Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Automating financial advice

Two months back, Abnormal Returns wrote a post entitled “You are not all that unique an investor” which linked to a short survey of the online money management space at World Beta. There are a number of websites in the US that provide personalized financial advice based on software. When one probes further, however, it is clear that this field is still evolving and has a long way to go. One website does not provide advice on asset allocation, it only compares funds that you are already holding with other funds in the same category and recommends cheaper or better performing funds from the same category. Another site emphasises its ability to give personalized advice but it is only in the legal fine print that I could find a disclosure that the advice is based on software tools.

But today I was reading an NBER working paper by Mullainathan, Noeth and Schoar entitled “The market for financial advice: an audit study” and I realized that software does not have to be particularly good to be competitive with traditional advisors. The bar for that is so low that existing software is probably good enough and of course the software will get better. On the other hand, five years after the financial crisis, there is no evidence whatsoever that traditional financial advisors are becoming any less conflicted.

Mullainathan, Noeth and Schoar used an audit methodology where they hired trained auditors to meet with financial advisers with different types of portfolios and submit a detailed report of their interaction with the adviser (for a total of 284 client visits). They find that “advisers not only fail to de-bias their clients but they often reinforce biases that are in the interests of the advisors. Advisers encourage returns-chasing behavior and push for actively managed funds that have higher fees, even if the client starts with a well-diversified, low-fee portfolio.”

It does not even appear that the traditional adviser personalizes the advice adequately: “advisers are less likely to ask younger or female auditors some basic question about their financial situation, and it also leads to worse advice since the adviser does not have full information.”

I think that financial advice is an industry ripe for disruptive transformation through the internet and software.


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