Finding an honest advisor needs an honest approach from investors

27th July 2011

Technically it isn't difficult, it's impossible. Markets are uncertain. Nobody can tell the future.  Complex statistical methods may help, but if mathematical models based on past data were reliable there wouldn't be warnings that "past performance is not a guide to the future".  Apart from anything else the measures of investment risk used are actually measures of volatility (which is a proxy for, not a measure of risk) and are calculated using statistics that assume normal distributions.  Markets are not normally distributed.  But without a working crystal ball, the technical difficulties/impossibilities have to be endured. 

The difficulty for the advisor is in being as honest as one can be when one doesn't know what the future holds, without sounding stupidly overconfident or pathetically cautious. 

The difficulty for the investor is in knowing both what is impossible and whose estimates of the uncertain future to believe, even if those estimates are not correct.

There are three main sources of difficulty. The investor, the advisor and the relationship between them. 

Consider investors. It is a truism that if an investment gains, the client claims the credit, if it falls, the client blames the broker. Independent investors who "keep records" carefully record their few big gains but forget dealing costs and multitudes of small losses.  Human beings tend towards overconfidence and the conviction that they are right because of their skill and wrong because of bad luck, while other people are right by luck, and wrong due to congenital idiocy. 

Investors often fail to have a true picture of their own abilities, goals and attitudes to risk before the event, while claiming (and really believing) that more or less risk was what they wanted after they've seen whether the risk paid off.

Consider relationships. As required by legislation, the honest advisor asks about attitude to risk, whether the honest investor is cautious, adventurous etc.  People told that "this has a 50% chance of making a profit", are likely to say yes, but told "this has a 50% chance of making a loss" they are more likely to say no.

The two are the same (win 50%, lose 50%), it depends on whether the focus of the question is profit or loss.  The different answers produce different risk profiles, and those lead to different investment recommendations and portfolios.  An honest client with two different but equally honest advisers who comply with the legal requirements, answering the same questions, on the same day, with slightly different phrasing could end up with two totally different portfolios.

Even with the best of intentions, total honesty and compliant with current legislation, the different profiles can't possibly both provide the appropriate level of risk (which, of course, isn't known anyway and will undoubtedly be changed by the client in the light of actual results). 

Consider the advisor. The advice should be honest. But honestly, the future is uncertain. 

In 1996 Tony Dye, a fund manager, predicted a crash, but he predicted it about a year or two before it happened. He took millions out of the market, was christened "Dr. Doom" by journalists, criticised by investment managers and his colleagues, laughed at, and even regarded as mad. He left his job.

Before anybody had changed the investment policy of the fund, the market crashed. Suddenly his funds were top over all periods up to about 7 or 8 years (from being 66th of 67 before the crash).  He never got his job back and never got an apology from the mockers.

How many fund managers will do as he did, knowing they will be mocked and either be proved wrong and despised, or be proved right and be hated for showing everybody else up?  And since the client will probably dump them anyway, switch to a new advisor and then lose money when the crash comes, who benefits?

This isn't necessarily about advisers lacking intelligence – if one of the bank CEOs in 2007 had radically changed bank policy, how long would they have lasted before the shareholders got them out because all the other banks were still making billions?

It is easy to be wise after the event, but human beings aren't always right in advance, and after the event they very quickly forget what the true position was before.

"Just find an honest advisor" is a nice idea, but in the real world, with real people, it isn't enough. 

Investors need to consider their own biases, the fact that the relationship has various sources of error and the forces at work on the advisor.  Bearing those in mind and then trying to give and receive honest information, is more likely to produce a good result. 

But remember, it is all uncertain.

More from Kim on Mindful Money

Why a great leader doesn't always make for a great business.

Financial regulation: Why bother at all?

The fairer sex? When it comes to business men and women are created equal

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