Thursday, November 3, 2016

Faulty Investment Assumptions

Ben Carlson wrote an interesting piece called Faulty Wall Street Assumptions where he goes through some misguided ideas financial professionals perpetuate about the way to investment success. What Carlson understands well, but may not show through to his readers is that it isn’t the financial professionals on Wall Street and elsewhere who are misguided. They are exploiting our faulty assumptions. Investors like you and me are making the mistakes.

Let’s go through most of Carlson’s list of faulty assumptions and look at why financial professionals behave the way they do.

Investing is about finding new opportunities and security selection.

The very best investors with superior access to company information may be able do well looking for new ideas, but retail investors just jump from one dashed hope to the next. Click-bait screams “5 NEW INVESTMENT IDEAS!” to exploit our weakness. Why would anyone go to the trouble of finding great new hidden gems and then give them away to us? We may get fooled, but those who peddle “exclusive opportunities” know what they’re doing.

A 200-page prospectus is a good idea.

When advisors give you long account statements and massive documents about new investments, they want you to ignore them. They want you to just trust them instead of trying to understand what you are buying. Most investments amount to a mix of stocks and bonds that can be explained simply. Demand an understanding of what you’re buying.

Clients want to be impressed.

I think Carlson got this one a little muddled. He paints a picture of misguided advisors working against their own interests and those of their clients. It’s true that clients may be best off if their advisors don’t try to impress them. Unfortunately, advisors will make more money over time if impressing clients is part of their strategy. The onus is on clients to be impressed by simplicity and clarity instead of being impressed when they get baffled. Many advisors sell expensive investments by walking a fine line between offering simple-sounding stories and using complexity when clients try to dig into the simple stories.

People care about risk-adjusted returns.

Carlson is spot-on with this one. Clients don’t care about the textbook concepts that advisors need to understand to do their jobs well.

Intelligence is all that matters.

The truth is that being brilliant won’t make you a successful active investor. The investing world is jammed full of brilliant people. You have to be much more brilliant than most of the other active investors. However, brokers and advisors have little to gain by explaining this to their clients. Clients are profitable when they think they’re getting brilliant advice and can be talked into making active moves. Brokers and advisors have little to gain and a lot to lose by saying “we’ve got some very smart people helping us choose these trades, but they’re no smarter than the guys on the other side of the trades.”

You have to have an opinion about everything.

In social settings, I hear friends ask financial guys all sorts of impossible-to-answer questions like “will interest rates go up?” and “will Apple stock tank?” The financial guys always have a smart-sounding response, even if they don’t really answer the question. It’s in their best interests to behave this way. It would be better if people understood that nobody knows the answer to these questions, but that’s not the world we live in. Once again, the onus is on clients to understand their advisor’s limits. Self-interest drives advisors to give answers when they don’t really know. An advisor who says “I don’t know” too many times is a former advisor in most cases.

People need certainty.

It’s true that people “really need is an honest assessment of the current situation and the prospects for the future.” While it may be dishonest to offer certainty, it is profitable. Advisors who subtly give the message “just follow me and you’ll be okay” do well. This is unfortunate, but it is reality. It’s the clients who need to look past this offer of certainty and try to understand what they’re getting.

Complex markets require complex solutions.

Once again, it’s true that simple solutions are best for the vast majority of investors, but advisors have learned that simplicity usually doesn’t sell. Until clients demand simplicity, expect advisors to convey the message that investing is complex, but that they can handle it for their clients to simplify their clients’ lives.

Past performance is all that matters.

It’s true that past performance does not guarantee future performance. However, we’re not wired to think that way. Touting past performance is an effective way to sell investments, even if it’s fundamentally dishonest. Advisors who want to actually help their clients will explain the need to avoid chasing recent winners, but expect many advisors to exploit our weaknesses and keep selling past performance.

Clients need more choices, more ideas, more products, more portfolio changes, more everything.

It’s true that clients don’t need this churn. But churn creates profits for brokers and advisors.

Conclusion

There are honest financial professionals who seek to do what’s best for their clients. However, financial incentives are powerful motivators. Even honest people are guilty of motivated reasoning where they find a way to believe that their actions are good for their clients. Further, there are many advisors with minimal training who just do what their employer’s tell them to do and have no real idea of what’s good for their clients. The result is a world where we all have to look out for our own best interests and not just blindly trust others.

5 comments:

  1. But you never said whether Interest Rates were going up and whether I should sell Apple?!?!? :-)

    I think in life you need to find:
    1) A reliable Mechanic
    2) A lawyer which seems reputable
    3) A financial advisor you can trust
    4) A set of medical professionals you can trust

    Trust is earned, is another important point.

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    1. @Big Cajun Man: I know you're joking, but I've been in conversations like this with people who find out I write a financial blog. They ask if rates are going up, I reply explaining that nobody knows, and they nod in apparent agreement and ask "but, really, do you think they're going up?"

      1) Hopefully, the need for a reliable mechanic will fade as we see self-driving cars for hire.
      2) Good luck.
      3) Unfortunately, to tell if your financial advisors is trustworthy requires enough financial knowledge that you don't need a financial advisor.
      4) Definitely need medical professionals, including different types of therapists.

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  2. "Intelligence is all that matters." In my experience, this is absolutely false. Investing success depends on wisdom, patience, and Spock-like logic. Intelligence may lead a person to those traits eventually but there's no guarantee. We all know an exceptionally smart individual who has no common sense whatsoever.

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    1. @Edward: Carlson and I agree with you. That's why he included it in his list of faulty assumptions. Our reasons are a little different from yours. Carlson is saying that investors shouldn't be overly impressed with a fund manager who is brilliant, mainly because all the other fund managers are brilliant as well.

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  3. 3) Unfortunately, to tell if your financial advisors is trustworthy requires enough financial knowledge that you don't need a financial advisor.

    So true!!

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