A Competitive Tale
“GENTLMEN, START YOUR ENGINES”
In every new client relationship, the conversation always turns to compensation. Periodically I am asked why I don’t charge clients based on the profits that we generate. When they ask me this question, I always ask them to choose between two colors. I ask them which is their favorite, black or red. When they look at me quizzically, I explain that I am going to take their money and go to Atlantic City to play roulette with their money. I will even follow their advice and bet on their favorite color. If they are right, we will instantly double their money, and if we are wrong then it’s all gone.
This is an extreme example of the problem with compensating an advisor based on the profits generated. Tell me how you compensate an advisor or anyone, and I will tell you how he/she will behave. In this extreme roulette example, the advisor has an incentive to gamble with your money. I don’t think anyone wants that. The tale that follows is about another, although much more subtle, form of gambling with your money. It deals with a situation an advisor I knew was in a few years ago and teaches us once again that selecting the right advisor isn’t very easy. For the sake of simplicity, let’s call him Jim.
In mid-2000, Sue inherited a lump sum of money. Like all new and inexperienced recipients of unearned wealth, Sue and her husband Harry faced the daunting task of what to do with the money. Neither Harry nor Sue had experience with investments, and they went to see Jim, one of their very best friends. Here’s what they told him. They told him they had a little bit over $500,000 to invest and they were going to give five advisors $100,000 each, and then based on how well the advisors performed based solely on rate of return over the next year, they would determine which advisor to use as their ultimate advisor. This was upsetting to Jim in that they were pretty good friends, and at first he was offended, but quickly realized that amongst friends there is a bit of “familiarity breeds contempt” at work and that they really had no way of knowing if they were a good fit since they were in fact novices. What Jim didn’t know is that they had actually inherited over $1.5 million. Even the best of friends exhibit unusual behavior when it comes to money. Every advisor knows that potential clients have a tendency to keep things from them initially.
Jim tried very hard to convince them this was not a good way to go about selecting an advisor. He might have had more luck talking to himself. They insisted this was a competition and the five advisors needed to view the next year as such. They were off to the races, and thus the subtitle of this tale is Gentlemen, Start Your Engines. Five advisors with $100,000 each and with a clear direction in mind—whoever made them the most money, would win the competition.
Because Jim is competitive by nature and a decent poker player, he chose a portfolio allocation that gave him the best opportunity to win. He correctly assumed the other four competitors would manage the portfolio as aggressively as possible, so Jim went the other way. He went the more conservative route. He decided to manage their money over the next year based on a 50/50 allocation. He would invest 50% of their money in stocks and 50% in bonds or fixed income. Before I go any further with this tale, I apologize to those purist advisors that would not have played the game. These were Jim’s friends, and he needed to help them. His strategy in this case was to hope for a bear market since the other four competitors were probably hoping for a bull market. If the market went down over the next year, he would be the winner. In his analysis, there were five of them, so randomly he had a 20% chance of winning if he chose the bullish route since luck would play a major role over such a short time period. By choosing the approach he did, he felt the odds increased to above 20% and could be as high as 50% if all four competitors did in fact go the aggressive route.
What happened a year later? A year later, Jim learned the truth about their total portfolio, and Harry and Sue moved the money they had set aside to give to the eventual winner as well as the other four portfolios over to his management. What were the specifics? What did the other competitors do with the money?
· Jim’s approach—He had lost them a little less than 4% over the year. This was a very bad period for almost every style of equity manager, with a few exceptions. Fortunately, the 50% allocation he had in bonds had performed well, he had one profitable rebalancing during the year and since Jim knew that bad things can happen in the market, he owned some low volatility equity styles that performed better than others during the year.
· Competitor 2—He was from a national full-service brokerage firm and decided that Internet stocks had dropped enough and they represented a great bounce-back opportunity. Because he also knew he was in a race, he decided to plunk it all down in an Internet-oriented mutual fund. When Harry and Sue transferred the account, it had a little less than $15,000. This was a whopping 85% loss. It’s interesting to note that the last few months of transactions for this particular account and the commission-compensated advisor behaved exactly as expected. When the competitor recognized that he was down with a few months left to go in the competition, he started focusing the client’s portfolio into riskier and riskier stock selections in the hope of making it all back with one lucky trade. This rapid trading generated more commissions, thus more income and gave him hope. Anyone that has ever traded has either witnessed or exhibited this type of “get it back with one trade” type of behavior. It’s a sure sign of desperation. Don’t do it.
· Competitor 3—He was Harry and Sue’s accountant. Many CPAs and accountants freelance as financial advisors. Some work on a fee basis and some are compensated on a commission basis. Either way, no good can come from using your CPA as your investment manager. Don’t do it. They are essentially running two businesses and they can’t focus. This competitor was essentially a commission-compensated advisor posing as a trusted professional. He was using his professional trust as an accountant to cross-sell financial advice. He invested their money in three front-end-loaded equity mutual funds. These funds were well known and still worth about $75,000 when the account transferred over. I guess he assumed that at least he would earn a commission on the transaction even if he did lose the race.
· Competitor 4—She was a neighbor of Harry and Sue’s who had decided to quit her engineering job and trade stocks, commodities, futures and options from home since she had been so successful trading in her spare time. One year later, the bull market in stocks had burst, the neighbor was back at work, the account had been dormant for four months and the account transferred over worth a little over $50,000. Their neighbor, as many do during the end of bull markets, had mistaken a bull market for ability.
· Competitor 5—This commission-compensated advisor was also from a well-known brokerage firm and decided he would turn their money over to a well-known money manager in one of their expensive wrap programs or individually managed programs that are so well advertised. He went with an aggressive growth manager that proceeded to invest the portfolio down to under $70,000 when it transferred over.
Jim was very glad to win the competition but also saddened by how it all transpired. He had increased his odds of winning the competition by utilizing game and behavioral theory to determine what the best course of action would be based on an expectation of how his competitors would structure the portfolio, as well as his understanding of how markets worked over a year. A year is a short timeframe with respect to the stock market. If you examine stock market returns over the course of a calendar year, you can see profits as high as 50% or losses as much as 35%. This simply means that a one-year random dart thrown at the stock market and held for a year can give you significantly varied results. Once again, Jim reasoned that if he built an aggressive portfolio, he would only have a 1 in 5 chance of winning the competition. But, if he took the conservative route, he would increase his odds from 5 to 1 to as high as 2 to 1 since the successful prediction of a bear or bull market over a short period like a year is mere chance. Jim was lucky, and so were Harry and Sue. Jim had a new client and, most importantly, they weren’t giving their money over to a bunch of dummies.
As I said at the beginning of this tale, the competition Harry and Sue established was a subtle form of gambling. They were unaware they had devised a selection criteria that encouraged disproportionate risk-taking instead of a more appropriate level of risk-taking that was in concert with their objectives. They see it now, but they didn’t see it then. They were lucky they started the competition when they did. Let me explain. In my opinion, timing matters, and I offer the following as proof.
What would have happened if they inherited the money in 1999 instead of mid-2000? What would have happened if each competitor behaved the same? Competitor 2 would probably have performed the best and been chosen as their ultimate advisor based on what would have been perhaps a triple-digit rate of return in 1999. However, when they turned the bulk of their money over to him in 2000, they would have lost almost all of it within a year. The key is that past performance, although somewhat of a predictor, is not always indicative of future performance, and unfortunately cannot be the sole criteria for selecting an advisor. I wish it were so simple but it isn’t. The fallacy of past performance as a selection criterion is especially true over short time frames such as one year.
Timing matters. Investment experts know that any of the strategies chosen by the competitors could have been the winner if the competition started at the right time. This is a significant piece of information, with profound implications. It is the reason that you can hire a conflicted, non-expert advisor and if you catch them during a bull market and they are bullish, they appear superhuman. They were lucky and may have had you in harm’s way, but it doesn’t matter. They have gained your confidence and you are theirs for life. It is the reason why financial advertising is so prevalent. They really have no idea if the strategy they are about to set sail with will work. They simply know if they get enough new investors coming through the door and they keep their strategy constant, it will eventually work. The people it works for will stay. For the ones it doesn’t, they will seek greener pastures. It is the investment business, and you must recognize it for what it is. It is why so many advisors can appear to be experts and why you must know better.
Harry and Sue were very lucky to have started their advisor experiment in 2000 instead of 1999. Throughout my career, I have learned that luck plays a bigger part in people’s success than I would have believed early in my career. I believe the harder you work, the luckier you get, but luck is certainly a factor. This tale is just one more illustration of how timing plays an important role in a person’s ultimate financial success. I know many consider this financial blasphemy, but I have observed it to be true and am happy to report that there is increasing academic evidence that agrees with my observations. It is the reason why I try to design low volatility, highly predictable outcome portfolios for clients looking to preserve wealth and advise the exact opposite for wealth builders. Volatility is a double-edged sword. It can and should be your best friend while building wealth and it might be your worst enemy once you are wealthy if you don’t respect it.