Head of Defined Contribution and Wealth Advisor Services Matt Sommer helped conduct a survey that explored the relationship between financial knowledge and the decision to seek investment advice and grant trading discretion. The results have significant implications for how financial professionals engage with clients.

The question of why individuals choose to rely on financial professionals for investment advice and trading discretion has been researched extensively. Many factors ranging from education level and homeownership to risk tolerance and financial satisfaction come into play, but perhaps one of the most significant factors is how knowledgeable an individual is about investing.

To explore this aspect further, Janus Henderson recently conducted a study that investigated the relationship between financial knowledge and the decision to seek investment advice, as well as opting to grant trading discretion to a financial professional. The study used data from the 2018 National Financial Capability Study (NFCS) Investor Survey, which is administered every three years to assess how individuals manage their financial resources and make financial decisions.

Findings on Financial Knowledge and Investment Advice

In examining at the relationship between financial knowledge and investment advice, the study considered both subjective (i.e., perceived) and objective (i.e., actual) knowledge. Among a sample of 1,203 respondents, objective financial knowledge was found to have a negative relationship with making investment decisions based on recommendations from a financial professional. This finding suggests that individuals with a high level of financial experience and education are capable of implementing an investment plan on their own. Furthermore, given recent innovations that have made “do-it-yourself” investing more accessible than ever, it is not surprising that relatively knowledgeable investors would opt to rely on their own abilities.

The study found no relationship between subjective knowledge and the use of investment advice, which indicates that this type of self-assessed knowledge may not play as significant a role in an individual’s choice to seek investment advice.

Another aspect of financial knowledge that the survey explored was overconfidence, which was measured by the disparity between what investors think they know and what they actually know. Past research has consistently found that individuals who are overly confident in their financial knowledge are less likely to follow investment recommendations provided by a financial professional.

Surprisingly, in contrast to this earlier research, our survey found a positive relationship between overconfidence and relying on advice to make investment decisions. One reason may be the data on overconfidence that we used from the NFCS survey focused on investment-specific knowledge rather than broad-based financial planning. It’s also possible that some level of confidence is necessary to start the often-overwhelming process of retirement planning, or even to make an appointment with a financial professional.

The Relationship between Financial Knowledge and Granting Trading Discretion

As expected, a negative relationship was found between subjective financial knowledge and an investor’s decision to grant trading discretion to a financial professional (although no relationship was found with objective knowledge). Furthermore, while overconfidence was found to be positively related to relying on recommendations to make investment decisions, the survey found that overconfident investors were less likely to grant trading discretion to a financial professional.

These findings indicate that investors who consider themselves knowledgeable, even in cases where their confidence is unfounded, tend to be reluctant to accept an arrangement in which they no longer retain the last word. After all, unlike investment advice that individuals may or may not choose to accept, granting trading discretion to a financial professional requires an investor to relinquish control of how their assets will be invested. These arrangements not only necessitate a high level of trust, but also an admission that the most favorable outcomes will be gained only if the individual is willing to be removed from the investment decision-making process.

What Are the Implications for Financial Professionals?

The study’s findings regarding objective and subjective knowledge have significant implications for financial professionals. First, the negative relationship between objective knowledge and the use of investment recommendations suggests that knowledge is a substitute, rather than a complement, for investment advice.

Financial professionals whose value proposition hinges on trade execution or asset allocation models may find that individuals with high levels of actual knowledge are likely to reject full-service investment services in favor of DIY solutions. The current marketplace offers numerous convenient ways to trade individual securities, as well as an abundance of low-cost mutual funds and ETFs for those who may want some level of assistance. To attract and retain these individuals as clients, financial professionals may want to consider offering services beyond just investment planning. While the transition from offering solely investment services to holistic wealth management has been underway for some time within the financial services industry, the urgency for late adopters has perhaps never been greater.

The study’s findings on investor confidence highlight the importance of this trait in the client-advisor relationship. Many financial professionals find it challenging to work with highly confident investors, and it is indeed a delicate balancing act. While care must be taken to not question the client’s belief system, a financial professional has a responsibility to supply clients with the information they need to make informed decisions.

Therefore, we believe one of the first steps a financial professional should consider when meeting with potential clients is to assess their level of confidence. Financial professionals must also be prepared to temper the suboptimal behaviors that tend to be common among highly confident investors. For example, one technique to help clients more objectively consider new investment opportunities is an exercise called premortem planning, which starts with the assumption that the client has lost their entire investment, then asks them to think about all the reasons why the investment failed.

Lastly, a key finding of this study is that while overconfident individuals tend to avoid discretionary relationships, they remain open to making investment decisions based on recommendations from a financial professional. As such, suggestions regarding discretionary investment services should be made only after trust is established and then integrated into the client engagement slowly. Providing education about the common behavioral investing mistakes may also help encourage overconfident clients to reconsider the value of these services.