It was absolutely wonderful receiving your responses to the previous newsletter on the language of investing. I find the insights and perspectives so valuable, and hope you will continue offering your reflections on this next article.
Truth in Advertising: Holding Ourselves and Our Advisors Accountable
I am connecting more and more frequently with people who want to invest in something they care about and get out of what is not aligned with their values. This theme is not new. The SRI (socially responsible investing) movement has been around for decades and has its roots in the same issues–disenchantment, morality and ethics conflicts, and desires for alignment. The last decade brought us sustainable, green, and impact investing, which extended the values of SRI to a broader set of issues and new classes of investments.
It’s even more intense now, though. People are going further and deeper. For example, it’s no longer unusual to have conversations about getting out of the stock market entirely, whereas even 10 years ago these same people trusted big corporations to be thoughtful and responsible. Today, the mood is much more oriented to local and regional solutions, DIY, direct engagement, transparency, and sharing.
As more and more people wake up to ecological, social, and financial limits, they are asking tough questions about the purpose of investing, the contradictions between what we say we believe and how we behave with our money, and how we might better integrate and align our whole selves with our financial decisions. There is a burgeoning appetite for direct, transparent, and personal financial experiences that are based on long-term relationships and a desire to break through the barriers that currently prevent this.
Fortunately, many of the barriers that are perceived to be impenetrable are actually of our own making, and so require just the power of our will and determination to break down. Perhaps even better, it’s getting easier and easier to make an end run around them.
It’s exciting times to be an investor, but, as an advisor myself, I also see how this puts the advisory services industry at risk. If not immediately facing a decline in business and profitability, mainstream financial advisors are certainly facing a crisis of relevance. This is largely to due to industry-wide adherence to outdated and disproven assumptions, failure to recognize the end runs, and a hefty dose of ego and self-satisfaction.
The investment advisory industry is at risk partially because it has become an “industry”. It is a highly lucrative and surprisingly large portion of the economy, and it’s characterized by some distinctive structural elements that enhance profitability, encourage dependency, and discourage innovation. These same elements make it susceptible to new entrants and disruption because it is not keeping up with what the world really needs, what investors are expecting, and what other tools and information are now available to them.
If the role of the professional investment advisor is to survive current shifts in the investing landscape, it will have to transform into something substantially different from what it is today. This isn’t going to happen overnight, but it can’t start unless we own up to some basic truths of today’s financial services industry. Below is a set of disclosures that I think every investment advisor in the world should have to make to every client and to themselves:
1. “Investing” in the Stock Market
Buying publicly traded stocks of companies is not the same thing as investing directly in a company. You are buying stocks that were issued in the past (sometimes many years ago) and that are now traded among various buyers--retirement plans and foundations but also high frequency traders, hedge funds, and other speculators/gamblers. When you buy a stock, your money does not go to the company. It goes to the previous owner. It’s like buying a used car. The only time your money goes to the company is during an initial public offering (IPO) or in the rare case that companies issue new stock. Trading used stocks is generally considered investing. It’s up to you to decide.
2. Outperforming the Market
If you decide that you want to place funds in publicly traded securities such as stocks and bonds, it is neither clever nor prudent to think you can pick stocks or managers who do better than the market over the long term. There is so much evidence on this point that it’s almost tiresome to have to talk about it. Instead of eroding your returns with high fees, you can buy low-cost index funds and always do as well as the market (minus the fees), or you can pay five times as much (about one percent) to play a loser’s game. If my word is not enough, I cite someone I think most people listen to. In his 2013 annual shareholders’ letter, Warren Buffett had this to say about investing:
“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit…. My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
3. The Risk/Return Equation
The investment management industry has a short-sighted and limited understanding of risk and return. Conventional risk/return modeling cannot adequately take into account each client’s personal values nor the changing nature of global and systemic risk (for more on this, see my paper “A New Foundation for Portfolio Management”). Whether advisors actually believe it personally or not, we put financial returns above almost everything else and insist that any “soft” considerations be quantified and measured in order to be relevant. We often ignore or, even worse, trivialize clients’ concerns over ecological, social, and financial limits, considering them as extraneous to the investment risk/return equation. Why not let clients decide that for themselves, and then help them achieve their vision? Mainly because that would require a different kind of work that is more challenging and less profitable.
4. The Prudent Person Rule
We have confused prudence and fiduciary duty with a rigid conformity to simulations, models, and asset classes. Our sense of prudence relies too much on (recent) historical patterns and not enough on the ways the future will be dramatically different. Modern portfolio theory is built on assumptions about risk and markets that simply do not hold up to the realities of this century. And we use fiduciary duty almost as a scare tactic for both ourselves and clients. We are afraid that if we don’t use conventional approaches we will be sued by clients or prosecuted by regulators, but the legal and regulatory foundations are not nearly as prescriptive or definitive as they have been portrayed. We tell clients we are bound to do what is in their best interests, when we’re actually refusing to respond to their true needs and goals.
5. How We Make Money
We make money by charging you a fee that is a percentage of the assets we oversee on your behalf. This is often about 1%, or $10,000 per $1 million under management. Sometimes we manage these accounts ourselves (by buying stocks and bonds), but often we place your funds with an outside manager who also charges percentage-based fees, and of course you pay extra for tailored services you request. We say that percentage-based fees are clear and simple for clients, but they also have hidden benefits for advisors that often conflict with the best interest of clients, especially those seeking alignment and integration. First, you may end up paying quite a bit for services you do not want or need. A percentage of assets is easy to understand mathematically, but it tells you nothing about what your money pays for or what the advisor is doing for you. Second, percentage-based fees encourage advisors to concentrate assets for enhanced profitability. Advisors are fond of saying that it takes as much effort to manage a million dollars as it does twenty or a hundred million or a billion, which reflects a natural bias toward increasing minimum account sizes, concentrating the number of clients, and applying a one-size-fits-all strategy.
These disclosures are not common, but they nonetheless reflect core operating principles of today’s financial services industry. In my view, they should serve as a starting point for any advisor-investor relationship. I encourage you to use these disclosures as a litmus test for yourself and any advisor you might work with.
I’m currently working on a paper about the business model for advisory services, and would love to hear your reflections on these disclosures and the issues they get at. Are you taking these issues into account when deciding where and how to invest your money? If so, how has that affected your investment choices? If not, how might these disclosures influence your decisions? Have you discussed any of these topics with your advisor, and if so what challenges or opportunities did that bring up?
Please share your reflections here!