In a similar vein, some people fear being left out or excluded from the social group to which they seek to belong. The ability to hold your own at a cocktail party or in the water cooler discussion has significant value. Sometimes the details of your investments are useful in gaining that place. Ideally, they may win you admiration. At the least, you will be seen as a solid member of the group.
For a small but significant number of people, it is not their natural peer group but a more desirable one to which they wish acceptance. Some seek to do what the cleverest or most in-the-know people are doing; they are forever trying to emulate “the smart money.” Others want to fit in with what used to be called “the beautiful people.” They are interested in investing with, and like, those whom society elevates. Still others seek influence through their proximity and imitation of power people. One may think of Jay Gatsby throwing grand parties for all those upper-class New Yorkers.4
Of course, seeking acceptance or social advantage through investments can leave you very vulnerable. A virtual army of financial folks stands ready to take advantage of such behavior. To mention only the most egregious example, why did all those people hand their money over to Bernie Madoff when even a little deliberation would suggest that his deal was too good to be true?5 Those who want their money to mingle with that of elite people must take great care that they are not sheared like sheep in the process.
It is easy to understand, though, that investors may seek to join with those they see as most clever, able, connected, or even fashionable. We are human beings, and seeking to emulate and be in the company of leaders comes naturally to us.
Should You Narrow Your Investment Goals?
In light of the many motivations that drive investors, there are numerous ways to think about best possible investing outcomes. My own preference, though, is to keep investing goals narrow and focus tightly on those related to making money.
The entire range of motivations driving investments, discussed earlier, are worthy of respect. There is a danger, though, that some may prove to be distractions or lead to unfruitful paths. The vision of a good outcome I bring to my own investing is straightforward. I seek to make the maximum amount of money while avoiding excessive or undue risk. Avoiding the headaches that come from human or technological errors is desirable and I generally seek ease of use. While willing to pay a fair price for services that are useful to me, I do not care for excessive fees. Furthermore, I demand transparency of such fees—hidden costs strike me as dishonest trickery. Like most people, I do not wish to pay even a cent for anything that economic science can show is actually worthless. I will not pay anyone to gamble for me (it is much cheaper to do that for myself). I never want to feel that I am being cheated, lied to, or played for a fool. Finally, as discussed in Chapter 17, I want to be treated as the client of a “true professional.”
It is a rather short list compared to the many things considered in Chapter 1. When negotiating investments, I omit many interests that would play a big role in some other negotiating situations. Among these are building strong relationships, living up to my code in life, making the world a better place, improving how I am seen by others, and boosting my self-esteem. Moreover, I have concluded that the investment world is not a place to look for solid new friendships.
This contraction reflects my concern about distractions and diversions in the investment world. As discussed in later chapters, the financial services industry and various intermediaries have developed sophisticated ways of manipulating human desires to reduce financial returns. Of great importance in pursuing best outcomes is avoiding actions that may look inviting but actually lead in other directions. An investor-negotiator should constantly ask herself whether a given move really leads to her ultimate goals.
In the end, it is for you to decide whether to follow me in thinning out the components of your investing good outcome. Such a decision is not required to make good use of this section of the book. It is best, though, that you consider the issue fully informed about the hazards and the stakes. You will find the chapters that follow very useful in thinking that through.
Chapter Summary
Think hard about what would constitute a good outcome in light of what you are trying to achieve through investing.
Avoid distractions and detours.
Almost everyone invests, in part, to make money.
Beyond increasing wealth, people invest for many different reasons.
Be honest with yourself about your investing goals and motivations.
Consider whether you should narrow your investing goals.
Notes
1. Amos Tversky and Daniel Kahneman, “Judgment Under Uncertainty: Heuristics and Biases,” Science 185, no. 4157 (September 27, 1974): 1124–1131.
2. Nassim Nicholas Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (New York: Random House, 2005).
3. Lynn Forester de Rothschild, “A Costly and Unjust Perk for Financiers,” New York Times, February 24, 2013.
4. F. Scott Fitzgerald, The Great Gatsby, reissue (New York: Scribner, 2004).
5. Robert Lenzner, “Bernie Madoff’s $50 Billion Ponzi Scheme,” Forbes, December 12, 2008.
Chapter 14
The Problem of Conflicts of Interest
Whenever we ask someone to act for us, place our trust in another, or fundamentally rely on anyone else, we must contend with the problem of conflicts of interest. Economists have long studied this simple truth: People have a strong tendency to respond to their own interests. Even those at the very highest levels of governmental, social, or commercial life usually take actions they believe will further their own goals and objectives. Indeed, one way of looking at human interactions is to start with the assumption that a person’s sole motivation is to advance his own interests. Such a rational actor will further the well-being of others only if he believes that to do so also somehow maximizes his own benefit.
The challenges posed by this problem are particularly acute when negotiating your investments.
For one thing, the stakes are very high. Where large amounts of money are involved, people’s tendency to advance their own interests above others’ is increased. With its long history, culture, and track record of placing its own interests above those of its clients, the financial services industry is particularly prone to this effect. Common sense tells us that extra caution is required when placing big money in the hands of people who covet it.
Furthermore, the financial world leaves us little recourse but to rely heavily on others and there are limits to how much an investor can become a do-it-yourselfer. A great deal of the process is necessarily not in your direct control. You must depend on others to identify, connect, execute, deliver, and record. With such reliance comes vulnerability. Will the other people involved in the transaction do what is best for you, or will they act according to their own motivations?
You have more choice, however, when deciding on investment strategies or choosing individual investments. It may be possible to minimize your reliance on the knowledge, judgment, and skill of others. Obviously, though, this comes with a big downside: You cannot know everything yourself, and eliminating others’ insights will leave you with few resources. One way or another, you end up looking for wisdom and guidance from other people. In doing so, there are steps you should take to minimize the dangers posed by the conflicting interests of the folks you seek help from.
Incentives Matter
In thinking about human behavior, economists say that incentives matter a great deal in deciphering how people act. As an investor-negotiator, you must think hard about what incentives are influencing those you are dealing with. How do they get paid? What pressures are being placed on them? What actions will bring them success? And, of course, which paths lead to their failure? Remember that this analysis must focus on how they understand their incentives. You might think that serving clients loyally is the highest measure of a job well done, but they may see it as
a road to the unemployment line.
To put it plainly, most financial advisors labor under terrible conflicts of interest. The history of the financial services industry is a system of commission-based compensation, and most of these folks still make their living from some variant of that arrangement. The conflicts are stark; the advisor wants to make as much money as possible, while the client seeks the best (which often correlates, at least in part, with least expensive) method of solving financial challenges. This problem is exacerbated by expensive multilayered organizations that often incentivize advisors to recommend actions contrary to what is best for their clients.
In the worst cases, they are but salespeople trying to place an expensive product. Why else would anyone recommend a mutual fund with a 5.75 percent sales charge when an equally good one exists with no such charge? The answer, of course, is that a significant part of their income flows from that charge. Similarly, why recommend a mutual fund with a 1 percent internal operating fee when a superior choice has an operating fee a tenth of that level?
While the financial services industry has a long history of commission-based sales, some financial advisors do not currently work that way. So-called fee-only advisors are compensated based on an agreed-upon rate and thus may avoid some of the conflict problems that commissions generate. This is a step in the right direction, but it by no means eliminates the problem. Consider, for example, what happens when the client asks a fee-only advisor about the wisdom of paying off a mortgage early. He may be loath to recommend a payoff when the funds used to reduce that debt will mean less money available to invest. That, in turn, would mean less revenue for him. Once again, the advisor may find the source of his own income to be the most compelling rationale for action.
Some Conflicts Other Than Money
Commissions and fees are among the most obvious sources of conflict, but they are by no means the only ones. Various indirect payments, soft money arrangements, sales quotas, inventory arrangements, and pay-to-play schemes are likely to influence the behavior of anyone in a position to route your money.
Consider this sobering thought: While claiming to scour the world on your behalf in search of the best investments, a big Wall Street firm is actually competing with you in that pursuit. When an advisor who is a registered representative of such a company suggests you buy stock in XYZ, his firm has decided to bet against the XYZ Company. If XYZ was really a great investment poised to go up, your advisor’s company would choose to hold its shares and buy as many more as it could for the firm itself. Even worse, it may be selling you shares from its own inventory. They are selling while urging you to buy. Not only are their interests not aligned with yours, but they are actually your competitor in the same marketplace.
Beyond money, time is an interest that is often in conflict. Financial workers are under great pressure, both external and self-imposed, to get new prospects. Every minute spent serving the needs of current clients is time not used searching for new ones. From your point of view, though, appropriate client service is as important as it is time-consuming. Doing competent work takes care and attention and cannot always be achieved quickly. Even the basic matter of doing a thorough job can raise serious conflict-of-interest issues.
Remember, too, that the overwhelming majority of financial advisors work for someone else. As with most other people who labor for a living, pleasing one’s boss is a compelling personal interest. Financial advisors of all sorts are under tremendous pressure to increase revenues. Thus, the heart, soul, and character of the person sitting across the table from you are not the only things determining how he may behave with your wealth.
Over the years, I have had the chance to teach many advisors, stockbrokers, and financial practitioners. On occasion, I have tried to focus their attention on the overwhelming challenges posed by ongoing conflicts of interest. Those attempts have not always been successful. It is not something that people in the industry wish to examine closely. Perhaps the difficulty is best summed up by this famous quote attributed to Upton Sinclair:
It is difficult to get a man to understand something, when his salary depends on his not understanding it.1
The problem of conflicts of interest is neither easily solved nor likely to go away. Careful attention to it, though, can give rise to dramatically better results. You are going to be negotiating with people who have such conflicts. Ignoring them is a mistake. Simply accepting their ill effects will make you poorer. On the other hand, minimizing their impact on your investments and demanding that those you work with do the same can make a tremendous difference in your outcomes.
Chapter Summary
Economists know that people usually act to advance their own interests.
You are vulnerable when the stakes are high and when you must rely heavily on others.
Incentive structures play a huge role in just how conflicted someone will be.
The financial world is full of conflicts of interest over money.
Watch out for conflicts that are not about money, too.
Don’t try to teach someone about the conflicts problem if his understanding will cost him his livelihood—he won’t get it.
Pay attention and work to minimize the negative impact of conflicts of interest on your investing.
Note
1. Upton Sinclair and James Gregory, I, Candidate for Governor: And How I Got Licked (1935; reprint, Berkeley: University of California Press, 1994), 109.
Chapter 15
The Problem of Asymmetric Information
Along with conflicts of interest, an investor-negotiator faces a second set of challenges related to what economists call asymmetric information. This is a fancy-sounding name for a very commonsense problem. Basically, you must negotiate with people who know a lot more than you do about the subject at hand.
Just as the car dealer recognizes which one is a lemon, and the home seller is aware of the secret damage to the roof, so, too, the financial worker knows a great deal more than you about the investments you are negotiating over.
They Know Much More Than You Do about the Tricks of the Trade
Most advisors have command of a great many practices, mores, and tricks of the trade that are far beyond the knowledge of even very smart regular people. This is even more relevant in fields where special jargon, routines, and techniques make common sense an almost irrelevant attribute. The result is an uneven playing field between the advisor and the client. The person receiving advice is badly disadvantaged and very vulnerable to being manipulated.
This is particularly true of investment advisors in light of the complexity and counterintuitive nature of financial markets. The advisor knows far more than you do about the investment arena. Regardless of intelligence or life experience, you possess only a sliver of the necessary information about the system, players, norms, jargon, and customs of the financial services industry. The fellow across the table, on the other hand, knows the system, the techniques, the players, and the secrets. Indeed, the advisor even knows the client in ways that can be used for gain.
A historical example may illuminate the point. Although it is quite illegal now, in the bad old days many stockbrokers engaged in a practice called front running. When a customer was about to buy a significant amount of a certain stock, that purchase would have the effect of raising the price. If the broker knew in advance, she could buy it for her own account before entering the client’s order. This ensured a profit for the broker, essentially at the client’s expense. While no one is making accusations of front running today in light of legal, ethical, and regulatory prohibitions, it nicely illustrates a large and troubling problem. Financial intermediaries know all sorts of things that you do not. They are in the business of using what they know to make money for them. You are left to wonder if they will use that knowledge to advance your interest in making money. Or, even worse, whether they will use it to make money at your expense.
Knowing More Creates Tremendous Opportunity to Take Advantage
of Others
The opportunities to take advantage of such situations are many and vast. Among these are overcharging, underserving, moving bad merchandise, guiding business to friends (or reciprocators), hiding fees, selling things that have no value, misleading, stealing, taking credit unfairly, and claiming random chance as skill. This list goes on and on. In reality, absent some sort of strong professional or moral code, those who guide us in areas we know little about can do just about whatever they wish. To use an extreme example, Bernie Madoff did not just mislead people about their investment returns—he made them up.
One answer to the problem of such information asymmetry is to learn more. It is a wonderful response, and I endorse it heartily—after all, isn’t that what this book is all about? That course of action has significant limitations, though. We cannot all become experts in the many areas of our lives. In the case of your investments and financial decisions, even dedicated study is unlikely to level the information playing field with those who work in that field every day.
To make matters worse, some portion of the financial industry’s profits are specifically based on taking advantage of the relative ignorance of other people. The markets are, to some extent, viewed as a contest, with the spoils going to the fittest players. That may be all well and good in transactions between giant investment banks, but it is immoral and unacceptable when the losers are working folks who foolishly place their trust in the wrong people or institutions. Giant firms loaded up with PhDs, former treasury secretaries, banks of computers, and all of my brightest Wharton students are always going to win. No society can long endure if it lets such behemoths vacuum up the life savings of everyone else.
Negotiating Your Investments Page 14