In every new client relationship the conversation always turns to how will the advisor be compensated? Periodically I am asked why I or others 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 and I will 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 they generate. Tell me how an advisor is compensated and I will tell you how they will behave. In this extreme case the advisor has an incentive to gamble with your money. I don’t think anyone wants that. The tale that follows is about another though 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 assume the advisor was me.
This is a case where in mid 2000, the wife of one of my friends inherited a lump sum of money and was facing the daunting task of what to do with the money. Neither my friend nor his wife had experience with investments and they came to see me. Here’s what they told me. They told me that they had a little bit over $500,000 to invest and that they were going to give 5 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 me in that they were pretty good friends and at first I was offended but I 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 we were a good fit since they were in fact novices. What I didn’t know is that they had actually inherited over $1.5 million dollars. 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.
I tried very hard to convince them that this was not the best way to go about selecting an advisor but they insisted that this was a competition and that the 5 advisors needed to view the next year as such. We were off to the races and thus the subtitle of this tale is Gentlemen, Start Your Engines—5 advisors each with $100,000 and with a clear direction in mind. Whoever made them the most money would win the competition. Since I am competitive by nature and a pretty good poker player I chose a portfolio allocation that gave me the best opportunity to win. I assumed the other 4 competitors would mange the portfolio as aggressively as possible so I went the other way. I went the conservative route. I decided to manage their money over the next year based on a 50% stocks, 50% bonds diversified portfolio. Before I go any further with this tale I apologize to those purist advisors that would have chosen to not participate, these were my friends and I needed to help them. My strategy in this case was to hope for a bear market since the other 4 competitors where probably hoping for a bull market. If the market went down over the next year, I would be the winner. In my analysis, there were 5 of us so randomly I had a 20% chance of winning. By choosing the approach I did, I felt that my odds increased to above 20% and could be as high as 50% if all 4 did in fact go the aggressive route.
What happened a year later? A year later I learned the truth about their total portfolio and they moved the money they had set aside to give to the eventual winner as well as the other 4 portfolios over to my management. What were the specifics? What did the other competitors do with the money?
My Approach—I 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 I had in bonds had performed well, I had 1 profitable rebalancing during the year and since I know that bad things can happen in the market I did own some equity styles that performed well during the year.
Competitor 2—He was from a national full service brokerage firm, what I call a SAD, and decided that internet stocks had dropped enough and that they represented value. Since he also knew he was in a race he decided to plunk it all down in an internet oriented mutual fund. When we transferred the account it had a little less than $15,000. This was a whooping 85% loss. It’s interesting to note that I examined the past few months of transactions for this particular account and the SAD behaved exactly as he should have. Once he 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. 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.
Competitor 3—He was their accountant. Many CPAs and accountants freelance as financial advisors. This competitor was a SAD posing as a trusted professional. He was using his professional trust as an accountant to cross sell financial advice. He invested their money in 3 front-end loaded equity mutual funds. These were well known funds that were 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 that 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, it hadn’t been traded in over 4 months and the account transferred over worth a little over $50,000. This lady like so many during that time period had mistaken a bull market for skill.
Competitor 5—This SAD 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. Since past performance indicated that technology was were it was at in terms of future performance he went with an aggressive growth manager that proceeded to invest the portfolio down to under $70,000 when it transferred over.
I was very glad to win the competition but also saddened by how it all transpired. I had increased my odds of winning the competition by utilizing behavioral theory to determine what would be the best course of action based on an expectation of how my competitors would structure the portfolio as well as my understanding of how markets worked over short periods of time such as a year. Once again, I reasoned that if I built an aggressive portfolio I would only have a 1 in 5 chance of winning the competition. But if I took the conservative route I would increase my 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. I was lucky and so where my friends.
As I said at the beginning of this tale, the competition that my friends 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. My friends were lucky in my opinion and I offer the following as proof.
What if they had inherited this money in 1999 and each broker would have acted the same way in 1999 as they did in 2000. Competitor 2 would have had the best performance and he would have been chosen as their ultimate advisor based on what would have been perhaps triple digit performance in 1999. However, when they turned the bulk of the money over to him in 2000 they would have lost almost all of it within a year. The key is that past performance is not 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 selection criteria is especially true over short periods of time such as one year.
My friends were very lucky to have started their advisor experiment in 2000 instead of 1999. Throughout my dealings with people I have learned that luck plays a bigger part in their success than I would have believed early in my career. It’s not the most critical element since I believe that the harder you work the luckier you get but that it plays a role nevertheless. This tale is just one more illustration of just how important luck or in this case timing plays in a person’s ultimate financial success. I know that many consider this financial blasphemy but I have observed it to be true and I am happy to report that there is increasing academic evidence that agrees with my observations.
Please note once again, this tale was told to me by another advisor. I have just put it in the first person because after all—these are tales that are meant to educate.