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The commission trap

Link Joshua VanDyke1 Comment

So you’re an investor, and you’ve got seemingly unlimited options for your money. Some seem awesome, some look a little suspect, and for the most part, you’re not really sure what’s going to work and what to stay away from. Typically, you’d talk to some type of financial advisor. Or you’d succumb to your own hubris and decide to get online and do this whole investing thing yourself until it becomes clear that you’ve made a huge mistake, then you’d talk to some sort of financial advisor. But now instead of trying to figure out how and where to invest money, you’re trying to figure out how to pick a trustworthy advisor who can help you with the investing part. Well, I’ve got one piece of advice: watch out for the commission trap.

There are several different ways that financial professionals are paid, the two most common are through fees and through commissions. Some advisors only charge one way or the other, some do both.

A fee-based advisor means that if you’ve got money invested, the advisor collects a fee (usually a small percentage) from your investments every year. It’s a pretty simple, pretty common model, and it makes sense because the advisor is invested in your success. It definitely doesn’t mean that the advisor is trustworthy, but you can at least take comfort in the fact that it’s a sensical payment model.
On the other side is the commission trap. There are a few bad things about commissions:

  • It means you’re buying a financial product. Advisors who collect commissions only get paid when a client buys something. Financial products, while veiled as beneficial to the customer, are generally not the best option. They prey on people’s desire for security and charge a hefty premium for it (annuity). What a financial product offers can almost always be had for a fraction of the cost with a much higher ceiling for growth by simply investing in the market. Not every product is always bad, but you definitely shouldn’t be buying lots of financial products.
  • It means the advisor is collecting a large commission. These products, specifically annuities, will pay out massive sums to advisors who can peddle them. Commissions between 5% and 10%, and sometimes even more, are common. That means if you take your $500,000 investment account and buy an annuity, the advisor could be collecting between $25,000 and $50,000. That’s a lot, suspiciously a lot. Brokers will pay advisors these kinds of fees is because the product is extremely lucrative for brokers, which means it’s probably not super beneficial for customers. 
  • It means there’s a conflict of interest for the advisor. They’re stuck with the tough decision (or maybe not so tough) of educating and caring for their client and promoting their best interests or putting food on their own table for their own kids, or taking a super nice vacation, or whatever else you could get excited about buying for $50,000. Unfortunately, the advisor’s interest will likely lean toward the $50k. Better not to put yourself, or the advisor, in a conflicting situation like that. 
  • It means that you’re probably not getting coached. Advisors who sell products aren’t evil (mostly), but they have to function more like salespeople than advisors or coaches in order to survive. Best case, the salespeople are catering to clients, giving them what they want without trying to rip them off. Worst case, the salespeople are manipulating or aggressively pushing bad products to people. Either way, coaching doesn’t enter the equation. There is no correlation between a customer’s desire for or the suitability of a product and the long term success of a client. So instead of coaching and educating clients, financial salespeople end up helping clients orchestrate their own financial purgatory, never making progress towards their goals. 

So keep an eye out for the commission trap when you’re evaluating an advisor.

The Investor Behavior Question

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So we looked at the problems with stock picking, market timing and track-record investing. The evidence strongly suggests we should avoid these investing pitfalls. So why do people still engage with them? Many people aren’t familiar with the research, which is an indictment on the investing industry, but the problem goes deeper than that. Even people who understand the research, even people who understand and assent to the research, still don’t consistently comply. Why is this? The industry calls it investor behavior, and it’s big business. I hear a lot about bad investor behavior, but I don’t hear much about why investor behavior is bad, or how to think helpfully about it. Here are a few reasons why I think it’s tough to be a good investor today:

1) The practice of buying low and selling high is ingrained in us. We’re deal shoppers. We see a good deal, something that’s worth more than its sale price, and we can feel great about the purchase. We’ve got TV shows that show us how to buy cheap houses and storage units in order to flip them for a profit. The booming fantasy football business teaches us to perform hours of research before drafting players (no? only me?) in order to find the underpriced guys who will overperform. We’ve got side hustles flipping cars, furniture, clothes, electronics, you name it. We’ve got sale adds spilling out of our mailboxes. That’s just how our world works, we shop for deals, things that are underpriced. Another way to say it, we’re always on the lookout for inefficiencies. But the stock market in not inefficient (see Are you stock picking?). It’s the one place we shop where there are no sales or discounts. It makes sense that we would apply our standard buying principles to investing, but unfortunately, our instincts aren’t helpful here.

2) Active investing feels right. Trading in a portfolio is exciting, especially if you think you’re good at it. A big win in the stock market makes for a really nice adrenaline hit. It’s similar to gambling. You can do it from your favorite chair in your living room, or a bustling coffee shop; it feels meaningful; it provides a perfect excuse to be constantly checking the news; you get to use your favorite tech gadgets (that’s what gets me). And even if you’re not the one making the trades, it just seems responsible to watch the news and track your returns every day. It seems right to talk predictively about the market, to decide on an investing strategy for the upcoming year. We’re not lazy people, we do our due diligence; unfortunately, with investing, we diligently do the wrong things.

3) We’re inundated with encouragement to engage in active investing. Financial news networks and websites were not created to educate their viewership, they exist to drive traffic. Since patience, diversification, minimal trading, (aka the staples of a good investment strategy) are really boring, news outlets lean heavily towards the predictive and active trading slant. Specific stock recommendations and bold market predictions fuel our instinct to do something with our investments. Again, it feels right to try to figure out where the market is going and how to profit from it. The news only tickles that itch.

Investing is counterintuitive and human behavior is often the trickiest part in investing. Sometimes we simply lack the knowledge required to be a good investor, but more often it feels like we should be doing more. When something needs fixing, we put our heads down and figure out how to fix it. Before we decide to buy something we do our research. But the way we make buying decisions in our every-day lives doesn’t work in the stock market. While we constantly look for inefficiencies, sales, discounts, deals, etc., the stock market is efficiently moving along on its unpredictable upwards trend. Instead of working to beat it, let’s ride it.

3 Questions to Ask your Financial Advisor

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Your investment advisor is a very important person. You rely on this person to help you navigate your lifelong financial journey, and hopefully guide you to a successful outcome. There are obvious characteristics we want in an advisor: integrity, honesty, diligence, etc., all good things. But there are other, almost equally important things most of take for granted in an advisor: What’s their investment strategy? What’s their view on the market? How do they expect to help you capture returns? These are questions we don’t tend to ask, after all, they’re the professionals, but the answers to these questions will have a profound impact on your future.

  1. Do you think the market is efficient or not?

This is a simple question with massive implications. Basically, you’re asking whether or not your advisor thinks he/she can consistently get you better returns than the market by actively buying and selling stocks (stock picking), moving in and out of different market sectors (market timing), and using funds with the best recent return history (track-record investing). If the market is not efficient then these are valid exercises. An inefficient market means that stock prices could be underpriced or overpriced and assumes that smart advisors should be able to figure out which stocks are which and pick the ones that will outperform all of the others. Unfortunately, advisors don’t consistently beat the market, they can’t consistently pick the winners. The results of choosing stocks and timing the market have been overwhelmingly negative and research has resoundingly supported the assertion that the market is actually efficient (Efficient Market Hypothesis). An efficient market means a stock is never overpriced or underpriced, its current price is always the best indication of its current value. If the market is efficient, that means it’s impossible for anyone to consistently predict or beat it, in fact, attempts to do so are more like gambling than investing. Instead of trying to outperform the market, the goal should be to own the whole of it as efficiently as possible. This brings us to the next question.

2. What Asset Classes Do I Own?

In order to efficiently own the market, you need broad diversification. That means you want to own many companies, but more importantly, you want to own many companies in many different asset classes (large companies, small companies, value companies, international companies, etc.). When you ask, most advisors are going to tell you that the large majority of your money is in Large US Growth companies (S&P 500), which is unfortunate because the Large US Growth company asset class is one of the lowest returning asset classes in history. That’s not to say the asset class is a bad investment, it’s great for diversification, but it’s certainly not where you want most of your money. Small and Value asset classes return better over time, so you want to ensure you’re broadly and significantly invested in those asset classes.

3. How will you help me capture returns?

There are three important components to successfully capturing returns: 1) diversify, 2) rebalance, 3) remain disciplined. Diversification (1) means you’ll have ownership in companies of all different shapes and sizes all over the world. Good diversification does two things for an investor: it reduces risk/volatility and increases return. Since we don’t know which sectors or stocks will do best this year, we own all of them, and then we rebalance, which brings us to point 2. The goal in rebalancing (2) is to keep an ideal percentage of each of the different asset classes in your portfolio. Since stocks and asset classes don’t all move the same way every year when one asset class is up and another is down your portfolio percentages get out of whack. That’s where rebalancing comes in. In order to rebalance your portfolio, your advisor will sell some of the asset class that went up and buy some of the asset class that went down, bringing the percentages back into alignment. This must happen systematically, for example, it could be every quarter, in order for it to be effective. The end result is that you’re automatically selling high and buying low. There’s no gut instinct, no guessing, no market timing, it’s committed disciplined rebalancing, which brings us to point 3. Discipline (3) isn’t something that comes naturally to most of us, but it’s extremely important in capturing returns and planning for your future. There’s a behavior element that all of this hinges on, if an investor doesn’t have the discipline to ride out the ups and downs in the market they can’t be a successful investor. The average investor switches advisors and funds and strategies every 3.5 years, that’s a losing game. So how will your investor help you stay disciplined and on track to capture those returns and achieve your goals?

Since I’m writing this and I’m an advisor, you probably assume I’ve got answers to these questions, your assumption is correct. But this isn’t just a sales pitch, good answers to these questions are critical for successful investing, and far too many people simply have no idea what their advisor is doing for them, whether good or bad. So ask a few questions!

How To Fix Your Finances

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If you’re super stressed about your money situation, which, according to CNBC is pretty common, you’ve got two options:

Option 1: tighten your budget and stick to it at all costs. This option is not a lot of fun, but it’s still very important. The basic principle of personal finances is to live within your means. This means that if you don’t have money for something, you don’t purchase it, instead, you save some money over time until you can afford it. It’s common sense, but it’s not commonly practiced. SNL is an authority on the topic: Don’t Buy Stuff You Cannot Afford. Though this definitely isn’t the fun option, it might be the more important option. Sticking to a good budget and living within your means teaches you to think differently about money. If you’re a subscriber to the ‘I want it and my credit card isn’t maxed out yet’ line of thinking, this budget thing won’t be easy, but it will change your life.

Option 2: make more money. This is much more fun. Instead of holding back, you’re increasing. You can be creative, start a side-hustle, work towards a promotion. The options aren’t exactly endless, but they’re pretty broad. Do something that is exciting, something that you love, or something with a loved one! The only rule is that your idea has to make some money (and also stay within the bounds of federal law).

Here’s the twist, you don’t have to pick just one option. Ideally, you’ll work on both simultaneously. If you only tightened the budget, you would confine yourself to a workable, but boring financial existence. If you only earned more money, you would spend it as soon as you earn it since you would never have learned the discipline and benefits of saving. Neither option, by itself, is likely to get you where you’re hoping to go. But together, these two strategies can create a real and lasting fix to your finances.

Be Wary of Investing Apps

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Investing today is easier than it’s ever been. One hundred years ago investing options were limited, there were no mutual funds, no ETFs, it was basically banks and single stocks. And even those few options were expensive and difficult to obtain. For most people, investing wasn’t a viable option. Today we’re drowning in all the investment options. It’s become so easy, so normal, you can download an app and own thousands of equities within minutes. The ease is good, and it’s good that more people are able to own equities (equities are the best passive wealth building tool in history) but there are also good and bad ways to own equities, and the ease seems to more often promote the bad ways.

Active investing is essentially gambling, even for professionals. We know the stock market moves relative to news and emotion, neither of which is consistently predictable. We also know that the current price of a stock is the best indication of its current value, stocks aren’t ever ‘on sale’ or ‘overpriced.’ So when an active investor buys or sells a stock share it’s just a bet, a bet that a specific company will either increase in value (in which case you’d buy) or decrease in value (in which case you’d sell). Successfully buying and selling stocks is tough, and no one can consistently do it well enough to beat the market over time, not even professionals. Research shows that the outcome of this active investing style is overwhelmingly negative. That’s part of the reason why we’ve seen a seismic shift toward more passive investment strategies over the last 20 years.

However, we’ve also seen the growth of in-app investing. I’m all for cool apps, and investing apps are among the coolest, but there’s an inherent problem in using an app as an envoy for your retirement. The fact that they are so easy to use is a temptation to actively use them. The fact that they look so nice gives the illusion that we’re doing something responsible with our money. Some offer worthless, even contradictory, commentary on market predictions. Some even promote super risky options (puts and calls) accompanied by incomplete (at best) information concerning the risk involved, and even how they work. Essentially, these apps promote a sort of sophisticated gambling, which is really fun, and really bad for your return probabilities. Apps that have claimed to stand for passive investing seem to be slowly moving toward an active style as well or at least offering it.

It’s probably best to treat investing apps like gambling apps since that’s effectively what they are. Don’t be duped by the bells and whistles, they offer an adrenaline rush and a lot of downsides. Most of us wouldn’t take our retirement fund over to the roulette table and put it all on red (talk about a rush!), so don’t dump your life savings into an app.