Conflicts Abound At Large Brokerage Firms

If you ever are interested in learning about the conflicts your advisor at a big firm might have when advising you, just go read their compensation plans.  They are complex and incentivize behaviors that may not be in your best interest.  Many of us at Greenspring started our careers at these firms so we weren't surprised to see that not much has changed.  I was particularly interested in a recent article that outlines the new compensation plans offered to advisors at Merrill Lynch and Morgan Stanley, the two largest brokerage firms in the world.  Here is an excerpt from the article about Morgan Stanley:

As for Morgan Stanley's lending award, it remains unchanged from last year at the advisor level: A maximum of $202,500 will be received for those showing growth in securities-based lending, tailored lending and home mortgages. Support staffers, though, can earn as much as $10,000 for their support of lending activities, up from $2,000 in 2015.

The president of the wealth management division stated in the article, "We continue to make private banking services our top strategic priority in support of [our] holistic advice."  Translation:  lets sell a boat load of banking products to our clients this year!  The fact that an advisor can earn over $200,000 if he sells enough lending products is sickening to me.  With that kind of money on the line, advisors are incented to push clients into loans.  Not only loans, but margin loans.  For the vast majority of investors this is a terrible idea.  Ask anyone who has heavily invested on margin how it worked out.

Merrill Lynch isn't any better.  Here is an excerpt:

Advisors who had fees and commissions of about $400,000 to $600,000 and received cash payouts of 40% in 2015, for instance, will need to produce $450,000 to $650,000 in 2016 to maintain the same payout level. Thus, a $400,000 producing FA who couldn't make the jump to $450,000 in production would make 5% less cash in 2016 — $152,000 vs. $160,000 in 2015.

Merrill's 2016 grid includes cash payouts of 34% of production to those reps bringing in yearly fees and commissions of under $250,000; 35% for those producing between $250,000 and $350,000; 38% for the $350,000–$450,000 range; 40% for $450,000–$650,000; 41% for $650,000-$850,000, 42% for $850,000-$1.05 million, and 43% for $1.05 million-$1.5 million.

So, lets say you are an advisor and its December 15th.  You've produced $425,000 in revenue for the year.  You know if you don't get to $450,000 in total revenue your payout (% of revenue you take home) is going to drop costing you thousands of dollars.  Do you think there is any incentive to push products that may not be in your clients best interest?  And this isn't just some small percentage of advisors that have to wrestle with this.  It is all of them.  When you look at the ranges, every advisor is going to be close to bumping up to a new payout.  Again, this is more incentive to sell products that the clients may not need.

Am I being harsh?  Don't advisors have a moral and ethical dilemma when they sell clients products that benefit the advisor more than them?  Maybe, but I have seen too much that leads me to believe it is happening frequently.  Dan Ariely, a professor of behavior economics at Duke puts it best:

Dishonesty is all about the small acts we can take and then think, no, this not real cheating. So if you think that the main mechanism is rationalization, then what you come up with, and that’s what we find, is that we’re basically trying to balance feeling good about ourselves. On the one hand we get some satisfaction, some utility from thinking of ourselves as honest, moral, wonderful people. On the other hand we try to benefit from cheating.

So rationalization is what we allows you to live with some cheating and not pay a cost in terms of your own view of yourself.

We all have biases and conflicts.  Advisors, like all of us, are prone to using rationalization to live with the products they are selling clients.  They have plenty of money, they'll be alright.  The performance has been great on this fund.  They have to bank somewhere.

Rationalizations are everywhere.  Our industry has to stop relying on an advisor's moral code and disclosure to clients (none of which work) and focus on setting up firms that avoid these conflicts altogether.  Greenspring has thought a lot about this.  That is why all of our revenue comes from our clients.  We don't want to be influenced by outside forces (earning a commission to sell a product, sales incentives, higher payout figures, etc) when we are advising clients.  We hope to see the industry follow this same path as the clients will be the real winners.

Brain-Damaged Investors

We've often talked about behavior being the key element in a successful investment experience.  We are starting to see signs of this behavior manifest itself in questions from clients asking if they should lighten up their exposure to emerging market stocks or energy investments.  Of course, these are areas of the market that have been hit the worst over the past several years.  It has been shown through countless studies that humans hate losses more than they love gains.  It has been hardwired into our DNA for thousands of years.  Fear kept us alive when we were living in the wild, dealing with life threatening risks on a daily basis.  Our fight or flight reaction has been finely tuned to allow our species to survive and thrive throughout human existence.  Unfortunately, those emotional responses that have been so beneficial over time are destroying our investment returns.  

When our investments fall, we get scared and our instincts tell us that something is wrong.  This is the way our brain has worked throughout time.  But what if we didn't get scared?  It was always more theory that our emotional response was hurting our returns, but 10 years ago an interesting study was done.  Here is the gist (from the WSJ):

The 41 participants in the new study included people with and without brain damage, including a control group of participants with brain damage that didn't affect their emotional processing. Players were given $20 and asked to play a simple gambling game that involved 20 rounds of coin tosses. If they won a coin toss, they earned $2.50. If they lost the toss, they had to give up a dollar. They could choose not to play in any given round, in which case they kept their dollar.

Logic indicates that the best strategy was to take the gamble in every round of the game, since the return on a win was much higher than the potential loss, and the risk in each round was 50-50. The players with emotion-related brain damage took a more logical strategy, investing in 84% of rounds, while the nonbrain-damaged players invested in just 58% of the rounds. Emotionally impaired participants outperformed the nonbrain-damaged participants, winding up with an average of $25.70 versus $22.80 at the end of the game.

How many investors take an approach like the non brain-damaged investor?  After they've lost money, they are less apt to play anymore.  I still come across investors who sold out of their investments in 2008 and never got back in.  Fear of loss is powerful.  It can make us behave irrationally.  How do we overcome this instinctive tendency?  First, before making any investment decisions, it is important to understand how you are feeling at that moment.  Am I scared?  Is this a logical decision?  Second, automate it.  Using a simple asset allocation strategy like a target date fund inside a 401k plan or an advisor managed model portfolio, allows us to make less decisions.  This is almost always a good thing.  Finally, and most importantly, get outside counsel.  Whether you work with a trusted advisor or just have someone you trust to go to when you are planning on making a change, it is important to find someone who will tell you what they are thinking.  Someone who doesn't have an emotional tie to your money but still is acting in your best interest.  Those investors who can not only recognize their emotional biases but also act against them (buying after a major drop in the market) will find tremendous success in the future.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.