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Mar 31, 2016

Misaligned Incentives

Samantha McLemore

Reading Bill Miller’s post about the permanent changes in investor behavior post 2008 reminded me of a situation I encountered last year.

When my grandmother passed away, she left me with a nice little portfolio. My grandparents set up accounts for my sisters and me when we were born and she was the main driver of the investment decisions – stock picking was her hobby.

I let the portfolio sit for a few years to recover from 2008, but a little over a year ago started working with the Financial Advisor to move some things around. He inherited my account from the original FA who left the firm, so we had to go through a “get to know you” stage. We discussed a lot of things – from families and hobbies to my risk tolerance (higher than average), objectives (capital appreciation), time frame (long term), etc – all topics one would expect to cover. I felt great coming out of the meeting; I was comfortable with his approach and style. A couple weeks later, he came back with a recommendation.

Well, what a disappointment. The strategy he recommended was conservative – bond heavy, focused on income and any equity funds he suggested were blue chip, large cap investments. Ugh! Not what I expected at all!

I called the FA and asked him about his recommendation pointing out that I didn’t think it aligned with what we discussed in our initial meeting. He made a case for protecting my investment during periods of higher market volatility, and how a traditional asset allocation strategy would work well to achieve my long term objectives (yada yada). He agreed to make small changes to incorporate more equities, but essentially he still wanted to “play it safe”. I acquiesced halfheartedly to his recommendation (victim of my own belief perseverance).

In the book Freakonomics, the authors delve into the world of residential real estate questioning a realtor’s incentive to sell a client’s house for the best possible price. Analyzing data pulled from home sales in Chicago revealed that when a realtor sells his/her own house, it’s on the market an average 10 days longer and sells for 3%+ more. Whereas the incremental income a realtor receives when selling a client’s house doesn’t outweigh the additional work of going for a higher number. The incentives aren’t aligned.

Is this happening with Financial Advisors? Are the wounds left from 2008 incenting FAs to create safer portfolios to avoid client backlash when the market is volatile, or worse tanks? Maybe his recommendation was subject to underlying hyperbolic discounting. To be fair, the guy is human. And, as we well know, humans exhibit behavioral biases. If his income depended on an aggregate stable portfolio, then why have my strategy rock the boat. Clearly, my long-term objective wasn’t aligned with the FA’s incentive to keep me happy (and as a client) during short-term periods of volatility.

My purpose here isn’t to make a blanket statement about the practices of all Financial Advisors. There aren’t facts and figures supporting my thesis – just observations based on personal experience. During a particularly turbulent period this January, my primary Financial Advisor (different guy) sent me a short note reminding me to not freak out; we’re in it for the long haul and shouldn’t make any rash decisions with the portfolio right now. I replied “Duh.”

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee dividends will be paid or continued.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.

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