The Importance of Education

Robert Shiller, he of the Case-Shiller Index (and therefore a reasonable symbolic candidate for 2008 Man of the Year, were it not for a certain presidential election), has an op-ed in The New York Times advocating a government program to subsidize financial advice for anyone, particularly low-income people. There is a lot to like about this idea. In Shiller’s proposal, the subsidy would only apply to advisors who charge by the hour and do not take commissions or fund management fees, so they would have no incentive to steer clients into particular investments or into unnecessary transactions. It seems reasonable that, if they had access to impartial advice, some people might not have taken on mortgages they had no hope of paying back or, more prosaically, some people might do a better job of budgeting and take on less credit card debt.

But I have one major reservation, which is that I’m not sure how good the financial advice would be. In my opinion, most financial advice floating around is worth less than nothing. To take the most obvious example: by sheer volume, the largest proportion of financial advice that exists (counting all advice that anyone gives to anyone else via any means of communication) is almost certainly advice on buying individual stocks, and the second largest is probably advice on choosing mutual funds. I am firmly in the camp that believes that whether or not stocks obey the efficent market hypothesis, it is not within the capabilities of any individual investor to identify stock trades that will have an expected risk-adjusted return higher than the market as a whole, net of transaction costs. I also believe it is not in within the capabilities of any stock mutual fund manager, and that all of the variation in risk-adjusted mutual fund performance can be explained by pure statistical variation. And even if I’m wrong about that, and there are a few exceptional fund managers out there, I don’t believe that any individual could distinguish the exceptional managers from the simply lucky ones; and even if he could, by the time he did he would be buying into a fund that had grown so big it was no longer capable of above-market returns.

If this is so, why doesn’t the market for financial advice take care of this problem?

Because that market has two major problems. First, you are unlikely to get rich advising people to buy a set of index funds and rebalance their portfolios every six months – not a lot of recurring business there. Most of the advice, as Shiller points out, comes from people who are biased – primarily people who are trying to sell you financial products that, in my opinion, are probably not good for you,* but also people trying to sell you books and magazines about which financial products you should buy.

Second, people want to believe there is a way to get rich. The idea that, given a sufficiently liquid market, anything you happen to know about a company (say, because you read it in The Wall Street Journal) is already priced into the stock price is deeply unintuitive to the human brain. And the idea that you can only rely on a very low real rate of return – basically, the yield on Treasury Inflation-Protected Securities – is something many people simply do not want to accept.

When you get away from investing in securities, perhaps there is more value that financial advisors can provide. For example, they could help explain the detailed terms of various financial products, or help people understand their spending patterns and come up with budgets. So on balance perhaps Shiller’s proposal would do more good than harm. But the risk is it would expose even more people to the sales pitches of financial services companies, which would no doubt multiply their marketing to independent financial advisors several times over. I agree that lack of financial understanding is a significant societal problem, but given the powerful interests involved, I find it hard to come up with a good solution.

* When I was an executive at my company, and “wealth management” specialists made the mistaken assumption that I and my co-founders had a lot of money, I saw a proposal from a major investment bank to buy a product that was guaranteed to return more than a major index of international stocks. The catch was that the return was based on the value of the index alone, and did not include reinvested dividends, and therefore in every historical period I could find for reference this product would have lost me money (relative to just buying an index fund tracking the same index). When pressed, the advisor said his bank didn’t have a position on whether or not this was a good investment. The other side of the trade was being taken by another party who was paying the bank a 3% underwriting fee; in other words, in aggregate the parties doing the trade were bound to lose money, and the bank was going to pocket its fee.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.