(The interview appeared in SAFE Newsletter Q2 2016)
Andreas Hackethal is Professor of Personal Finance at Goethe University Frankfurt’s House of Finance and Program Director of the Research Area “Household Finance” at the Research Center SAFE. His empirical research is on individual investment behavior, financial innovations and the role of financial advice. Hackethal is a member of the advisory council of the German Financial Supervisory Authority BaFin and a member of the Exchange Experts Commission which advises the German Federal Ministry of Finance. He maintains a video-blog on financial literacy and co-founded the FinTech company vaamo.
Which are the most common mistakes you find when analyzing private investors’ portfolios?
In Weber et al. (2015) we analyze eleven prominent investment mistakes and find that three of them lead to the highest costs for some 5.000 investors in our sample. The first is over-trading: many investors trade too frequently which results in excessive transaction costs. The second mistake is when people invest in small, illiquid stocks – “lottery stocks” – that promise high returns but put most of the investment at stake. The third and most common mistake is poor portfolio diversification, e.g. investors essentially place bets on single companies, industries or countries and bear specific risk that carries no return premia. Overall, we find that private investors on average lose four percent each year in risk adjusted returns due to investment mistakes (see Figure 1). This is a lot.
How can we help people to make better investment decisions?
There are at least three potential fixes. One is financial education: to teach people the most important investment rules, such as diversification and cost containment. However, most people are already aware of these basic rules but still feel tempted to chase extra returns by trading on peer recommendations, opinions and technical rules. So, it seems that lack of willingness to follow the prescriptions of text book finance or the lack of self-control are the main culprits. In accordance with this view, many empirical studies found that conventional financial education programs are too weak to change behavior (e.g. Fernandes et al., 2014).
Another possibility is to narrow down the choice set of investors. For example, you could offer investors only certain products such as Exchange Traded Funds (ETFs) which are, in principle, highly diversified at low costs. However, in a recent paper (Bhattacharya et al., 2014) we observe that investors apply the same poor investment patterns when trading ETFs: they trade ETFs on narrow indices instead of buying and holding the “right” ETFs. Other investment default solutions, such as the German “Riester-Rente” come with other, by now well-known caveats.
The third possibility is personal financial advice or automated investment guidance. In Bhattacharya et al. (2012), we analyzed different forms of personal financial advice and addressed the questions: Who seeks advice? And: Does good advice help to improve portfolio performance? We find that investors who needed advice the most, did not seek it while those who sought advice adhered to the recommendations only partially and, as a result, did not improve their portfolio performance. This means that good advice is a necessary albeit no sufficient condition for better investment behavior.
When people do not follow given advice, do they not trust the adviser?
One explanation is indeed that private investors fear that the adviser is biased because of product commissions or specific orders to sell certain products. This fear was fuelled by the revelations in the aftermath of the financial crisis. Therefore, in ongoing work, we analyze what happens when advice is not conflicted. We conducted a field study with a bank that, next to traditional commission-based advice, newly offered to its clients a novel form of advice where advisers are paid a flat fee and where any product commissions are reimbursed to the client. Everything else remained the same: there were the same advisers who had the same menu of products to offer, who used the same tools and advised the same clients. The adherence rate to the advice increased substantially with the new compensation scheme from below roughly one in two to over two in three. With positive effects: we observe a significant increase in portfolio diversification and performance.
If fee-based advice is so successful, it should be offered more frequently. Has the market already responded to these insights?
Many incumbent financial institutions are currently introducing fee-based advisory models. Also, so called FinTechs or Roboadvisers introduce new business models to the market where remuneration is almost exclusively fee-based. These providers of automated investment guidance face the same challenges as banks: how to make people adhere to the guidance provided? In response, they narrow down the investment choice set to preconfigured sound portfolios, so that clients can no longer trade on opinions but, by default, attain broadly diversified portfolios at low cost. These new models also come with a radically simplified investment process. It is no longer necessary to educate clients on various product types and submarkets but to reduce the level of complexity of the decision process down to a level which can be fully understood and handled also by first time participators in capital markets.
But how can investors tell good financial advice from bad?
In Hackethal et al. (2011), we advocated that financial institutions should be obliged to report to their clients how their portfolios performed. Specifically, they should disclose past portfolio returns before and after costs and the historical risk profile of the portfolio. Ideally, portfolio risk is compared to the risk level that investors actually planned to bear. However, there is evidence that people might be tempted to misinterpret this information. Telling good or bad investment decisions from plain luck or a bad market situation is extremely difficult and people tend to mistake one for the other. So, too much information might confuse recipients. In my opinion, smart disclosure is very important but, to maximize learning effects, it must be tailored and timed according to investor needs and preferences. What specific kind of smart disclosure helps individual investors adapt their behavior in the right way is still an open question which we address in ongoing research projects.
Bhattacharya , U., Loos, B., Meyer, S., Hackethal, A. (2014)
Kelley School of Business Research Paper No. 2014-46.
Bhattacharya, U., Hackethal, A., Kaesler, S., Loos, B., Meyer, S. (2012)
"Is Unbiased Financial Advice to Retail Investors Sufficient? Answers from a Large Field Study",
The Review of Financial Studies, Vol. 24, Issue 4, pp. 975-1032.
Fernandes, D., Lynch Jr, J. G., Netemeyer, R. G. (2014)
"Financial literacy, financial education, and downstream financial behaviors",
Management Science, Vol. 60, Issue 8, pp. 1861-1883.
Hackethal, A., Inderst, R., Meyer, S., Rochow, T. (2011)
"Messung des Kundennutzens der Anlageberatung",
Wissenschaftliche Studie im Auftrag des Bundesministeriums für Ernährung, Landwirtschaft und Verbraucherschutz.
Weber, J., Hackethal, A., Loos, B., Meyer, S. (2015)
"Which Investment Biases Really Matter for Individual Investors?",
forthcoming as SAFE Working Paper.