“Making a living based primarily on commissions doesn’t make someone a bad person, but it does make them a salesperson.”
– Tony Isola
Just think about it…
Consider those who sell newsletters and magazines with stock tips, how to get rich flipping real estate; or tried and true trading techniques. If any of these purveyors actually had proprietary and valuable information that could reliably produce profits if acted upon – why in the world would they tell anyone about it? The much more lucrative path would be to use the technique itself rather than promote it to their competition!
One of the most fascinating examples of pure salesmanship is the financial news media. A network like CNBC has no other incentive beyond the mission to produce the highest possible ratings so that the advertisers can be charged the maximum amount possible. The goal is nothing more than to produce revenue for the parent company. So if you are CNBC and you wish to maximize the viewership, what do you do? If you have a basic understanding of human psychology, your content will prey on fear and greed and consist of lots of high decibel “pundits” making outrageous predictions and statements about specific stocks and markets in general. Most of these will be of the negative variety – market crash predictions will be routine. You will also make sure to convey how incredibly important every single piece of economic data is, no matter how trivial. You will have Roundtables, “Mad Money”, BREAKING NEWS, “Trading Nation”, and all kinds of daily silliness. And it will work, because human brains are wired to be uncomfortable with uncertainty. That is why viewers are instinctively drawn to people who espouse their opinions with extreme confidence.
“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 pushed my limit a little farther.”
– Charlie Munger
Incentives and Correlations
One book that I enjoyed reading is Freakonomics, a popular and perhaps somewhat controversial book written over a decade ago by a pair of economists that took an entertaining and unconventional look at causes and effects in certain quirky topics in everyday life. It examines the influence and prevalence of incentives and correlations, in areas that we may never have ever considered them.
For example, the authors make the case that real estate agents routinely will convince sellers to lower the home price in order to maximize the chance of selling the home, knowing that the house should sell for the higher price. In this case a transaction occurring at all is far more important to the agent than waiting for a potential sale at a slightly higher price that would be meaningful for the seller, but nets very little additional commission for the agent. Data shows that real estate agents leave their houses on the market longer than those of their clients, and they get higher sales prices as a result. The implication is that agents may tend to prey on the fear of a seller not getting a transaction done at all, at the expense of a lower sale price for the homeowner. Regardless of whether or not this occurs, it does point out the real difference in incentives in a scenario where an agent represents a seller but may not have interests that are as well aligned as one may assume on the surface.
In financial product sales, “information asymmetry” is often combined with an effort to prey on human greed or fear. Information asymmetry exists when one party to a transaction has much more or better information that the other (think of a car salesperson or a funeral director). All too often a high commission financial product is sold in conjunction with the promise of protection against a pending crash; or alternatively, a high fee product is sold in tandem with the suggestion of huge upside potential. Information asymmetry is commonly found in situations where non-trivial costs are embedded inside of a financial product and either lightly disclosed or not at all. Many expensive funds and annuities are sold this way. Our advice is to pay close attention to the incentives: how does the person on the other side of this transaction get paid or otherwise benefit?
Of course, full transparency and knowledge of fees, costs, and compensation would be ideal for investors, although unsurprisingly the industry has lobbied against this for years and years. Information asymmetry often produces a negative outcome for one of the parties, and when coupled with poorly aligned incentives it can be a recipe for disaster.
As always, thank you for your trust and confidence in us. Your feedback is always welcome.
Michael Traynor CFA®
Chief Investment Officer