Despite the widespread use of financial advisors, we know little about how advisors shape their clients’ portfolios. Recent studies highlight underperformance and return-chasing by advisor-directed investments. However, advisors may add value by building portfolios suited to each investor’s unique characteristics, an approach described as “interior decoration.” We use unique Canadian household data to explore avenues through which advisors may add value: (1) by inducing clients to take investment risk (and hence increase expected return), and (2) by tailoring investment risk to clients’ particular circumstances, as opposed to delivering one-size-fits-all portfolios.

Household survey data show a strong correlation between portfolio risk and the use of an advisor in Canada. Advised households allocate more of their portfolio to risky financial assets such as stocks. However, this association does not imply that advisors caused more risk-taking. Clients of advisors are more educated, wealthier, and earn higher salaries than unadvised households.

To resolve this association-versus-causation problem, we studied a 2001 regulatory change that imposed licensing, financial reporting, and capital requirements on financial advisors operating outside of Quebec and that resulted in a decrease in the supply of advisors unrelated to the demand for advice. Using a differences-in-differences model to compare affected households to those in Quebec, we found that the change reduced households’ likelihood of using an advisor by roughly 10 percent.

Exploiting this variation within an instrumental variables model, we estimated that advisors increase their clients’ risky asset share by 30 percentage points. This suggests that advisors facilitate more risk-taking, perhaps by relieving households’ anxiety when taking financial risk.

We delved deeper into advisors’ impact on risk-taking by examining the portfolios held by advised households. Using data from four Canadian financial institutions, we measured the extent to which advisors customize their advice. The data included transaction-level records on more than 10,000 financial advisors and their 800,000 clients, along with demographic information on both investors and advisors. Many of the investor attributes—risk tolerance, age, investment horizon, income, occupation, and financial knowledge—ought to be of primary importance in determining the appropriate allocation to risky assets. For example, lifecycle funds allocate nearly the entire portfolio to equities for young investors and then reduce this exposure as investors near retirement.

We tested whether advisors adjust portfolios in response to such factors by studying variation in the proportion of equities in investors’ portfolios. We found that advisors modify portfolios based on client characteristics, with a particular emphasis on clients’ risk tolerance and lifecycle stage. Risk-tolerant clients hold riskier portfolios. While risk-taking peaks at the same age as in a lifecycle fund, younger clients take less risk, and older clients take substantially more risk. Counter to theories of optimal portfolio allocation, we found slightly more risk-taking among clients who face greater employment income risk.

Most striking was that clients’ observable characteristics jointly explain only 13 percent (i.e., R-square) of the cross-sectional variation in risky share. In contrast, we found that accounting for clients who share advisors (i.e., advisor “fixed effects”) has substantial explanatory power. Advisor fixed effects more than double the model’s explanatory power, from 13 percent to 32 percent. One interpretation is that, instead of customizing, advisors build very similar portfolios for all their clients. Another interpretation is that matching between investors and advisors leads to common variation in portfolio allocations among investors of the same advisor; that is, advisor fixed effects stand in for omitted client characteristics that are common across investors of the same advisor. We found little support for the latter hypothesis.

So what explains variation in recommendations across advisors? We found that advisors may project their own preferences and beliefs onto their clients. We were able to observe the portfolio allocations for advisors who maintain investment portfolios at their own firm. We found that their own risk-taking is the strongest predictor of risk-taking in their clients’ portfolios, even after controlling for advisor and client characteristics. No matter what a client looks like, the advisor views the client as sharing her preferences and beliefs.

Lastly, we examined the cost and investment performance of advised accounts. The average client pays an annual fee of nearly 2.7 percent of assets, an additional fee of 1.7 percent per year compared to lifecycle funds. Advisors do not add value through market timing or fund selection. Investors’ net underperformance therefore equals the fees that they pay. Accounting for an equity premium of, say, 6 percent per year and our earlier finding that advisors raise their clients’ allocation to risky assets by 30 percentage points, we estimated households gain 1.8 percent per year from using an advisor. After paying fees of 1.7 percent in excess of a lifecycle fund, investors give up nearly all of the incremental expected return. To be clear, advisors may still add value through broader financial planning. Advisors may, for example, help establish and meet retirement savings goals, create tax-efficient asset allocations, and reduce clients’ anxiety.

We thank Univeris, Fundata, Ipsos-Reid, and four anonymous financial firms for donating data and giving generously of their time.