Beware the Broken Business Model

| January 19, 2015
Share |
Retirement Strategies

Last time we discussed the startlingly poor returns achieved by the average investor.  To summarize, DALBAR, Inc. (www.dalbar.com) found the average equity investor underperformed the S&P 500 index by 7.42% per year for the 30 year period from 1984 to 2013.  Remarkably, this was not the first time investors have failed miserably in their quest for stock market wealth.  DALBAR has found similarly poor performance in each of its previous 20 annual Qualitative Analysis of Investor Behavior (QAIB) reports.  They conclude the problem is behavioral.  Investors make poor choices and their improper investment behaviors are corrosive to their success.

Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it. – attributed to Will Rogers, American humorist

Ironically, good investment choices are the goal of every rational investor.  No one seeks failure, yet failure persists.  Decades of data dispute investors recognize they have a problem, let alone pursue strategies that solve their shortcomings.  Good choices and sound investing are illusive.  If taming bad behavior was easy then everyone would make the appropriate course corrections as soon as they stubbed their investing toes enough to learn they were traveling on the wrong road.  What should an investor do to fix their poor behavior patterns?   DALBAR suggests professional help is critical to bridging the gap between purpose and performance.  DALBAR’s QAIB analysis routinely states “the most important role of the financial advisor is to protect clients from the behaviors that erode their investments and savings”

Where are the customer’s yachts?

Fred Schwed, Jr. lifted this query for the title of his 1940 expose on Wall Street in the roaring 20’s from a conversation between a novice investor and his suitor, a broker trying to impress his prospect by showing him the fine watercraft of the top brokers of his day.  The wily novice in the story got it right.  The fundamental role of every financial professional is to enhance their client’s wealth.  Brokers, advisors and agents are believed to be experts in their field, driven to serve their clients best interests through experience and wisdom.  At least, that is what consumers expect.  Unfortunately, the realities of the marketplace tell a different story.

A Broken Business Model

A 2007 study titled Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry by Professors Bergstresser, Chalmers and Tufano found remarkably little evidence traditional brokers and financial advisors benefit their clients.  To quote their study, “In Summary, we find a reasonably clear pattern of results.  We find that the brokered channel sells funds with inferior pre-distribution-fee returns.  The channel does not show any evidence of superior aggregate market timing ability, and shows the same return-chasing behavior as observed among direct-channel funds”  Direct channel funds refer to mutual funds bought directly by investors, rather than using an advisor to help select the “best” funds and manage “improper” behavior. But wait, DALBAR (and the financial industry as a whole) considers one of the fundamental benefits of using a broker is managing and correcting bad client behavior.  Does this mean the answer is a bit more sophisticated?  The study continues, “Finally, more sales are directed to funds whose distribution fees are richer. This work leaves us with the puzzle of why investors continue to purchase funds that appear to be no better at substantially higher costs.”  Now there is an indictment of an entire industry.  The study looked at actual returns of mutual funds sold to investors from 1996 to 2004 and could find no reason why investors should use brokers or advisors to manage their mutual fund purchases.  A similar study in 2006 titled Prudent Man or Agency Problem? On the Performance of Insurance Mutual Funds by Professors Chen, Yao and Yu looked at the performance of mutual funds sold by insurance brokers from 1990 to 2002.  Their findings were equally critical, to quote “We document that insurance funds underperform non-insurance peers by more than one percent in average annual returns.”  They also contend “There is no evidence that insurance funds make less risky investments.”

Both of these studies clearly articulate why clients are so frustrated in their attempts to maximize investment returns.   The problem extends beyond improper investor behavior.  Traditional brokers, advisors and agents are equally culpable.

Earn an additional $25,000 to $100,000 in commissions on every 4th client – Actual marketing pitch mailed to financial advisors encouraging them to attend a “Million Dollar Producer” seminar

Why do so many advisors continue to sell sub-standard funds to their clients?  At the root of the problem is a system of financial reward based on sales commissions and high fees.  Brokers and agents are not required to put their client’s best interest ahead of their own.  Brokers are simply required to offer “suitable investments”, which opens up the potential for incredible conflicts of interest. Clients assume they receive sound investment advice.  Instead, their accounts are drained by a commission structure designed to compensate the indulgent self-interests of their advisor. Ultimately, every dime paid out in high fees and commissions is extracted from the investor’s pocket.

If the advisor does not add value, and our two studies clearly show most do not, then it is little wonder why the average investor underperforms the market.  The lucrative commissions and financial rewards awaiting traditional advisors can quickly drown out common sense, let alone the frustrated cries of clients as they watch their financial future languish against the headwinds of a broken business model.

The dream of Peaceful Wealth cannot be realized in an environment of improper client behavior or an advisor’s commission driven self-interest.  Does fixing both of these impediments to Peaceful Wealth immediately insure fare winds and following seas?  The answer is no.  Next time we will look at the role our investment strategy plays along the course of our journey.

This material is intended for educational purposes only and is not intended to serve as the basis for any investment or purchasing decisions.

Share |