Incentives matter when it comes to investing | Abnormal Returns

• abnormalreturns
• March 16th, 2012

Business models matter. Incentives matter. This should all be the fodder for Econ 101, but it seems like we need to keep learning this lesson over and over again. This week the Greg Smith op-ed in the New York Times raised the issue of incentives on Wall Street once again the fore.

If it is not already clear, Wall Street was never on your side. One need only take a cursory glance at Josh Brown?s Backstage Wall Street to see up close how Wall Street works against your better interests.? What really rankles many about Wall Street and Goldman Sachs ($GS) in particular was the illusion that was somehow not the case. The Epicurean Dealmaker writes:

Continuing to paint yourselves as client centric when you are the opposite rankles. It is rank hypocrisy. It is bad public relations, because sooner or later people figure out you have not been telling the truth. Certainly there is nobody among your counterparties in the trading world who is under any misapprehension as to whose interests you put first. And increasingly, there are fewer and fewer muppets left elsewhere who believe the old line. It may in fact have the highest currency and belief among your own junior employees, whom you entice to join you in God?s work.

There do seem to be some exceptions to what typically goes on in the financial world.? Tom Davenport writing at HBR extolls the culture that has been built into Vanguard from its origins and how it contrasts with that of Goldman Sachs. He writes:

But it isn?t true that the entire finance and investment industry is guilty of the cultural lapse that Smith is describing. In fact, if Goldman?s senior management and board would like to study a culture that does put clients first, they should hop in a limo and go 110 miles southwest to Valley Forge, Pa.?the home of the Vanguard Group.

The fact is that incentives matter. How you get paid affects how you do your job. That is why it is so important to know how all the various parties you interact with in the financial world are compensated.? Mike Shedlock at Mish?s GETA writes:

Therein lies the rub. Wall Street pimps and whores have no fiduciary responsibility to clients but they do have a vested interest to peddle compete garbage to anyone and everyone?

Interestingly, independent investment advisors such as myself do have a hard legal requirement of fiduciary responsibility.

However, Wall Street pimps and whores do?not?have a legal requirement for fiduciary responsibility. Instead they duck and hide under ?suitability? clauses.

Even if you don?t use intermediaries to do your investing you are still likely at the mercy of hidden incentives. For instance, do you know how you online broker is compensated for order flow? Maybe they internalize some of their order flow. It can make a difference. Rock bottom commissions do come with some tradeoffs. Another example is ?commission-free? ETF trading. Again there is some compensation arrangement there that is allowing you to trade for free. It is worth understanding what is taking place.

As we note in our forthcoming book you are alone are the only one looking out for your own financial interests. The challenge is that you cannot invest for the future without interacting in some significant ways with big swaths of the financial industry. Your incentive is to understand the players in your investing game and just how they get paid, because some one is always getting paid.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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