Watching Out for the Misguided Beliefs of Financial Advisors

Your financial advisor isn’t dishonest; he’s just incompetent. That is the TL:DR (Too Long; Didn’t Read) conclusion of a 2016 academic paper, “The Misguided Beliefs of Financial Advisors,” by Juhani T. Linnainmaa, Brian T. Melzer, and Alessandro Previtero. For many years, the common view of advisors in the retail investment sphere is that they gave bad advice because of a conflict of interest. Interestingly, the findings of this paper indicated that the advisors’ investments were similar to the portfolios they recommended to their clients, and that similarity persisted even after they left the investment industry.


The Problem

Definition of a Financial Advisor

Titles in the Canadian financial services industry are largely unregulated. Therefore, almost anyone can call themselves a financial advisor. It has been a common title in local bank branches where the staff usually hold a mutual funds licence and are also trained to sell deposit accounts, credit cards, lines of credit, and mortgages among other things.


For several years, Quebec has prohibited the use of the term “financial advisor” and permits the use of the term “financial planner” only for those who hold the proper Pl. Fin. (plantificateur financier) credential. All other provinces and territories left financial titles unregulated.


Sadly, Ontario took on title regulation in financial services and promptly rubber-stamped every credential available. Except for the credentials offered by FP Canada, the other credentialling bodies were identified as being subject to various terms and conditions. In other words, the institutions that offer the credentials need to either improve or establish a public registry, develop a complaint form for the public, publish disciplinary actions against credential holders, improve records retention, enhance the current curriculum – notably on ethics and conflicts of interest in the case of some – and improve oversight of credential holders.


As Ontario defined a financial advisor, the credentialed person needs to meet the educational requirements related to the products and services provided by the individual. Therefore, someone who sells investments and calls him- or herself a financial advisor, must be credentialed by an approved body to engage in that role.


Nevertheless, if every credential out there has been approved, it appears unlikely that well-meaning but misguided advice is on the way out anytime soon. Saskatchewan and New Brunswick are also working on title protection in financial services but considering the weight of the Ontario industry in the Canadian landscape, it may be difficult for them to do better.


What Your Financial Advisor May Get Wrong

Certainly, not every financial advisor gets investment recommendations wrong. The particular data set used by the authors drew from information provided by two large Canadian institutions representing 4,000 advisors and 500,000 clients. The advisors provided advice on asset allocation and make recommendations about the purchase or sale of unaffiliated mutual funds.


Frequent Trading

Frequent trading and return chasing often go hand in hand. At the level of illegality, frequent trading could amount to “churning,” the practice of excessive trading to generate commissions, but this is becoming less common in the mutual fund world now that deferred sales charge mutual funds are no longer permitted to be sold – and happily, they will soon be out of the segregated fund world, too.


Nevertheless, frequent trading in an effort to outperform can be detrimental to an investment portfolio even if done for well-meaning purposes. This is particularly the case when frequent trading occurs in a non-registered account since capital gains (or losses) may be realized, resulting in tax consequences for the client.


Expensive, Actively Managed Funds

The average fees of the mutual funds selected by advisors and clients ranged between 2.36% and 2.43%. Management expense ratios have come down somewhat since this report was published, but high fees tend to go hand in hand with actively managed funds. Active management does not necessarily mean that the mutual fund manager is trading frequently. It simply means that the fund management team’s mandate is to seek returns that outperform the benchmark index. For example, a Canadian equity mutual fund that is actively managed will choose a subset of Canadian stocks that are believed to outperform the broader Canadian stock market and may stick with those choices for an extended period, making very few changes in a year. However, there are also actively managed mutual funds that are very active indeed; the fund managers may completely turn over the selection of stocks in less than a year. Naturally, the frictional costs associated with that kind of turnover will weigh against the return of the fund and require even stronger benchmark-beating performance to achieve superior net returns.


Return Chasing

Clients and advisors earned annual net returns of 3% below their market benchmarks. Return chasing involves the purchase of mutual funds just after they have gone up in the hope that they will continue to grow. This approach differs from a “buy-and-hold” strategy in which a strategic mix is established and adhered to over the long term, perhaps with periodic rebalancing back to the original mix.


Somewhat alarmingly, to the extent that advisors deviate from the portfolio of mutual funds they recommend to their clients, they tend to focus even more strongly on recently outperforming funds with higher expenses and more idiosyncratic risk.



One of the theoretical advantages of mutual funds is that investors can achieve broad diversification with the purchase of as little as a single fund because the underlying securities owned could number literally in the 100s. However, certain actively managed funds may have set a particularly narrow mandate, for example, Canadian energy stocks. An advisor may recommend several narrow-mandate funds to build a reasonably diversified portfolio when all the funds are combined, but if the advisor holds a particular conviction that a region of the world is expected to do very well, and narrowing it down further, believes that a certain sector of the economy is set to outperform other sectors, that advisor’s clients may find themselves invested in a disproportionately large number of European healthcare stocks, to suggest an example.


A Solution(?)

The authors suggest that, since their study finds that conflicts of interest are not the main issue behind poor investment returns, perhaps better education and enforcement of professional credentialing requirements may help. However, their comments do not sound particularly enthusiastic. The kinds of people who choose to go into investment advisory roles may be convinced at the outset that these approaches are appropriate.



Here I am addressing people who are inclined to seek a relationship with an investment advisor rather than invest on their own or use a so-called robo-advisor.


First, anybody who is planning to ask someone else to manage their finances should be conducting a thorough interview and among other things, find out whether there is a good fit between you. This is as much an emotional and psychological question as it is a practical and skill-oriented one.


Second, you must clarify how the advisor is getting paid. Mutual funds at the mass retail level typically include a trailing commission, paid by the fund company to the advisor and the advisor’s firm, to compensate them for ongoing investment advice. More recently, advisors are getting paid based on a percentage of the investment portfolio’s value, usually referred to as “assets under management” or AUM. The mutual funds sold under this arrangement do not have a trailing commission; instead, the advisor’s compensation is negotiated with the client. Often, the percentage is reduced as the value of the assets is increased.


Canadians who read US investment publications may want to ask if the advisor operates as a fiduciary. Except for those who are portfolio managers, the regulations generally do not impose a fiduciary standard of care on investment advisors. However, credentialling bodies like FP Canada or The Institute of Advanced Financial Planners, require members to adhere to a best interest standard. Granted, these bodies provide financial planning credentials, not investment advisory designations, but most financial planners are licensed to sell mutual funds or other securities. You may also want to look for people who are members of the Financial Planning Association of Canada; members pledge to act as fiduciaries.


Germane to the issue of well-meaning but misguided advisors are questions around investment philosophy that respond to the issues noted above.


  • Does the advisor actively trade or buy, hold, and rebalance? Are tax implications considered?
  • What kind of mutual funds are purchased: Passively indexed or actively managed?
  • If the funds are active, what are the typical MERs? Are they low-cost? What is the stated rationale for an active strategy?
  • Are the portfolios narrowly concentrated or do the selected funds provide global diversification?
  • How is asset allocation decided?


These are by no means the only questions to ask, but given the findings of the study, these are crucial. Furthermore, since these beliefs are firmly held, an advisor is likely to provide honest, well-intentioned answers.


As an advice-only financial planner, my clients tend to be self-directed. However, I am occasionally asked to offer an opinion on an investor’s portfolio that was constructed by an investment advisor. This paper about misguided beliefs helps to explain at least some of the portfolios I’ve seen. There is a lot more to be done to professionalize financial advice in Canada, but bringing to light issues raised here certainly offers the potential for some improvements.


This is the 194th blog post for Russ Writes, first published on 2023-04-24


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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.


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