Incentives – Can they make you a better investor?

//Incentives – Can they make you a better investor?

Incentives – Can they make you a better investor?

 

Through experience and the school of hard lessons I have learned that to underestimated the power of incentives in any business or personal interaction is a huge mistake.
 
I think you will agree that considering the incentives of the person you are dealing with makes immediate intuitive sense.
 
The only problem is…
 
It is something that we often forget, mostly to our detriment.

 
In the excellent article “24 Standard Causes of Human Misjudgment” Charlie Munger, Warren Buffett's partner, gave the following answer when asked about the underestimation of the power of incentives.

“Well you can say, "Everybody knows that." Well I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”

 
It is thus very important for you to always be clear as to what the incentives of the party you are dealing with are, especially when investing.
 
Examples of incentives are:
  • Your stockbroker – She want to earn commission and thus want you to do as many transactions as possible.
  • Your bank advisor – He want to sell you the product that gives him the most commission not the one the most suitable for your needs
  • Your fund manager – She want to earn fee income from managing the fund, the bigger the fund the higher the management fee she receives

 
 
In this great article Why I Fired My Broker by Jeffrey Goldberg in The Atlantic he details his experience with brokers, the incentives and conflicts of interest. (Thanks to John Bethel from Controlled Greed.com for bringing the article to my attention)
 
In the article Goldberg mentions:

 

I should have seen the signs of dysfunction much earlier.

It was more than a decade ago that our first Merrill Lynch adviser put us in a company called Boston Chicken. A Merrill analyst described it as “the restaurant concept of the ’90s.” It went bankrupt in 1998.

Only later did I learn that Merrill had underwritten the initial public offering for Boston Chicken stock, and so had an interest in selling the company to its customers.

There were other brilliant pieces of advice—long-term “buy and hold” recommendations that emerged from the Merrill analysis factory: Qualcomm; Sun Microsystems; Nokia; and Citibank, of course, which has recently dipped as low as a dollar a share. The full-service trading fees at Merrill—$80, $100, $130, for modest chunks of stock—were high, but we were told that we were paying a premium for quality research.” 
 
In an interview Goldberg had with George Soros the billionaire hedgefund manager he said:

 

“You think a brokerage should be a place you go to pay commissions for fair and unbiased advice, right?” he asked.
“Yes,” I said.
“It’s not. It never has been.” He then cited another saying of Buffett’s: “‘Wall Street is a place where whatever can be sold will be sold.’ You are the consumer of their dreck. What they can sell to you, they will sell to you.”
 
 
A comment by Seth Klarman, a value investor with an outstanding track record, summed up the point of this article with this quote:
 
“The average person can’t really trust anybody. They can’t trust a broker, because the broker is interested in churning commissions. They can’t trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now it’s even worse because even the most sophisticated people have no idea what’s going on.”
 
Your own worse enemy
Not only that but investors are sometimes their own greatest enemy.
 
As financial adviser Larry Gellman, also in the Goldberg article, explained why brokers do not care about your financial future.
 

“Throughout the late 1990s, investors were firing their brokers and money managers because they didn’t own enough tech and Internet stocks, so everybody got loaded up at the tech party right before the cops came,”. “Most of them were busted and never even got a drink. Some of them got lawyers and came after their brokers. So the brokerage firms all came away saying, ‘Never again.’"

 
 
This all sound dreadful but it is really not bad at all once you think in terms of the incentives of the party you are dealing with and act accordingly.
 
But you also have to be willing to spend some time researching and making decisions. Even though you may hate figures and paperwork. 
 
Your finances and investments are a far too an important part of your life to leave to others.
 
What to do
1. You have to take a step back and plan. Determine what the goal of your investment activities are.
 
Here making more money than the neighbours or beating the market by 40% per year is probably not realistic or appropriate.
 
2. Determine how you are going to do it, invest through a fund or do it yourself.
 
The main factor to decide between the two is how much time you are prepared to spend on managing your finances. But time spent should not be your only consideration. Who knows, you may even start enjoying actively managing your money once you get into it.
 
Brokers can be avoided by opening your account at an execution only or internet broker and doing your own investment research with the help of newsletters, good books and following other great investors.

 
However, in spite of all the negative news above there are still good brokers and funds to be found but you must just make an effort to find them.
 
To help you take a look at my article About your stockbroker

 

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You just have to do your homework and, once you have decided what avenue to take, stick to your decision even if you have periods of under performance.
 
You, your broker or the fund you decided on may have times, sometimes a few years, of under performance and it would be unrealistic to expect otherwise.
 
A large body of investment research has shown that switching investments in a period of under performance is exactly the wrong thing to do.

 
Aim with the article
My aim with this article was not to paint an overly negative image of the investment industry but rather to remind you to be careful when making investment decisions.
 
 
You have spent a lot of time working and saving the capital you have accumulated and I am sure do not want to lose it through a bad investment that could have been avoided.

 

Your thinking about incentives analyst

 

 

 

By | 2017-05-19T15:11:10+00:00 July 12th, 2009|