I grew up in the investment business in the early 1990s on the ginormous fixed income trading floor at the then Merrill Lynch in the World Financial Center in New York City. It was a culture of trading and instant gratification. “What have you done for me lately?” covered no more than that day, often less. I frequently argued that we should consider the interests of our customers – among of the biggest investment managers, pension funds and insurance companies in the world – in our dealings so as to build long-term relationships and enhance longer-term profitability even if it meant making a little less in the near-term.
I got nowhere.
We called our accounts “clients” to their faces, and I thought of them that way, but they were customers at best and marks at worst to virtually everyone on the floor, and especially to our managers. We didn’t call them “muppets” like the guys (and it was almost all guys then) came to at Goldman Sachs, but we may as well have. Our mission was clear. We were to make as much money for the firm as we could as quickly as we could. Lunch was a long-range plan. In his first and funniest book, Liar’s Poker, about our counterparts at Salomon Brothers, Michael Lewis got the tone, the approach and the atmosphere precisely right.
That said, I think the idea that the major investment banks have a legal obligation to look out for their institutional clients is absurd. They are truly acting as brokers, not investment advisers. These customers are also professionals and aren’t doing the big banks any favors either. They seek information wherever they think it’s available and aggressively shop around for the best bids and cheapest offers when they have business to do. Therefore, I think the common claim that these banks unfairly took advantage of their customers during the mortgage bubble by, for example, creating lousy bonds to sell to those customers in order to go short and trade against them and are thus somehow liable to them are so much sanctimonious blow-hardary. If institutions, run by professionals who claim expertise and sometimes have it, are hell-bent on buying garbage paper, I see nothing wrong with somebody in the business of making markets providing it to them. There was lots of competition among the banks to get customers to trade with them and those very same customers aggressively tried to drive the best bargains they could, playing the banks against each other routinely. That their judgment was sometimes poor was not necessarily the fault of the banks (the banks’ honesty in such transactions remains at issue). Similarly, I feel little sympathy for want happened to Lehman Brothers – except for some of the personal tragedies – and think “too big to fail” is both ridiculous and dangerous.
Under the current rules, banks owe little to their customers beyond making good on the trades made and honesty in the transaction (which does not require telling a customer he’s nuts to make the trade even if and when he is). If you want to play in the big leagues, you shouldn’t expect your opponent to throw you a BP fastball. Trading is a zero sum game. Not every player gets a trophy, even for participation.
Unfortunately, this pedal-to-the-metal Wall Street aggression has largely carried over into the banks’ dealings with Main Street, where any general claim to equal bargaining positions is rank nonsense. Charles Merrill may have said that Merril needs to act in the best interests of its retail clients (“The interests of our customers must come first,” a statement he appears to have believed), and those words may even appear in advertising (see above), but the company will deny any such obligation in customer arbitrations. When push comes to shove, the big investment banks want to be clear that they are brokers, not fiduciaries, in every transaction with every type of customer (except for the clearly delineated investment advisory clients). They just don’t want their everyday customers to get that. It’s bad for business.
This problem is at the heart of the current controversy over whether retail brokers can and should be held to a fiduciary standard. By law, any fiduciary — a physician, accountant or attorney, for example — is required to act in the best interest of his or her clients and seek to avoid all material conflicts of interest. In our business, investment advisers are required to act as fiduciaries, but stockbrokers and insurance agents — the clear majority of those who offer financial services — generally are not (at least not yet).
In 2010, the Dodd-Frank Act authorized the Securities and Exchange Commission to establish a “no less stringent” fiduciary standard for brokers than the duties that investment advisers must follow. In the meantime, the U.S. Department of Labor is expected to propose new rules this fall that would require that brokers and other securities professionals act solely for the benefit of their clients when advising on individual retirement accounts. As Jason Zweig reported last week, the various parties interested in this issue have been actively lobbying and spinning ever since — mostly as to why they can’t or shouldn’t be fiduciaries.
It is still unclear what the SEC will do while the Labor Department is actively moving to invoke the fiduciary standard with respect to IRAs, much to the chagrin of most of the brokerage business. To be clear, there are some inherent problems with a universal fiduciary standard, some of which Zweig outlines. Moreover, as a practical matter, how can an advisor recommend what is best for a client if and when s/he doesn’t have the necessary product on his shelf? And why should an institutional trading firm be held to this standard? In the institutional investment world, customers can stick it to the banks as readily as the banks can stick it to them yet there is no call for customers to look out for their brokers. However, retail advisors should be expected to look out for the people who entrust their money to them in the same way that other professionals (like doctors and attorneys) are so required. But whatever happens in the regulatory arena, there needs to be a major change in norms and a remarkable change in culture before individual clients can expect to get the full range of help they need.
Seeing those changes through will not be easy.
We all like to think that when a better idea comes along, it takes hold quickly and easily. According to this heroic view, following the scientific method, knowledge marches forward systematically by the addition of new truths to the supply of old truths, or the increasing approximation of theories to the truth, and occasionally, the correction of prior errors. Such progress might accelerate in the hands of a particularly gifted practitioner, but progress itself is guaranteed by the scientific process itself. However, as Thomas Kuhn demonstrated more than half a century ago in The Structure of Scientific Revolutions, knowledge advances in fits and starts; overcoming a dominant paradigm is a very difficult task. Good ideas don’t always win or win quickly.
Indeed, the scientific process implicitly recognizes as much in that it builds-in various systems and checks to try to deal with our cognitive limitations, including general skepticism, open and public disagreement and debate, formal precision, empirical testing, and peer review, often requiring significant levels of effort and ingenuity. In essence, if we are to have any success at reaching some rough approximation and advancement of truth we need to nurture and encourage every opportunity for the falsification of factual claims and norms.
The advent of research and analysis of our inherent cognitive and behavioral biases have provided a basis for understanding why it can be so hard to overcome old ways of thinking even when they are inferior or in error. Precious few of us — even scientists — exercise truly independent thought very often and none of us does so nearly often enough. As no less an authority than Daniel Kahneman acknowledges, making consistently good choices based upon good reasoning is really hard. Training ourselves to do so more intuitively is even harder. The academic research is crystal clear on that point. That’s partly because it takes lots of practice and we’re lazy and partly because it isn’t just a skill to be learned.
Productive critical thinking — and that’s really the goal — requires adequate domain knowledge to go along with lots of practice. But far too many of us (even the professionals) in the investing world have neither. Critical thinking can’t be effectively undertaken in investing or anywhere else if and when there isn’t sufficient knowledge of the subject matter. One’s knowledge base provides the foundation of and context for engaging in the critical thinking needed to falsify a working hypothesis.
To pick a prominent example of effective critical thinking in literature, Holmes deduced that Watson had been in Afghanistan prior to their first meeting in part because he was very practiced and accomplished in the art of observation (critical thinking) but also because he had a broad and deep knowledge of the British military, geography, how injuries heal, and current events. Without that practice and that knowledge, Holmes would have remained entirely in the dark about Watson’s path to their meeting.
I knew you came from Afghanistan. From long habit the train of thoughts ran so swiftly through my mind, that I arrived at the conclusion without being conscious of intermediate steps. There were such steps, however. The train of reasoning ran, “Here is a gentleman of a medical type, but with the air of a military man. Clearly an army doctor, then. He has just come from the tropics, for his face is dark, and that is not the natural tint of his skin, for his wrists are fair. He has undergone hardship and sickness, as his haggard face says clearly. His left arm has been injured. He holds it in a stiff and unnatural manner. Where in the tropics could an English army doctor have seen much hardship and got his arm wounded? Clearly in Afghanistan.” The whole train of thought did not occupy a second. I then remarked that you came from Afghanistan, and you were astonished. (A Study in Scarlet).
With sufficient education and proper training, we have the opportunity freely to exercise critical thinking skills for profit, fun and even for the good of society. As these skills and the knowledge base to use them effectively are in extremely short supply generally, if you have them and exercise them, you will have a tremendous advantage. Sadly, the human condition inhibits our willingness and our ability to do that.
There is a wide body of research on what has come to be known as “motivated reasoning” and – more recognizably for those of us in the investment world – its “flip-side,” confirmation bias. While confirmation bias is our tendency to notice and accept that which fits within our preconceived notions and beliefs, motivated reasoning is the complementary tendency to scrutinize ideas more critically when we disagree with them than when we agree. We are also much more likely to recall supporting rather than opposing evidence. Upton Sinclair offered perhaps its most popular expression: “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”
Since most retail brokers believe that they will make more money with the current model than via the investment adviser model, they have a strong motivation to retain the current approach. A paradigm shift will also result in a higher professional and legal standard of practice, which (at the very least) makes brokers nervous. Moreover, since the current model provides substantially more money upfront, our general human opposition to delayed gratification means that it will be hard to overcome the opposition to a fiduciary standard.
Yet even if a fiduciary standard were revenue neutral for the investment professional, even if the hurdles to implementing it were readily overcome, and even if the arguments in its favor were unassailable, there is very good reason to expect that changing this cultural norm of the investing world would still be difficult. As a starting point, retail advisors need to be much better informed about our industry and about how best to serve their clients than they presently are. The barriers to entry into the investment business in terms of education, competence and knowledge are virtually non-existent. One can pass multiple licensing exams and be free to transact virtually any type of securities business while remaining essentially ignorant about risk management, asset allocation, expected returns, portfolio construction, appropriate diversification and much more. Without an adequate knowledge base, critical thinking doesn’t really help.
But education and training are far from enough. Knowing what’s best doesn’t mean that an advisor will do what’s best. This point was driven home to me recently by a fine article in The New Yorker by Atul Gawande, of whom I was already a big fan and admirer. He talks about it on The Colbert Report below.
Dr. Gawande began his study by examining two seemingly similar historical examples of would-be innovations that caught on quite differently. In 1846, anesthesia was developed so as to elevate surgery from a difficult, frenzied and excruciating procedure into a systematized and thoughtful process where real care could be provided. This innovation “spread like a contagion, travelling through letters, meetings, and periodicals.” Within six months, anesthesia had been used in almost all the capitals of Europe and in most regions of the world shortly thereafter. Within seven years, it was used in virtually every American hospital.
Meanwhile, infection remained surgery’s “great scourge” in that it killed as many as half of those who underwent a major operation. In the 1860s, Scottish surgeon Joseph Lister became convinced that Pasteur’s germ theory of disease offered a means to understand and treat the problem and devised ways to use carbolic acid for cleansing surgeons’ hands and patients’ wounds to destroy germs in the operating field and thus prevent infection. The results were striking but, unlike anesthesia, this antiseptic method was routinely rejected or ignored. As Dr. Gawande points out, “[i]t was a generation before Lister’s recommendations became routine.”
Why do some good ideas “take” and others do not?
In Dr. Gawande’s examples, the difference wasn’t economics as “the incentives for both ran in the right direction.” Both painless surgery and much lower death rates by managing infection ought to attract more patients. Generally, new ideas that run counter to established beliefs and practices are not necessarily embraced quickly or fully (as I have discussed in a different 19th Century medical context here). But each of Dr. Gawande’s test cases espoused thinking that was quite different from convention. Both also required some technical complexity.
There were two key differences, however. “First, one combatted a visible and immediate problem (pain); the other combatted an invisible problem (germs) whose effects wouldn’t be manifest until well after the operation. Second, although both made life better for patients, only one made life better for doctors. Anesthesia changed surgery from a brutal, time-pressured assault on a shrieking patient to a quiet, considered procedure. Listerism, by contrast, required the operator to work in a shower of carbolic acid. Even low dilutions burned the surgeons’ hands.” Thus important but underutilized solutions “attack problems that are big but, to most people, invisible; and making them work can be tedious, if not outright painful. The global destruction wrought by a warming climate, the health damage from our over-sugared modern diet, the economic and social disaster of our trillion dollars in unpaid student debt—these things worsen imperceptibly every day. Meanwhile, the carbolic-acid remedies to them, all requiring individual sacrifice of one kind or another, struggle to get anywhere.”
The fiduciary standard debate is much more like the infection fight than the change in the way surgery was done. Because investing is so hard and so uncertain, it will not always be easy to see the added benefits to clients of a new norm. More importantly, going that route will make life more difficult for brokers. Finding what’s best for a client is much harder and takes much more work than finding an investment that’s merely suitable. Simply making a sale and moving on will no longer work.
Dr. Gawande then goes on to consider the global problems of death in and around childbirth and the treatment of cholera. Simple, lifesaving solutions for each have been known for decades, but they just haven’t spread all that well. The problem in those cases is similar to that seen with respect to the use of antiseptics – doing things right “demands painstaking effort without immediate reward.”
The most commonly attempted remedy is instructional. Please do X. That works, but only up to a point. The other common approach is legalistic – You must do X – or its gentler cousin – If you do X we will offer you Y. But the first of these law-and-order approaches is often ignored when the punishments are light or unenforced and causes people to quit when the punishments are more stringent. And incentives are often a practical and administrative headache. More importantly, they do not change the culture such that the right thing gets done effectively and consistently over the long haul. Without that, good practice may not outlast the incentive.
The best method for changing the culture seems to be the use of mentors. People working with people on a one-on-one basis offer the best results, even if we tend to disfavor them. Making this approach work is particularly difficult because the process cannot be rushed. “High touch” works; “low touch” does not. “In the era of the iPhone, Facebook, and Twitter, we’ve become enamored of ideas that spread as effortlessly as ether. We want frictionless, ‘turnkey’ solutions to the major difficulties of the world, like hunger, disease, poverty. We prefer instructional videos to teachers, drones to troops, incentives to institutions. People and institutions can feel messy and anachronistic. They introduce, as the engineers put it, uncontrolled variability. …[P]eople follow the lead of other people they know and trust when they decide whether to take [a new idea] up. Every change requires effort, and the decision to make that effort is a social process.” As Dr. Gawande succinctly puts it, “People talking to people is still how the world’s standards change.”
Significantly, the changes in surgical practice only fully took hold following a change in the dominant narrative. In the prevailing story, “surgeons had seen themselves as warriors doing hemorrhagic battle with little more than their bare hands. A few pioneering Germans, however, seized on the idea of the surgeon as scientist. They traded in their black coats for pristine laboratory whites, refashioned their operating rooms to achieve the exacting sterility of a bacteriological lab, and embraced anatomic precision over speed.”
The parallel to the dominant Wall Street narrative is obvious. Wall Street and testosterone are as connected in the culture as a burger and fries. The institutional buy-side has largely made the transition from favoring brains to balls, but the sell-side has not. And the retail sell-side follows suit. That’s the culture. Retail reps often want to be big swinging dicks too.
For the fiduciary standard truly to be effective, that culture needs to change. Client success will need to be the measure of advisor success rather than sales made and commissions earned. Client retention will need to matter more than moving an “axe.” And if the culture is going to change, real leadership will need to be exercised by industry heavyweights and, even more importantly, by those with influence at their firms spreading the word by high-touch, careful mentoring. It won’t happen overnight. But if we want to turn financial services customers into clients and for their investment practices to improve the way they should, it’s got to happen.