Incentive Structures

Or why you are your own best advisor

Today I want to take some time to discuss something that is often ignored or misunderstood by a lot of people.

Let’s talk about Incentive Structures, how they work, and why you should pay attention to them when making even the most minor of decisions.

Do your own Homework

The only person on earth with your best interests as their number one priority is you.

I understand that this is a hard truth to swallow, but it is fundamental that you understand it, because if you don’t you will make decisions that will harm you.

You may have a loving wife, fantastic friends, qualified bankers and investment advisors who have a fiduciary responsibility towards you.

None of that matters.

Spouses can get divorced, friends can drift apart, and bankers and investment advisors can cheat you out of your hard earned money.

Now, this isn’t a relationship blog, so I won’t tell you how you should act when it comes to your relationships with friends and families.

When it comes to financial advisors however, I feel like I have something worthwhile to say, and so I will tell you this.

Financial advisors, no matter how competent, and how seriously they take their fiduciary responsibilities towards you, are no substitute for your own research and understanding of exactly what is going on with your money.

There is a long and colorful history of brokers, bankers and advisors enriching themselves at the expense of their clients. This has been so common for so long that 60 years ago Fred Schwed wrote a book title “Where are the Customers' Yachts?”

The title is a reference to an old wall-street story:

A visitor to New York is admiring the yachts docked on the piers. His guide kindly informs him that those are the yatchs of bankers and Brokers, paid for by the commissions their customers pay them to keep their finances in order.

Naively, he asks “But where are the customers' yachts?”

Of course, none of the customers could afford yachts, even though they dutifully followed the advice of their bankers and brokers.

The Incentives

“Show me the incentives and I will show you the outcome.”

- Charlie Munger

Incentives, even small ones have a major impact on how people and companies behave, so it is very important to pay attention to them.

So what are the incentives influencing your financial advisor?

Financial Advisors, Financial Managers and Brokers may be fiduciary, but there is wide latitude given to them when it comes to their dealings. It’s this discretion that causes the problems, but it is necessary in order for them to do their job at all.

After all, any fiduciary may well make a clear and well reasoned case as to why certain companies or funds should be sold and some bought… But of course, what if those clear and well reasoned cases also include some benefit to the fiduciary?

Often times advisors will pitch funds to their clients who have unusually high fees, or which don’t fit the clients desired risk profile, and as a result of that they get some “kickbacks”.

This may sound illegal, and in some cases it may well be, but what of the cases where it isn’t as clear cut as an advisor getting paid by the fund managers to pitch their funds?

What happens if for example the fiduciary simply works for the same parent company as the fund? It may seem minor, but these minor effects have impacts that may cost you thousands of dollars!

But perhaps you’re smart! Perhaps you come up with an incentive plan for your advisor where he only gets paid if you make a profit on a trade! What could go wrong? No has ever gone broke by making profitable trades!

A lot can go wrong.

Just ask Tracy Dewart who discovered that her Alzheimer’s stricken mother had her JP Morgan brokerage account (mis)managed:

After about six months, she learned that the account, worth roughly $1.3 million at the start of 2017, had been charged $128,000 in commissions that year — nearly 10 percent of its value, and about 10 times what many financial planners would charge to manage accounts that size.

In August 2017 alone, Mr. Rahn had sold two-thirds of the portfolio, or about $822,000, and then reinvested most of the proceeds, yielding about $47,600 in commissions, according to monthly financial statements and an analysis by Genesis Forensic Consulting, the firm Ms. Dewart’s lawyer hired.

You may make a profit in every trade, but those commissions you’re paying to trade are costing you a fortune!

Alright, then perhaps you tweak the incentives! Now you only pay commissions and fees if the manager is worth it!

You decide on a benchmark, and your advisor only gets paid if he outperforms the benchmark. In fact he gets 25% of the out-performance.

This way, if the S&P500 (the benchmark) goes up 15%, your advisor only gets paid anything if he too goes up at least 15%. If you’re up 25% compared to the 15% of the S&P500, then you’ve outperformed by 10% and the advisor will get paid 2.5%, leaving you with a 7.5% out-performance.

Doesn’t that sound foolproof? After all, you only pay anything if the advisor made up for it in out-performance.

Of course not.

The advisor will simply make riskier and riskier bets in order to get that out-performance. After all, he’s not risking his money, he’s risking yours!

So why would he care if you make 10% or -100%? His commission is the same either way. It’s better for him to take your money to the casino and put it all on red, that way he’s got a 50% chance of getting handsomely rewarded.

The Results

This misalignment of incentives are very common, and it’s important to be aware of them.

The problem that you as an individual investor have is that you simply don’t know the forces, incentives and disincentives that are acting on your prospective advisors, and you won’t know when they change either.

So you will have to keep a watchful eye on them, and make sure that they are aligned with your goals and objectives.

The problem with that solution, is that it is a hell of a lot harder to keep an eye on what your advisor is doing, if you haven’t got a clue what’s going on in your portfolio and with your finances!

And if you do have a clue as to whats going on with your portfolio… Why do you need an advisor?

Investing and saving is easier than its ever been, and even dumb retail investors like me and you can easily put our money to work as well as or better than the pros!

Simply open an account at a low cost brokerage, purchase a diversified index fund, and let time do it’s thing.

You don’t need to pay hundreds of thousands in fees to dodgy advisors who are doing you more harm than good.

You don’t need to be a stock market genius either!

Just pick a solid index fund, invest in it regularly, and forget about it until you retire.

This is the place where I’d put in my brokerage promo link and ask you to sign up to a brokerage that will give me a kickback when you do, like many financial bloggers do.

I won’t.

I don’t want you to be a product I’m selling.

I want you to be financially independent on your own merits, aware of your finances and able to make your own investment decisions.

You’re smart, you can find a brokerage on your own.

If you have any questions or comments, shoot them on Twitter @TiagoDias_VC or down below!