The quality of the financial advice provided by passive advisers is more highly regarded by the most financially literate, a new study shows. Less financially savvy, overconfident people, on the other hand, tend to seek out advisers who advocate active investing.
Financially literate people rate the advice provided by advisers who favour index investing more highly than advice from those who still recommend active funds. Overconfident, less financially literate individuals, on the other hand, are more susceptible to advice that aligns with their prior stance, often failing to evaluate new advice objectively. Those are two key findings of a new study on how people react to financial advice.
Antoinette Schoar from MIT Sloan School of Management and Yang Sun from Brandeis University conducted a randomised controlled trial to investigate how investors process different types of advice, and how individuals’ perceptions of financial advice are influenced by their prior beliefs about investment strategies, their financial literacy and their self-assessed financial knowledge. Their findings are published in a new study called Financial advice and investor beliefs: experimental evidence on active versus passive strategies.
How the trial was conducted
Schoar and Sun first assessed participants’ financial literacy levels by asking them eight questions, such as how to calculate compound interest and “If the interest rate rises, what should happen to bond prices?” They also asked subjects to do a self-assessment of their financial literacy.
The researchers then categorised each participant as preferring either an active or passive investment approach, based on their responses to a survey about their beliefs regarding financial markets and the best investment strategies.
As part of the trial, participants were shown two videos — one making the case for passive funds and the other advocating the benefits of stockpicking and market timing. On average, the pro-passive video proved to be far more persuasive. This effect, say the study’s authors, was entirely driven by the financially savviest members of the sample rating the advice it contained highly, even if they previously favoured active management.
“Financially literate individuals,” the paper explains,”find the passive advice to be higher quality and demonstrate a strong ability to differentiate their responses to different types of advice. They appear resistant to being persuaded by the active narrative. In contrast, less financially literate subjects struggle to make this distinction and respond with similar magnitudes to both types of advice. This susceptibility potentially makes them vulnerable to lower quality financial advice.”
Overconfident investors risk losing out
Interviewed for the MIT Sloan website, Antoinette Schoar said the findings show how investors who overestimate their financial knowledge can lose out on good advice from a financial adviser.
“Sometimes people think they know more than they actually do,” she said. “This is particularly problematic because, even if you know some finance, the average person never will know as much finance as the adviser or the firm behind the adviser.”
“Most academic research suggests that a passive strategy outperforms in the long run. The textbook finance recommendation would say that a passive strategy that minimises fees is right for the average household.”
People with low levels of financial literacy, she went on, are often quick to trust a financial adviser who recommends adopting an active investment approach, mistakenly believing that it’s a superior strategy.
“These people tend to think that they can do a good job actively managing their portfolio, and they look for advisers who recommend active management. Even when they receive good advice — that is, passive advice — they don’t want to take it. This is, to me, the population that is maybe most at risk: the people that overestimate how much they know.”
Advice does change perceptions
Although the study found that people tend to rate advice that fits their prior beliefs more highly, a more encouraging finding is that most people do update their beliefs in the direction of the advice they receive, irrespective of their previous views. In other words, advice that challenges existing beliefs leads to more significant changes in perceptions. Also, the advice participants received during the trial significantly impacted their portfolio choices.
Interestingly, participants also rated advice they received more highly when it came from advisers seen as having fewer conflicts of interest. They had a strong preference, for instance, for advisers who charged flat fees instead of being pid commissions. This effect was particularly strong among less financially literate investors.
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