by David Robertson, CFA
June 2016
A system is defined as, "a set of connected things or parts forming a complex whole," and complex they can be. Computer systems, for example, can confound experts and frustrate ordinary people. So many things can go wrong that troubleshooting is an exercise requiring deep understanding, intense concentration, and often unbelievable patience.
The system of financial and investment services is another system fraught with complexity that is equally capable of confounding and frustrating people. Massively interconnected, often highly obfuscated and constantly changing, investment services often leave people bewildered. Too often they encounter the same dreaded set of options as they used to with computer systems: Abort, retry, fail? While such errors have a nasty tendency to come at the worst possible time, such as when people most need help, fortunately there is something investors can do about it.
That old computer error message, according to Wikipedia, "was sometimes used as an example of poor usability design in computer user interfaces" and indeed, the same criticism of "poor usability design" can be applied to investment services. This criticism highlights a darker reality that far too many investment services were not "designed" for usability at all. Rather, much of the complexity evolved so as to first serve the interests of the industry itself. Examples abound.
Perhaps the worst offenders have been the big banks. Week after week we learn of new multi-billion dollar penalties levied on these institutions for deliberately manipulating markets. Week after week, we fail to see any of the individuals responsible for the actions go to jail. Nor do we observe settlements in which the offending organization is required to so much as admit to wrongdoing. It seems as if banks have not only not learned lessons from past misdeeds, but rather have been emboldened by the dearth of consequences to commit more.
In addition, the Department of Labor (DOL) recently issued a ruling known as the "fiduciary rule" that now requires brokers to act in the best interests of their clients. In one sense it is absolutely appalling that the very basic standard of fiduciary duty has not always been the standard of conduct. In another sense, stock transactions emerged from a "sales" culture and it is unsurprising that there are still remnants of it. Further, with the understanding of "buyer beware", it can be argued that when investors are not served well by brokers, they have to accept much of the blame themselves. There are no laws against being a bad consumer nor should there be.
These arguments belie the reality, however, that the vast majority of people do not understand that brokers have not been required to act in their best interest. Unfortunately, this has the effect of tainting the entire industry despite the fact that there are many individuals who act in accord with fiduciary duty and professional designations such as the Chartered Financial Analyst (CFA) that require it. Our preference would be to allow different business models, including the historic brokerage model, but to require the equivalent of the surgeon general's warning on cigarettes if those models don't require their agents to act in the best interest of their clients. Then investors can decide for themselves what they prefer and accept the consequences.
Of course the mutual fund industry has hardly been a stellar citizen either. Far too often funds that closely resemble cheap index funds charge high fees for active management. Often included are substantial fees for marketing which provide little or no benefit to the investor, but often benefit the firm. Fees of all types are often obfuscated or hidden altogether which increases the difficulty of making evaluations and comparisons.
Finally, the value proposition of many investment advisers also tends to be lacking. Daniel Kahneman illustrates the point nicely in his book, Thinking, Fast and Slow. He evaluated the performance of a firm's advisers by analyzing investment outcomes over an eight year period in an effort to determine the persistence of skill. He found there was none; the correlations were effectively zero. In other words, the performance upon which the advisers' bonuses were paid was merely a function of luck.
These results, which can be generalized to nearly all investment services, also demonstrate the chasm between perception and reality, both within and outside of the industry. Too often industry participants are considered "experts" simply by virtue of membership, and completely irrespective of education, experience, professional accreditations, and record of investment decision making. Kahneman was somewhat surprised that none of the advisers seemed especially surprised or disturbed by what he considered to be an indisputable demonstration of "illusion of skill", but that experience is probably more the norm than the exception.
It would be nice if investors could just wait for improvement to come to them as improvement in applications for computers and mobile devices is arriving at a frenetic pace. In the field of app design, the efforts to improve user experience are so broad and powerful that they have acquired their own abbreviated moniker, "UX".
Unfortunately the trends in investment services often seem to stymie progress more than encourage it. An economic climate of strong returns, lax legal and regulatory response, and poor transparency has served to mask many unhelpful industry practices. Perhaps even worse, as Jim Ware, author of High Performing Investment Teams, identified in a 2010 article [here] and that we addressed earlier [here], there has been precious little leadership advocating for improvement.
In Ware's research there was no mistaking the prevalence of malfeasance: When he anonymously polled industry participants with the question, "'Do you believe that investment firms routinely commit these [ethical] breaches?' 93 percent and 81 percent responded in the affirmative." Further, two-thirds of them said, "Yes, those breaches occur at our firm."
Ware dug in further to better understand how firms set out with high ethical goals but then so often betray them in practice. He found that among the industry participants he surveyed, they believed that "most industry participants are taking the low road.” In Ware's words, "The smart response, according to game theory, is to do likewise." The general sense is: "So if our competitors are getting ruthless - so should we."
Ware pursued the issue further with Marianne Jennings, professor of legal and ethical studies at Arizona State University's W.R Carey School of Business. Jennings had asked her students and ethics course participants to name one thing they did in the past year at work or in their personal lives "that troubled them." The results were "amazing" and "astonishing" to her. She notes, "They can spew it right out as a problem ... but they did not stop themselves." In other words, they recognize ethical problems, but they don't act to prevent them.
Given the "poor usability design" of many investment services, it's no wonder that many investors experience alternating measures of frustration, depression, and anger. When a bunch of conflicts and problems build up in computer systems, users normally have the option doing a hard reboot. Wouldn't it be nice if investors could do the same thing? Such a radical measure would be a convenient way to completely clear out all of the harmful practices and ethical deficits and to create a solid foundation for better functioning.
That will not happen in all likelihood, however, unless and until a massive change in sentiment occurs in the investing public which is not likely to happen any time soon. There is simply not a sufficient level of activism or sense of urgency. Strong returns and low volatility the last seven years have masked many problems and dulled the appetite for change. Sentiment could change with a massive market downturn and another financial crisis, but even then fundamental change is not going to happen until a critical mass of investors demand it and change behaviors by refusing to purchase low quality offerings. We are nowhere near that now.
In the meantime, however, there is a silver lining. Just like critical errors in computer systems are potentially "fixable by operator intervention," so too can investors do things to help their own cause. Historically, the investment industry primarily has operated as a "sales" culture meaning that most services are pushed out, or "sold" to investors. The opportunity for investors is to turn that dynamic around by becoming better "buyers" of services. And they can do that by getting more proactive and resourceful in engaging with the industry.
One clear first step is investor education. Too often investors don't even have enough of a foundation of investment knowledge to ask good questions of providers - which is a basic precondition for being a good consumer. This is emphatically not limited to individuals. As one example among many, Michael Liersch, head of behavioral investing at Merrill Lynch, indicated at the CFA Society of Philadelphia's (CFAP) conference for endowments and foundations last week, when he presents, typically not a single person in the audience can even describe what his field of behavioral finance is about.
This is especially a shame because behavioral finance is essentially about decision making which is arguably one of the most important aspects of investing. Not only is this field incredibly important for investors, it is also increasingly accessible. An outstanding example is Kahneman's book noted above, but there are plenty of others.
It isn't just behavioral finance where progress is being made either. There is a terrific and growing body of research in nearly every corner of the investment world that keeps producing useful insights into security selection, asset allocation, portfolio design, cost vs. performance, expected returns, and a whole host of other topics. The efforts to generate this research have always existed; the problem has been that too few of them end up benefiting investors. Indeed, these developments are providing a new frontier of competitiveness for those who pursue and implement them aggressively.
To be sure, many investors have responded to the industry's shortcomings by taking the DIY route and doing all of the investing work themselves. This is fine for some who have the time and interest to devote themselves to the task. Further, as commissions and other costs have declined over time, it is a more viable approach than it used to be. On the other hand, however, it normally takes a pretty big commitment and for many of those who have pursued that path in the past, they discovered some important holes in their understanding of the markets the hard way.
Alternatively, there is a middle ground that can make a lot of sense for certain investors. While there are clearly a wide range of shortcomings with investment services in general, there are also plenty of important exceptions. It doesn't make sense to throw the baby out with the bathwater. Yes, it's true there are a number of industry practices that don't help investors, but it is also true that a number of providers recognize this fact and are creating ways to do better. Advances in research and decreases in costs are creating the potential to fundamentally improve the standard of value in the industry.
The opportunity and challenge for investors is to explore new resources. In order to do that successfully, however, they will first need to become more proactive in evaluating and seeking them out and an important aspect of this is becoming better consumers. At the CFAP conference, Wes Gray, CEO and CIO of Alpha Architect, described what may be emerging as a new paradigm. He said a number of investors "know they are getting screwed by Wall Street" and are taking the initiative to actively learn and find better solutions. His firm, for example, focuses on "inbound marketing" by providing lots of useful information and research. This type of model can provide a great deal of education for people who demonstrate the initiative, but it also structurally reduces the selling costs of the services. Such examples may portend an important change in how services are procured.
Of course many investors will complain that they are overwhelmed with other activities and simply don't have the bandwidth for evaluating investment services more aggressively. Others will shudder at the thought of getting engaged at all. And that's fine; many investors simply don't have the option to do things differently. But if there is one lesson to be gained it is that a fairly passive degree of engagement with investment services providers has not worked very well for investors - for a whole host of reasons. So whether you are looking for help with financial planning, investment management, asset allocation or some challenge that does not fit neatly inside existing silos, there are important opportunities to circumvent many of the industry's shortcomings by exercising some "operator intervention".
June 2016
A system is defined as, "a set of connected things or parts forming a complex whole," and complex they can be. Computer systems, for example, can confound experts and frustrate ordinary people. So many things can go wrong that troubleshooting is an exercise requiring deep understanding, intense concentration, and often unbelievable patience.
The system of financial and investment services is another system fraught with complexity that is equally capable of confounding and frustrating people. Massively interconnected, often highly obfuscated and constantly changing, investment services often leave people bewildered. Too often they encounter the same dreaded set of options as they used to with computer systems: Abort, retry, fail? While such errors have a nasty tendency to come at the worst possible time, such as when people most need help, fortunately there is something investors can do about it.
That old computer error message, according to Wikipedia, "was sometimes used as an example of poor usability design in computer user interfaces" and indeed, the same criticism of "poor usability design" can be applied to investment services. This criticism highlights a darker reality that far too many investment services were not "designed" for usability at all. Rather, much of the complexity evolved so as to first serve the interests of the industry itself. Examples abound.
Perhaps the worst offenders have been the big banks. Week after week we learn of new multi-billion dollar penalties levied on these institutions for deliberately manipulating markets. Week after week, we fail to see any of the individuals responsible for the actions go to jail. Nor do we observe settlements in which the offending organization is required to so much as admit to wrongdoing. It seems as if banks have not only not learned lessons from past misdeeds, but rather have been emboldened by the dearth of consequences to commit more.
In addition, the Department of Labor (DOL) recently issued a ruling known as the "fiduciary rule" that now requires brokers to act in the best interests of their clients. In one sense it is absolutely appalling that the very basic standard of fiduciary duty has not always been the standard of conduct. In another sense, stock transactions emerged from a "sales" culture and it is unsurprising that there are still remnants of it. Further, with the understanding of "buyer beware", it can be argued that when investors are not served well by brokers, they have to accept much of the blame themselves. There are no laws against being a bad consumer nor should there be.
These arguments belie the reality, however, that the vast majority of people do not understand that brokers have not been required to act in their best interest. Unfortunately, this has the effect of tainting the entire industry despite the fact that there are many individuals who act in accord with fiduciary duty and professional designations such as the Chartered Financial Analyst (CFA) that require it. Our preference would be to allow different business models, including the historic brokerage model, but to require the equivalent of the surgeon general's warning on cigarettes if those models don't require their agents to act in the best interest of their clients. Then investors can decide for themselves what they prefer and accept the consequences.
Of course the mutual fund industry has hardly been a stellar citizen either. Far too often funds that closely resemble cheap index funds charge high fees for active management. Often included are substantial fees for marketing which provide little or no benefit to the investor, but often benefit the firm. Fees of all types are often obfuscated or hidden altogether which increases the difficulty of making evaluations and comparisons.
Finally, the value proposition of many investment advisers also tends to be lacking. Daniel Kahneman illustrates the point nicely in his book, Thinking, Fast and Slow. He evaluated the performance of a firm's advisers by analyzing investment outcomes over an eight year period in an effort to determine the persistence of skill. He found there was none; the correlations were effectively zero. In other words, the performance upon which the advisers' bonuses were paid was merely a function of luck.
These results, which can be generalized to nearly all investment services, also demonstrate the chasm between perception and reality, both within and outside of the industry. Too often industry participants are considered "experts" simply by virtue of membership, and completely irrespective of education, experience, professional accreditations, and record of investment decision making. Kahneman was somewhat surprised that none of the advisers seemed especially surprised or disturbed by what he considered to be an indisputable demonstration of "illusion of skill", but that experience is probably more the norm than the exception.
It would be nice if investors could just wait for improvement to come to them as improvement in applications for computers and mobile devices is arriving at a frenetic pace. In the field of app design, the efforts to improve user experience are so broad and powerful that they have acquired their own abbreviated moniker, "UX".
Unfortunately the trends in investment services often seem to stymie progress more than encourage it. An economic climate of strong returns, lax legal and regulatory response, and poor transparency has served to mask many unhelpful industry practices. Perhaps even worse, as Jim Ware, author of High Performing Investment Teams, identified in a 2010 article [here] and that we addressed earlier [here], there has been precious little leadership advocating for improvement.
In Ware's research there was no mistaking the prevalence of malfeasance: When he anonymously polled industry participants with the question, "'Do you believe that investment firms routinely commit these [ethical] breaches?' 93 percent and 81 percent responded in the affirmative." Further, two-thirds of them said, "Yes, those breaches occur at our firm."
Ware dug in further to better understand how firms set out with high ethical goals but then so often betray them in practice. He found that among the industry participants he surveyed, they believed that "most industry participants are taking the low road.” In Ware's words, "The smart response, according to game theory, is to do likewise." The general sense is: "So if our competitors are getting ruthless - so should we."
Ware pursued the issue further with Marianne Jennings, professor of legal and ethical studies at Arizona State University's W.R Carey School of Business. Jennings had asked her students and ethics course participants to name one thing they did in the past year at work or in their personal lives "that troubled them." The results were "amazing" and "astonishing" to her. She notes, "They can spew it right out as a problem ... but they did not stop themselves." In other words, they recognize ethical problems, but they don't act to prevent them.
Given the "poor usability design" of many investment services, it's no wonder that many investors experience alternating measures of frustration, depression, and anger. When a bunch of conflicts and problems build up in computer systems, users normally have the option doing a hard reboot. Wouldn't it be nice if investors could do the same thing? Such a radical measure would be a convenient way to completely clear out all of the harmful practices and ethical deficits and to create a solid foundation for better functioning.
That will not happen in all likelihood, however, unless and until a massive change in sentiment occurs in the investing public which is not likely to happen any time soon. There is simply not a sufficient level of activism or sense of urgency. Strong returns and low volatility the last seven years have masked many problems and dulled the appetite for change. Sentiment could change with a massive market downturn and another financial crisis, but even then fundamental change is not going to happen until a critical mass of investors demand it and change behaviors by refusing to purchase low quality offerings. We are nowhere near that now.
In the meantime, however, there is a silver lining. Just like critical errors in computer systems are potentially "fixable by operator intervention," so too can investors do things to help their own cause. Historically, the investment industry primarily has operated as a "sales" culture meaning that most services are pushed out, or "sold" to investors. The opportunity for investors is to turn that dynamic around by becoming better "buyers" of services. And they can do that by getting more proactive and resourceful in engaging with the industry.
One clear first step is investor education. Too often investors don't even have enough of a foundation of investment knowledge to ask good questions of providers - which is a basic precondition for being a good consumer. This is emphatically not limited to individuals. As one example among many, Michael Liersch, head of behavioral investing at Merrill Lynch, indicated at the CFA Society of Philadelphia's (CFAP) conference for endowments and foundations last week, when he presents, typically not a single person in the audience can even describe what his field of behavioral finance is about.
This is especially a shame because behavioral finance is essentially about decision making which is arguably one of the most important aspects of investing. Not only is this field incredibly important for investors, it is also increasingly accessible. An outstanding example is Kahneman's book noted above, but there are plenty of others.
It isn't just behavioral finance where progress is being made either. There is a terrific and growing body of research in nearly every corner of the investment world that keeps producing useful insights into security selection, asset allocation, portfolio design, cost vs. performance, expected returns, and a whole host of other topics. The efforts to generate this research have always existed; the problem has been that too few of them end up benefiting investors. Indeed, these developments are providing a new frontier of competitiveness for those who pursue and implement them aggressively.
To be sure, many investors have responded to the industry's shortcomings by taking the DIY route and doing all of the investing work themselves. This is fine for some who have the time and interest to devote themselves to the task. Further, as commissions and other costs have declined over time, it is a more viable approach than it used to be. On the other hand, however, it normally takes a pretty big commitment and for many of those who have pursued that path in the past, they discovered some important holes in their understanding of the markets the hard way.
Alternatively, there is a middle ground that can make a lot of sense for certain investors. While there are clearly a wide range of shortcomings with investment services in general, there are also plenty of important exceptions. It doesn't make sense to throw the baby out with the bathwater. Yes, it's true there are a number of industry practices that don't help investors, but it is also true that a number of providers recognize this fact and are creating ways to do better. Advances in research and decreases in costs are creating the potential to fundamentally improve the standard of value in the industry.
The opportunity and challenge for investors is to explore new resources. In order to do that successfully, however, they will first need to become more proactive in evaluating and seeking them out and an important aspect of this is becoming better consumers. At the CFAP conference, Wes Gray, CEO and CIO of Alpha Architect, described what may be emerging as a new paradigm. He said a number of investors "know they are getting screwed by Wall Street" and are taking the initiative to actively learn and find better solutions. His firm, for example, focuses on "inbound marketing" by providing lots of useful information and research. This type of model can provide a great deal of education for people who demonstrate the initiative, but it also structurally reduces the selling costs of the services. Such examples may portend an important change in how services are procured.
Of course many investors will complain that they are overwhelmed with other activities and simply don't have the bandwidth for evaluating investment services more aggressively. Others will shudder at the thought of getting engaged at all. And that's fine; many investors simply don't have the option to do things differently. But if there is one lesson to be gained it is that a fairly passive degree of engagement with investment services providers has not worked very well for investors - for a whole host of reasons. So whether you are looking for help with financial planning, investment management, asset allocation or some challenge that does not fit neatly inside existing silos, there are important opportunities to circumvent many of the industry's shortcomings by exercising some "operator intervention".
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