The Calculus of Trust

The bestselling book “Freakonomics” chronicles the search for the hidden incentives behind all sorts of behavior. It characterizes the field of economics as the study of incentives – how people get what they want, or need, especially when other people want or need the same thing. “Freakonomics” gives entertaining examples of how odd results can be explained by carefully evaluating people’s incentives, like how cheating can be applied to teachers and sumo wrestlers and why most crack cocaine dealers are willing to live in near-poverty conditions.

There is no industry more ridden with conflicts of interest and misaligned incentives than investment management. David Swensen, the Chief Investment Officer of Yale University (one of our MarketRiders experts) writes: “Relationships with external investment managers provide a fertile breeding ground for conflicts of interests…. (we) seek high risk-adjusted returns, while outside investment advisers pursue substantial, stable flows of fee income.”

To properly evaluate any financial advice you are given, you must understand the incentives of the adviser. If your broker or insurance agent is your best friend, remember that he feeds his family by selling you “products” that may not be best for you. The financial adviser you pay by the hour may talk a little too much and be pedantic in delivering his advice to keep the meter running. Those who are paid a percentage of your assets want more of your money. We explain these incentives in more detail on our website How Wall Street Keeps You at the Table.

Regulations in the financial services industry put another and more subtle dimension on incentives for advisers. Did you know that a Broker / Dealer works under different legal standards than a Registered Investment Adviser? Did you know that a Certified Financial Planner must pass much more rigorous examinations than brokers or advisers? We’ve brought you articles this week so that you can be more informed about these issues and upcoming regulatory changes that could impact you.

Speaking of incentives, our August 14th newsletter comparing the mutual fund industry to the tobacco industry ended up in the New York Times which prompted the VP of Research at Morningstar to make dismissive comments about our arguments. Applying the Freakonomics incentives concept, we publicly bet him that a portfolio of 10 ETFs recommended by MarketRiders would beat 10 Morningstar 5-Star rated mutual funds. He refused to accept our wager. We weren’t at all surprised. After all, he’ll make much more money perpetuating the myth that his system works, than losing his own money by actually using it.