Investors want help, but many lack trust

Financial advisers feared that the Internet would make them obsolete. Stock prices rose in 1999 as if they had no ceiling, and confident investors found huge amounts of free advice on the Internet. At a meeting with advisers that year, I tried to allay their fears, reminding them that patients can find huge amounts of free medical advice on the Internet yet seek out physicians when that pain in the chest persists. “Good advisers are like good physicians,” I said. Good physicians promote health and well-being, and good advisers promote wealth and well-being. Patients leave the offices of good physicians not only with prescriptions that promote their health but also with the sense of well-being that comes from understanding the diagnosis, dire as it might be, and knowing the way forward. The same is true for good financial advisers.
Advisers’ fears that the Internet would displace them were allayed when stock prices plunged as if they had no floor and investors’ confidence plunged along with prices. “I feel sick,” wrote one investor on a Yahoo.com message board. “I feel like a deer caught in headlights … I’m scared to get out now, because I have lost so much money.” Trading stocks when prices were high was “really a form of entertainment,” said Donald Williams, a software company executive, who said he looked for a financial adviser when almost half of his portfolio vanished. “I didn’t want to make any mistakes with the bulk of my assets,” he said. Charles Schwab & Co. Inc. promoted do-it-yourself investing in its early years, catering to confident investors who traded a lot but wanted no advice, but now it caters to investors seeking advice. “Talk to Chuck” is the company’s slogan today.
Investors are increasingly re¬sponsible for their financial future as company pensions disappear. They seek information, protection and advice from financial advisers, governments, television, the Internet and fellow investors. Some of the advice they receive is good and some is bad. Some delivers what investors want and some does not. Some sticks with investors and some washes away.
Good financial advisers are good financial physicians. Good advisers possess the knowledge of finance, as good physicians possess knowledge of medicine, and good advisers add to it the skills of good physicians: asking, listening, empathizing, educating and prescribing. Physicians face “non-complying” patients who do not take their prescribed medicine as instructed, and financial advisers face non-complying clients who imperil their future by spending too much in the present. Compelling clients to comply is a difficult task when clients are young athletes or actors.
“These kids are making serious money,” said Scott Feinstein, a financial adviser. “They don’t realize the pressure that friends and family will put on them. They don’t have the maturity to say no.” One young client called to say that he wanted to buy a $35,000 watch. “What time does it say?” asked Mr. Feinstein. “Ten minutes after three,” answered the client. Mine says 10 after three too, and it cost me 60 bucks,” said Mr. Feinstein. “Put the watch down.”
Larry Ellison, the head of Oracle Corp., is one of the richest men in the world and a winner of the America’s Cup sailing competition. But the life of his financial adviser is difficult. Documents in a trial revealed that Mr. Ellison lives well. His annual lifestyle expenses amount to $20 million. A villa in Japan costs $25 million, a new yacht costs $194 million and preparations for America’s Cup cost $80 million. The documents include e-mails to Mr. Ellison from his financial adviser. One e-mail said, “I know this e-mail may/will depress you. However, I believe it’s my job to address issues you’d prefer not to confront. You told me years ago that it’s OK to raise the “diversification issue” with you quarterly … Well, I’m doing so. View this as a call to arms.”
Trust in financial advisers has diminished greatly in the recent financial crisis. Investors have been distressed to find that the values of their investment portfolios have plummeted and that some investors have been paying money to advisers who sent it to operators of Ponzi schemes. “All right, so it was just a matter of time before I wrote to see if you’re still working or you ran away to Belize,” one of Scott Rodabaugh’s clients wrote in late 2008.
“People are confused and angry,” Mr. Rodabaugh said.
Some investors expressed their anger in more than worried e-mails. Four German pensioners kidnapped their financial adviser in June 2009 because they suffered losses in their American real estate investments. They tied up the adviser with tape, gagged him and beat him up, breaking two of his ribs. Afterward, they forced him to sign a statement promising to compensate his investors for their losses. The adviser was eventually freed when his trustee read a secret message in a fax of that statement and alerted the police.
Fees come between financial advisers and their clients as they come between physicians and their patients. “I have a million dollars in my portfolio,” thinks a client. “I don’t mind paying a fee for the management of stocks. Stocks are complicated and I cannot manage them on my own. But the management of bonds is easy and cash needs no management at all. Why am I paying you a fee for these?” Financial advisers hope that clients would understand the value of their services and the fairness of their fees, yet fees are difficult to discuss because clients regularly misperceive the value of the services of financial advisers.
Imagine that you are seeing a physician because your stomach hurts. The physician asks many questions, examines your body, provides a diagnosis and concludes with education and advice. The examination, diagnosis and education are free, says the physician. All you have to pay is the price of the pill you received. That would be $200, please. Financial advisers act regularly as the physician in this story. Financial advisers frame themselves as investment managers, providers of “beat the market” pills, when they are, in truth, mostly investor managers, professionals who examine the financial resources and goals of investors, diagnose deficiencies and educate investors about financial health.
Financial advisers are not capricious as they frame themselves as managers of investments when, in truth, they are mostly managers of investors. They respond to the perceptions of investors. Some of my undergraduate students spend a quarter as interns in financial services companies, often assisting financial advisers.
“What do you think financial advisers do?” I ask before they leave for internships. “Financial advisers are investment managers,” they say.
I wait for the term papers at the end of the quarter. “What a surprise,” they write, “financial advisers spend most of their time prospecting for new clients and advising old ones.”

ADVISER RESPONSE

Financial advisers respond to investor perceptions by framing fees for managing investors as fees for managing investments. Rule 12(b)-1 fees are one example. The fees were originally designed to help mutual fund companies attract new investors and eventually save investors money as funds grow and their costs decline. Yet the fees go to financial advisers who recommended the funds to their investors, and payment to advisers can extend into decades, long after money was placed into the funds. Mary Schapiro, chairman of the Securities and Exchange Commission, is critical of 12(b)-1 fees. “Despite paying billions of dollars, many investors do not understand what 12(b)-1 fees are, and it’s likely that some don’t even know that these fees are being deducted from their funds or who they are ultimately compensating.” The SEC is drafting new rules “designed to enhance clarity, fairness and competition when investors buy mutual funds.”
Yet Robert Kurucza, a partner in Goodwin Procter LLP, a law firm serving mutual fund companies, noted the downside of the proposed SEC rule. 12(b)-1 fees compensate financial advisers for investment advice they continue to provide decades after they have placed clients into funds. Decreased compensation is likely to decrease advice.
Financial advisers are hampered by investors’ misperceptions of their services. They are also buffeted by differences in the recommendations of investment experts. Diversification is one example. Not all recommended diversification a century ago and not all recommend it today.
In 1911, the magazine World’s Work received a letter from a businessman who read an advertisement headed “Diversify Your Investments” and wanted to know if his portfolio was indeed diversified. The magazine’s analysis revealed that while the portfolio seemed diversified, it was not. All the securities in the portfolio were issued by companies in one state and all were bought from “one banking house, a house of the middle class, which maintains a fair selling market in its own securities at all times but is not a particularly good seller of securities for its customers.”
“Do not put all your eggs in one basket” was the diversification advice of the World’s Work, but the magazine noted that not all agree. Marsden J. Perry, chairman of the boards of directors of the Union Trust Co. and the Norfolk Southern Railroad believed in “putting all [a person’s] investment eggs in a few baskets, provided he can keep careful watch of those baskets.”
There is no universal rule for investing, Mr. Perry said. “There are as many individual preferences as there are different kinds of investments available. People differ widely in their choice … It depends on the type of mind the individual himself possess, and some prefer dividing their investments over a wide range of business activity, while others are temperamentally unfit to assume the management of such a diversification of interests.” Andrew Carnegie advised investors to refrain from diversification and put all their portfolio eggs in one basket and watch that basket.“In my investments, I have adhered more to the Carnegie method than to the other,”said Mr. Marsden, “generally in a few baskets, which I have watched.”
Some investors are reluctant to accept advice because they have made up their minds, but others are on guard because they suspect the motives of those offering advice. In that, investors are like automobile owners. We suspect that automobile mechanics repair what need not be repaired, and our suspicions are often well-founded. The Transportation Department estimated that more than half of auto repairs are unnecessary. Many mortgage borrowers would have saved themselves heartache, default and foreclosure if they had been more skeptical of those who advised them.
Suspicion leads some investors to trust the advice of fellow non-professional investors more than they trust the advice of professionals.

Meir Statman is the Glenn Klimek Professor of Finance at Leavey School of Business at Santa Clara University, visiting professor at Tilburg University in the Netherlands and an expert on behavioral finance. This article was excerpted from his book “What Investors Really Want: Discover What Drives Investor Behavior and Make Smarter Financial Decisions” (McGraw-Hill, 2010).

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