When you go to a fast food restaurant you know pretty much what you are going to get, even if you are going to Manhattan’s first Chick-fil-A restaurant. You know from the get-go you are not going to a 3-star Michelin restaurant like Jean-Georges. They are two very different experiences with different expectations.
The same can be said for financial advice, e.g. investment management. Tom Brakke at the research puzzle in a smart post points out how investors almost always get advice based on the business model of the manager. Brakke writes:
More generally, it’s easy to lose sight of how investment advice is shaped by the business model of the person and/or organization providing it — and to misjudge the impact that it can have in practice…The path of least resistance will always be in the direction of the business model. To deliver (or receive) true value, you need to know when it is best to go another way.
This is clearly the case with financial advisors who are compensated based on commissions. In that business model there are any number of “potential conflicts of interest” that investors should be aware of. Dan Ariely writing at WSJ answered this very question for a reader recently:
Can financial advisers, brokers and others in the financial industry truly follow their fiduciary responsibilities when they are paid on commission? -Helene
If you’re asking whether they can act in their customers’ best interests and give objective advice, the answer is no. Even more depressing, it seems humanly impossible to be paid more for some outcomes than others—to get more money if the client invests in stock A rather than stock B—and avoid bias.
I’m not saying that financial advisers do this intentionally. We all do it when our interests motivate us to see the world in a particular way: We use our tremendous brainpower to convince ourselves that what is good for us is also objectively good.
That’s why we must eliminate (or at least reduce) conflicts of interests in the markets—and why you should always try to figure out whether your service providers have conflicts of interests. Luckily, in the U.S., we understand these pitfalls and don’t allow our politicians to be corrupted by special interests or money.
While there is some good news in that the fiduciary standard is likely to be expanded to include all retirement accounts, there are still plenty of opportunities for conflicts of interest. The only defense against which is awareness and education. Jason Zweig writing at WSJ notes:
A broker or adviser who serves as a fiduciary over your retirement assets doesn’t necessarily have to act in your best interest when managing your other assets; make sure you ask. A fee-only adviser isn’t always the cheapest or best option, depending on your needs. Everyone giving investment advice has some conflicts of interest, no matter how he charges. And no amount of regulation can exempt you from the responsibility of being a skeptical and attentive investor.
Business models matter. If you don’t know the model on which your advisor is working, find out….fast.