Through experience, and the school of hard lessons I have learned that I 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. However I have found that it is something that I sometimes forget.
In the excellent article ā24 Standard Causes of Human Misjudgmentā Charlie Munger, Warren Buffett's partner, gave the following answer when asked about the underestimation of the power of incentives.
āWell 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.ā
It is thus very important to be clear as to what the incentives of the party you are dealing with are especially when investing.
Examples of incentives are:
Ā· Your stockbroker ā She want to earn commission and thus want to do as many transactions as you allow.
Ā· Your bank advisor ā He want to sell you the product that gives him the most commission not the one necessarily the most suitable for your needs
Ā· Your fund manager ā She want to earn fee income from managing the fund, and the bigger the fund the higher the management fee
In the great article Why I Fired My Broker by Jeffrey Goldberg in The Atlantic 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:
āI 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 āthe restaurant concept of the ā90s.ā 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 adviceālong-term ābuy and holdā 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 Merrillā$80, $100, $130, for modest chunks of stockāwere high, but we were told that we were paying a premium for quality research.ā
In many cases, we were. Bernstein, the chief strategist, has actually been bearish for much of the past decade. Given his recent disposition toward market pessimism, I asked him why he didnāt tell Merrillās clients to dump their equities seven months ago. āI said it as best as I could within reasonable professional standards,ā he said. āIām not going to yell āSell, sell, sell!ā Iām not going to go out and be irresponsible.ā
In an interview Goldberg had with George Soros the billionaire hedge-fund manager Soros says:
āYou think a brokerage should be a place you go to pay commissions for fair and unbiased advice, right?ā he asked.
āYes,ā I said.
āItās not. It never has been.ā He then cited another saying of Buffettās: āāWall Street is a place where whatever can be sold will be sold.ā You are the consumer of their dreck. What they can sell to you, they will sell to you.ā
A comment by Seth Klarman, a value investor with an outstanding track record, summed up the point of this article with this quote:
āThe average person canāt really trust anybody. They canāt trust a broker, because the broker is interested in churning commissions. They canāt trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now itās even worse because even the most sophisticated people have no idea whatās going on.ā
But investors are also sometimes their own greatest enemy.
As financial adviser Larry Gellman, also in the Goldberg article mentioned above, explained why brokers do not care about your financial future.
āThroughout the late 1990s, investors were firing their brokers and money managers because they didnāt own enough tech and Internet stocks, so everybody got loaded up at the tech party right before the cops came,ā. āMost 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, āNever again.ā ā
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.
You also have to be willing to spend some time researching and making decisions. Even if you hate figures, paperwork, investments etc.
Our finances and investments are far too an important part of out lives to leave to others.
First 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 annum is probably not realistic or appropriate.
The next step is to determine how you are going to do it.
Invest through a fund or do it yourself.
The main factor to decide between the two choices is how much time you are prepared to spend on managing your finances with funds taking less of your time.
Brokers can be avoided by opening your account at an execution only broker and doing your own investment research.
Remember, in spite of all the negative news above there are still good brokers, newsletters and funds to be found.
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 will have times, sometimes a few years, of under performance, it will be unrealistic to expect constant out-performance.
Furthermore a large body of investment research has shown that abandoning an investment strategy or fund in a period of under-performance would be exactly the wrong thing to do.
Tim du Toit
www.Eurosharelab.com
I think you will agree that considering the incentives of the person you are dealing with makes immediate intuitive sense. However I have found that it is something that I sometimes forget.
In the excellent article ā24 Standard Causes of Human Misjudgmentā Charlie Munger, Warren Buffett's partner, gave the following answer when asked about the underestimation of the power of incentives.
āWell 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.ā
It is thus very important to be clear as to what the incentives of the party you are dealing with are especially when investing.
Examples of incentives are:
Ā· Your stockbroker ā She want to earn commission and thus want to do as many transactions as you allow.
Ā· Your bank advisor ā He want to sell you the product that gives him the most commission not the one necessarily the most suitable for your needs
Ā· Your fund manager ā She want to earn fee income from managing the fund, and the bigger the fund the higher the management fee
In the great article Why I Fired My Broker by Jeffrey Goldberg in The Atlantic 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:
āI 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 āthe restaurant concept of the ā90s.ā 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 adviceālong-term ābuy and holdā 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 Merrillā$80, $100, $130, for modest chunks of stockāwere high, but we were told that we were paying a premium for quality research.ā
In many cases, we were. Bernstein, the chief strategist, has actually been bearish for much of the past decade. Given his recent disposition toward market pessimism, I asked him why he didnāt tell Merrillās clients to dump their equities seven months ago. āI said it as best as I could within reasonable professional standards,ā he said. āIām not going to yell āSell, sell, sell!ā Iām not going to go out and be irresponsible.ā
In an interview Goldberg had with George Soros the billionaire hedge-fund manager Soros says:
āYou think a brokerage should be a place you go to pay commissions for fair and unbiased advice, right?ā he asked.
āYes,ā I said.
āItās not. It never has been.ā He then cited another saying of Buffettās: āāWall Street is a place where whatever can be sold will be sold.ā You are the consumer of their dreck. What they can sell to you, they will sell to you.ā
A comment by Seth Klarman, a value investor with an outstanding track record, summed up the point of this article with this quote:
āThe average person canāt really trust anybody. They canāt trust a broker, because the broker is interested in churning commissions. They canāt trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now itās even worse because even the most sophisticated people have no idea whatās going on.ā
But investors are also sometimes their own greatest enemy.
As financial adviser Larry Gellman, also in the Goldberg article mentioned above, explained why brokers do not care about your financial future.
āThroughout the late 1990s, investors were firing their brokers and money managers because they didnāt own enough tech and Internet stocks, so everybody got loaded up at the tech party right before the cops came,ā. āMost 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, āNever again.ā ā
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.
You also have to be willing to spend some time researching and making decisions. Even if you hate figures, paperwork, investments etc.
Our finances and investments are far too an important part of out lives to leave to others.
First 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 annum is probably not realistic or appropriate.
The next step is to determine how you are going to do it.
Invest through a fund or do it yourself.
The main factor to decide between the two choices is how much time you are prepared to spend on managing your finances with funds taking less of your time.
Brokers can be avoided by opening your account at an execution only broker and doing your own investment research.
Remember, in spite of all the negative news above there are still good brokers, newsletters and funds to be found.
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 will have times, sometimes a few years, of under performance, it will be unrealistic to expect constant out-performance.
Furthermore a large body of investment research has shown that abandoning an investment strategy or fund in a period of under-performance would be exactly the wrong thing to do.
Tim du Toit
www.Eurosharelab.com
