Know your financial advisor’s incentives

Published in The Hindu - Sunday Magazine on Jun 28, 2009

Financial services companies have mandatory “Know your customer (KYC)” guideline; It’s time investors have a “Know your Financial Advisor (KYFA)” guideline.

Last weekend a doctor couple met me for advice on planning their finance and investments. After hearing about the mess that they were in, I could not resist but ask why they had not sought professional financial advice earlier. The reply threw me back – apparently every single investment decision was made only under the guidance of their financial advisor – who surprisingly never charges a penny. What? Who is this “brilliant” Good Samaritan? – was my retort (forgive my callous sarcasm). It turns out their “advisor” was an “agent” (not exactly like the one in Matrix, but close) – meaning his primary source of income is the commission that he makes from the investment products he sells. So what? You may ask. Well…the issue is – “independence”.

The fundamental conflict of interest

To help my clients understand this better I posed them with an analogical question- would you go to a doctor who works pro-bono but gets paid only from the medicines that he gives you? “Of course not” was their reply. “Why?” I asked. “Because then the doctor would not only be tempted to prescribe more medicines than required but also resort to prescribing the more expensive ones”. Fine, what if the doctor gets a percentage cut from the pharma company, on the medicines he prescribes? I probed further. “Hmm…” they said – “The pharma companies would love to implement this, because doctors would turn into direct selling agents and they can do away with medical reps.”.

Unfortunately something that is so obviously a conflict of interest in the medical context is most easily overlooked when it comes to the financial services industry. Infact I think I can safely (and sadly) state that conflict of interest has become industry practice in finance. We don’t seem to hesitate even once before taking “advice” from agents, who get commissions from the very companies whose products you choose! Be it your stockbroker, real-estate broker, wealth manager or the insurance advisor – all of them are agents who earn commissions based on what product you invest in, how much you invest, how often you buy and in the case of stockbrokers - also based on how often you sell. Why, even the investment banker who advices on Mergers & Acqusitions is an agent who gets paid a “success fee” that is proportional to the size of the transaction – only if the client is successful in buying or selling. So they would do whatever it takes for the deal to go through, because that’s when they get paid big bucks; the bigger the acquisition the better. Strangely despite this incentive problem even large companies look to investment bankers for “advice” on M&A. Do you think they are going to say no to billion dollar acquisitions like Tata-Corus or Hindalco-Novelis simply because the transactions are inherently risky and involve taking on a lot of debt that may put the entire company at risk of collapse? Obviously no! They would do whatever it takes to convince the company to go ahead with the acquisition so that they can earn their big fee. Because their incentive doesn’t allow them to be concerned about the success/ failure of the M&A, just like how your agent, cloaked in the robe of a financial advisor, does not care about how well your investment does – they just want to close the sale and pocket the commission.

Stocks

You may be ogling over how often your stockbroker (online or offline) provides you with free “research” based advice (“recommendations” or “calls” in industry parlance) - some broking firms even tout the frequency and the quantity of such recommendations as their USP. But not many people realize that the monthly, weekly, hourly, (minute by minute?) buy/sell recommendation is aimed to fulfill the broker’s requirement of generating commission income, which incidentally is earned only when you execute a trade (buy/sell). Remember investment “recommendations” from a stock broking firm is not some kind of “value added” service or advice; it’s merely a marketing tool to induce you to trade.

Mutual funds and other investment products

The new proposal by SEBI - mandating mutual funds to remove entry loads, which is used by the funds to pay the distributing agents, is a step in the right direction. If the revised proposal is implemented, investors need to directly pay a mutually agreed commission to their agent - which is a good thing because at least it makes the process more transparent. But still a couple of larger issues remain un-addressed. First is the case of ULIPs, which despite becoming an extremely popular investment class of-late, have very little regulation in terms of fee structure to agents or disclosure of it (may be that’s why they are popular in the first place!). Second, there are no signs of finding a solution to the more fundamental problem of agents turning into financial advisors and hard selling investments, purely for their own benefit (“incentive”).

Way forward

My opinion - as long as financial advisors are agents who earn their fee only when an investment product is sold, their incentives increase the risk of mis-selling by supplanting investors’ need. The only way to protect yourself from this is to know exactly “how” and “how much” your financial advisor will get paid (what’s in it for them?) - before you make your investment decision.

Are you a victim of the trend?

Published in The Hindu - Sunday Magazine on Jun 07, 2009

When it comes to stock investing, misguided reasoning of trends prevents investors from buying cheap.

After the stock market witnessed a historic bounce post elections, the number of emails that I receive with request for investment advice has doubled. What puzzles me is why people who want to invest in the market wait for the prices to go up before stepping in. It’s like waiting for the discount sale to end so that you can start shopping! Shouldn’t the inverse be true? If I am a net buyer of stocks until I near my retirement (I expect most people are), I would be glad if the prices stay down so that I can continue to buy cheap. In fact I would like all the appreciation to happen only after I reach the stage in life when I plan to stop investing and begin to encash my savings.

One reason people are eager to watch their stock prices constantly rise is because they are unable to bear their neighbours’ boasting about property appreciation. But there is a key difference between the two classes of investment – stocks and real estate. Most people buy property by taking a hefty loan- sometimes up to 85% of the value of the property. The property investment itself happens on a lumpsum basis on day zero, although repaying the loan would continue for the next twenty years. Since the entire investment is done upfront, it pays for the appreciation to kick-in with immediate effect. On the contrary, when it comes to stocks, people don’t generally take a loan and make their total investment upfront. Instead they invest periodically over time to reap a lumpsum benefit after many years. In the event of a constant upward trend in stock prices, while you may earn high total returns on your early investments, the returns on your later investments would shrink. In fact the higher up on the upward trend line you invest, the lower your total returns.

But why do most people hesitate when they get an opportunity to buy when the market trend is down? Apparently, the culprit is “our brain”. Our brains are pattern-seeking organs and extrapolate every trend that they spot. When we see the market falling, we expect it to fall forever. Similarly when it is rising, we expect it to rise forever. And funnily the age of the trend makes this faulty reasoning even more pronounced and convincing. For example, if the market has continued to fall for many months, then we think it will definitely fall even further. Likewise our confidence gains strength as the market rises and eventually reaches its peak when the market is at its peak. As a result, most people get caught in “perfectly bad timing” by waiting for prices to fall significantly before they sell or rise significantly before they decide to buy.

Another figment of our brain is “loss aversion”. Our hatred to experience a loss is more than our love for profits. So we are not even willing to suffer a short term notional loss by buying on the downward trend, although doing so would give an opportunity to reduce our average purchase price and increase our chance of “actual” profit when the trend reverses. On the other hand, we are perfectly okay in buying on the upward trend; despite the fact that this increases our average purchase price and exposes us to higher risk of “actual” loss should the trend turn direction (something that trends always do sooner or later).

I have seen many people get jittery when their stock does not increase the next minute after they purchase it. Let it fall a few points below the purchase price and they are petrified. Some quickly sell when the price breaches random stop losses while others just stay invested, cursing themselves. The latter group would either sell at rock bottom when they finally give up hope or wait for the trend to recover and reach a level close to the purchase price so that they can then sell for a minimal or zero loss. But isn’t the idea of investing to make a profit?

Here’s one more common behavioral quirk. God forbid, if the stock rises for two consecutive weeks after the purchase, people start thinking that they have cracked the code to the roulette table or something. What could be worse is that some of them start believing that they have acquired a special “skill” to invest, when the fact of the matter is “it’s not them”, “it’s the trend”. Misguided by the trend, instead of cashing out with the money, they either make new bets or increase the size of existing bets – at higher prices. “If I made 50% in one month, imagine how much I can make in one year” would be the governing logic. As you know, this is no logic but just rubbish - because most trends don’t last forever; even the one’s that do, go through many crests and troughs in-between.

What works best in stock investing is finding fundamentally good companies that have historically shown resilience in their business performance and buying them during bad times when the price gets beaten down, while adding to the position at lower levels. This way, instead of getting victimized by the trend, you can take advantage of it!