A Tale of Incentive
“SHOW ME THE MONEY”
Many people are familiar with the phrase, “Show me the money.” It comes from the movie Jerry Maguire. In the movie, the audience listens to a long phone conversation between Tom Cruise and Cuba Gooding Jr., in which Cuba is testing Jerry’s resolve as his agent, that eventually culminates in the famed, “Show me the money” phrase. In the movie, Cuba Gooding Jr. plays a professional athlete who is unhappy with his current contract, and Tom Cruise plays a sports agent who is looking to rebuild his career after a nervous breakdown. In the movie, each thinks the other should do more than they are currently doing to make the other’s job easier, and this is the impetus for the famed phrase.
If you put yourself in the mindset of Cuba Gooding Jr., this tale illustrates the difficulties associated with hiring an advisor or an agent. There are often intangibles that will determine the person who you hire, but in the case of Cuba Gooding Jr., at least he knew how his agent was getting compensated. Most people who work with advisors don’t understand the nature of an advisor’s compensation. Said another way, most people who work with advisors don’t understand what motivates an advisor. Let me tell you right now, money motivates them. Show me how you will compensate an advisor and I will show you how they will behave.
Throughout these tales, we have learned about the two main types of advisors. The first I call the commission-compensated advisor or sales-driven advisor. The second, I call the fee-based advisor. Let me introduce a third type of advisor, which I call the profit-driven advisor. It’s important for anyone who deals with any of these three or a combination of these three to understand exactly what motivates each. Since I’ve been all three, I have insight into how the three types of advisors are motivated. Let’s take them one at a time.
The commission-compensated advisor makes money from selling a product or a series of products that are typically high in cost, proprietary to the firm or both. What they all have in common is they make their income from transactions, so they are transaction-centric. The more the merrier. They love periods of market fear or greed because this is precisely when most customers want to switch from whatever they currently own to something else. You’ll never hear your transaction-motivated advisor say, “Wow, you have a great portfolio, let’s hold everything.” Why not? “Show me the money” is why not. When they get a call that lets them make more money, they might let their conscience be their guide, but I doubt it. Another often-overlooked characteristic of commission-driver advisors is that since they make their money on a commission basis, they typically make a significant percentage of their income in the early stages of a relationship.
Let me give you an example. Suppose your rich aunt left you $100,000. The commission-driven advisor will typically sell you some type of high-cost mutual fund or maybe even an annuity, with an upfront commission of about 5%, or $5,000. You think you have hired a financial advisor, but you are mistaken. They have no further interest in dealing with you unless you have more money to invest or want to sell your recent purchase because although most will receive a small residual income from maintaining your account, it is too small to provide you with the type of service you deserve. Their main income comes from the next $100,000 sale. You become an annoying phone call.
I classify commission-driven advisors into three broad areas. The most recognized type is the full-brokerage firm advisor at firms such as Merrill Lynch, Smith Barney, Morgan Stanley, Wells Fargo and RBC. A lesser-known type is the insurance agent who sells investments on the side. They cross-sell, and you can find them at firms such as Northwestern Mutual, State Farm, Mass Mutual and Allstate. The last is what I call the boutique type. The best example of a boutique type is the firm of Edward Jones. The boutique type comes in many forms. They have titles such as financial planner, estate planner, financial consultant, investment advisor and many more. They often have the exact same titles as what you might find when dealing with a fee-based advisor. So be very careful to distinguish between the two. It is very possible and likely for someone who claims the title investment advisor to act as a commission-driven advisor at times and a fee-based advisor at other times. My rule of thumb is simple; if at any time a person can act as a commission-driven advisor, they are a commission-driven advisor. How can you tell a commission-driven advisor from a fee-driven advisor? Ask for a copy of their ADV. It is a document, required by regulators, that explains in plain English what your advisor does. If they don’t have one, they are commission driven. If they do, read the fine print.
Let’s look at fee-based advisors. They make their money by maintaining a relationship with the client over many years and hopefully many decades. The typical compensation schedule is to charge a percentage of assets under management. The larger your assets, the less they charge as a percentage. A typical fee might be 1–2% of assets under management. Fee-based advisors seek to maximize their income in two ways. The first is by becoming your trusted advisor on matters that deal with overall financial advice. Some will even say they play the role of personal chief financial officer for the client. The second way they seek to maximize income is by growing your assets in a consistent and predictable fashion over time. This may seem like a wonderful thing at first, but make sure you read between the lines. This means they won’t grow your money in a spectacular fashion over time either. They seek consistency because they fully understand spectacular results mean spectacular risks. They know that when clients get less than spectacular outcomes, their income is at risk. Therefore, they choose slow-and-steady as their business model. This means fee-based advisors have a tendency toward diversification when managing your portfolio. It’s not a bad thing, but if you want spectacular results, you are out of luck. They are not in the business of spectacular outcomes. They are in the business of highly probable outcomes. Because fee-based advisors make their money on an ongoing basis instead of upfront like a commission-driven advisor, client retention is of paramount importance to them.
Let’s take the same $100,000 your rich aunt left you and invest it with a fee-based advisor instead of a commission-driven advisor. The upfront compensation model costs you about $5,000 on day one. The fee-based advisor will charge you 1% per year, or $1,000 per year, and typically invests in a portfolio of inexpensive, well-managed products that are not proprietary to their firm. They know their business model and understand math. They know that in order to make as much money as the upfront model, they have to retain a client for five to six years. Therefore, client retention is critical to a fee-based advisor. This is a good thing for clients. This means that when you call them, you in fact do have an advisor. When you call them, you in fact are not an annoying phone call. This means that when times are turbulent and you are fearful or greedy and want to alter your portfolio, you will hear the steady, unbiased phrase, “You have a pretty good portfolio and we know that periods like this exist. I think you should maintain the plan that we have worked under for all these years.”
Let me tell you something many fee-based advisors won’t want to hear. Most of them utilize modern portfolio theory or MPT. I can teach a fifth grader MPT in about 30 minutes. I am not a fan and I don’t believe modern portfolio theory works for most people. It is often too risky during turbulent times or periods in which people are losing money. I calculate about 90% of the risk or volatility in a portfolio comes from the allocation of stocks to the portfolio. Modern portfolio theory does not make allowances for tactical asset allocation or investment behavior, and I think it’s an inferior strategy for all but the most risk-seeking investors. Most fee-based advisors don’t know this, and they are thus not experts, because they don’t take you—the most important variable in investing—into consideration.
Let’s look at the benefits of managing your own money for spectacular results. Because fee-based advisors have a diversification tendency, they seldom seek spectacular results. A consistent, steady and predictable outcome is in concert with their business model. If you are seeking spectacular outcomes, returns in excess of 20% per year, you must make these types of decisions on your own. Don’t work with a fee-based advisor in these instances. Work on your own. The chances of your success are remote, but if you must persist in this unlikely quest for spectacular results, let me repeat, you must go it alone. You will probably fail, but this doesn’t mean you shouldn’t try. Do yourself a favor though, do it while you are young and can recover from spectacular failure. Why do I so strongly believe you will fail? The answer is obvious. Look around. Only a handful of investors ever experienced spectacular success. This brings us to the third type of advisor, or the profit-driven advisor. It is just for fun, because there isn’t a compelling reason for folks to hire these types of advisors unless they are true experts.
Profit-driven advisors make their money based on the profits they generate for you. If they don’t make profits, they can’t stay in business because they won’t make enough money to pay their expenses. Profit-driven advisors are “hedge funds,” and the typical compensation schedule is 2% per year plus 20% of the profits that they make for you. They operate as small businesses. They open an office, hire employees, buy the appropriate software and risk your money based on their judgment. They can have as few as one employee or as many as several hundred depending on the amount of money they manage and the complexity of their methodology. Most people will never deal with a hedge fund because they don’t have enough money to meet their required minimum investment, but these tales are about teaching and you should know about alternative investment relationships.
At first glance, it seems the hedge fund or profit-driven advisors are the perfect investment vehicle. Their compensation is based on performance, so they have an incentive to make your money grow. In addition, because the rewards of extreme compensation are so tantalizing if they rise to the top, many, perhaps the best investors in the world, gravitate toward this type of advisor/client relationship. However, there are also hidden risks. On balance, these type of advisors create more potential for loss than the expertise they might provide. What are these risks and can they be mitigated? The major risk of investing on a performance basis is the tendency to take more risk with your money than perhaps you would want them to take. Why would they take on more risk? Because they make the bulk of their money from the 20% performance fee that they charge on the profits they generate. The more profits, the higher the performance fee. So how can you mitigate these risks if in fact you are fortunate enough to have sufficient wealth to qualify for this type of advisor? The answer is surprisingly simple. Only invest in those funds in which the management of the firm has substantially all of their money invested under the same style as they propose to manage your money. You want them to take risk, but you want them to feel the pain of taking too much risk when things don’t work out. They must have their money where their mouth is or else terrible things can happen. Let me give you an example of what can happen when risk is misaligned.
If profit-driven advisors don’t have their capital at risk, they can simply place an all-or-nothing bet on a game of chance. If they win, they may multiply your investment by many times, but if they lose, you will lose it all. Heads they win 20% of your profits, tails you lose 100% of your investment. If they have their own money at risk, they will avoid making these types of ruinous decisions. We will always see hedge funds go out of business because the managers of these funds did not have a substantial portion of their net worth invested in the funds they were running. Their interest was not in the interest of the client. Never invest in a hedge fund in which the manager doesn’t have the bulk of their money at risk alongside you. You may think this is an extreme example, but I’m not too far off the mark. Once again, the consistent failure of hedge funds is proof. I seriously doubt that any hedge fund would borrow 30 times their capital in order to invest if they had their own money on the line. Nevertheless, this type of highly leveraged disaster will continue to play out.
Show me the money and I’ll predict behavior with great accuracy.