only too happy to advise you, identifying someone who’s a genuine expert and, crucially, has your interests at heart is far more tricky than you might imagine.
The bottom line is that, no matter how professional we like to think we are, almost all of us have conflicts of interest, and it’s a particularly serious issue in the financial sector.
Can you trust an advisor?
Let’s start with financial advisors. As with every profession, there are good advisors and not-so-good ones. In my experience, even advisors who don’t dispense the best advice generally mean well. But advisors are only human, and if they’re incentivized to recommend a certain course of action, that’s what most will recommend — even if it’s not the best advice for the client.
Take actively managed funds, for example. The evidence is overwhelming that only a very small proportion of active funds beat the market in the long run. Therefore most investors are better off avoiding them, using low-cost passive funds instead, and resisting the temptation to buy and sell. And yet it is still extremely common for advisors in Canada to recommend active investing.
So why is that? Well, the simple answer is that advisors are often paid more money if their clients use active funds. Many advisors, for example, are paid through commissions from mutual fund companies, typically in the form of a trailing commission, or recurring payment, for as long as the client holds the fund. Actively managed mutual funds tend to have significantly higher expense ratios than passive funds, and these include a portion dedicated to advisor compensation.
Other advisors are employed by banks or other large financial institutions which offer their own actively managed funds. These advisors are usually incentivized through sales targets, bonuses or company performance metrics to sell in-house products.
Research links conflicts to poorer outcomes
There have been several studies over the last ten years into the effects of financial incentives on the types of investment Canadian advisors recommend.
One study, entitled The Misguided Beliefs of Financial Advisors, showed how Canadian advisors often steer clients into high-fee active funds, and encourage them to trade too often — both of which usually lead to lower long-term returns. (Surprisingly, the study showed that advisors often made the same mistake with their own money, but that’s another story!)
A 2016 study by the Ontario Securities Commission called Missing the Mark: Behavioural Insights and Investor Decision-Making, found that clients tend to trust their advisors’ recommendations without questioning the potential conflicts of interest arising from commission-based compensation.
The Canadian Securities Administrators (CSA), which regulates securities markets in Canada, has produced and commissioned a number of studies on this subject. The findings have been broadly consistent, namely that advisors are more likely to recommend funds that paid higher commissions, and that such commissions often lead to inferior investment outcomes, compared to cheaper products with similar risk-return profiles.
In response to such findings, the CSA and other regulators have introduced measures to improve fee transparency and address conflicts of interest in financial advice. However, concerns remain about whether these changes are sufficient to protect investors from biased recommendations.
What about DIY investment options?
Of course, you don’t need to go through a financial advisor. Some investors choose to use self-directed investing platforms, such as RBC Direct Investing, TD Direct Investing, BMO InvestorLine or CIBC Investor’s Edge. But these platforms may also have incentives to promote active funds over low-cost index funds or ETFs.
It’s in the interests of TD Bank, for example, for TD Direct Investing to sell TD mutual funds, most of which are active, and therefore more expensive than passive funds. Platforms may also receive embedded commissions, including ongoing trailing commissions, when customers invest in active funds from other providers. In addition, platforms may have agreements with fund providers to promote certain active funds, particularly those with the highest fees.
There are other online discount brokers like Questrade, Wealthsimple Trade, and Interactive brokers. Like the bank platforms I’ve just referred to, these aren’t financial advisors, but they do encourage certain behaviours which may or may not be in their clients’ best interests.
For example, online brokers tend to encourage regular buying and selling, even though the evidence suggests that the less trading you do, the better your outcomes are likely to be. They also promote investing in individual stocks, and often cryptocurrencies and complex, leveraged products — all of which are very much riskier than investing in funds.
On some platforms, like Questrade or Interactive Brokers, it’s also relatively easy for inexperienced investors to to engage in margin trading, which allows you to borrow money to trade larger positions than you could with your own capital. Again, this is extremely risky.
Yet none of this should surprise us, and it all comes down to incentives. Simply put, brokers make money by encouraging us to trade. The more often we trade, and the more we buy, the higher their income will be.
What’s the answer?
This all makes for sobering reading, but it’s reality. It’s no exaggeration to say that the whole investing industry is riddled with conflicts of interest, and not just in Canada. But that’s not to say you can’t trust any financial professional, and it certainly shouldn’t deter you from investing altogether.
The key thing is to be wise to people’s incentives. Everyone has commercial incentives, even journalists. After all, nobody would read the investing pages in the weekend papers, or watch TV channels like CNBC, if all they did was recommend that you simply invest in index funds and ignore the ups and down of global stock markets.
So be on your guard against financial marketing masquerading as advice. If someone recommends a certain course of action, ask yourself: Why are they saying what they do? In most cases, the advice that financial professionals give is closely linked to their company’s business model and, in particular, to how they themselves are paid.
There are some excellent financial advisors out there, and, at some stage in our lives, almost all of us will need to use one. Until then, take some time to learn about evidence-based investing and to develop the skills and habits required for successful investment outcomes. And whatever you do, just get started, preferably with a low-cost provider like Justwealth. The longer you leave it, the longer it will take you to achieve financial independence.
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