We’ll begin this post with an economics lesson, illustrated by an example from Major League Baseball. The following is an excerpt from a post on ESPN.com, “Desperate GMs Can Cripple a Franchise,” updated on January 13, 2007. The author is Keith Law of Scouts, Inc., a frequent commentator on ESPN.com. Here’s the quote:

“Economists have a name for this problem: moral hazard. It refers to any situation where an agent (in this case, a GM) can take a risky action where he will not have to face the full consequences if the action turns out badly. A GM who hands a player a seven-year deal knows that if the deal works out, he’ll probably keep his job (and even earn a raise), but if the deal doesn’t work out, he might lose his job. But he’ll still earn the money he was guaranteed under his contract, and he won’t have to deal with the albatross contract, or the restrictions it places on payroll.” (Desperate GMs Can Cripple a Franchise, Keith Law, ESPN.com, January 13, 2007).

You’re probably wondering what this has to do with investing or, more importantly, what it has to do with your money. If you are a serious investor — someone who cares about being successful and is engaged with their financial future, you should understand how “investment professionals” deal with you. Investment professionals would include brokers, registered investment advisors, financial planners or any other self-named or self-proclaimed purveyor of investment advice or products. Every one of these people is, in one way or another, a salesperson. They are compensated when an investor initiates a course of action that results in the consumption of the products and/or services that the investment professional is promoting. I know this, because it is what I do. Like all professions, some of us are quite skilled, very professional and have our interests aligned with those of our clients. Some of us are quite self-serving and are way more concerned with our interests than those of our clients. Regardless of skill or motivation, it is critical for the consumer to determine if his or her interests are being served. In order to ascertain this, the consumer must understand the motivation and goals of the provider.

When I traded commodities for a living, I was typically buying from and selling to, other professional traders. The more that I understood their positions, their needs and their personalities, the more likely I was to profit from my trading. It made playing poker look like child’s play.

So, as an insider, I offer these insights gleaned from almost 30 years as an investment professional. These are not offered cynically (although they can be taken that way) – there are many dedicated professionals who do a world of good for their investment clients. I attended a professional meeting one time where I heard one committed advisor describe his concept of financial stewardship for his clients. He actually used a biblical example, talking about how a shepherd cares about each one of his sheep; how the shepherd knew each sheep individually and cared for their needs. That was contrasted to a sheepherder. The sheepherder has a flock, he gets them from point a to point b, protects them as best he can, but the shepherd employs an impersonal and process driven style of care. This investment professional saw himself as a steward, a shepherd, knowing and caring for each of his clients. The next presenter got up and said, “I am a salesperson. I have product to move. Every day I look for someone who needs or wants what I sell, I sell what I can to whom I can and then I look for the next buyer.” Neither of these attitudes is necessarily right or wrong, but the consumer should know who’s who. Some people want a salesperson, some want a shepherd.

Regardless of the advisor’s style, he or she ultimately has to deal with three crucial things; Hope, Hype and YTB. These three things are part and parcel of each investment professional’s ongoing “moral hazard.” How the advisor approaches these things dramatically impacts the consumer.

First; Hope – All investing requires a “leap of faith.” No outcome is completely assured; not even the return on government bonds. Some investments require more faith than others. Some even require a willing suspension of disbelief. As such, every investment advisor must offer hope to investors. Sometimes that hope is justified, sometimes it is not. So, your advisor should be able to explain to you, in language and terms that you understand and are comfortable with, where his or her hope comes from. You are entitled to understand what assumptions underlie the expected returns. NOTE: EVERY INVESTMENT SOLD BY PROSPECTUS INCLUDES LANGUAGE SOMEWHAT LIKE THIS: PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. No truer words were ever spoken. Investors and advisors both have a tendency to assume a straight-line progression of past results into the future. Mutual fund companies are included in this – their performance charts, graphs and numbers perpetuate this assumption. The sales materials they provide to brokers and investors promote and encourage this hope. Few advisors, and fewer investors, are sufficiently skeptical when considering track records. Track records should be a starting point for analysis, not the motivating factor for making an investment decision. Investment advisors are bombarded by “hope mongers.” Mutual funds, wrap account advisors, newsletters, web sites, and any other conceivable (or inconceivable) investment vehicle provides hope for brokers. These brokers are in the business of proselyting – they are looking to convert you, have you accept their “hope” and invest with them.

You need to get an explanation of why they have hope and if the salesperson can reasonably and rationally outline a logical reason for their hope. Then you can decide if you can embrace the same hope.

Second; Hype – This is what, in my opinion, has built the retail investing business. You can’t miss hype in any investment pitched to people. Even a local sports talk radio show that I listen to runs commercials for financial planners. The internet is awash in hyped investments – some are obviously all hype – Nigerian e-mails still abound, but some are more subtle. Whether softpedaled or delivered with the subtlety of a sledgehammer, Wall Street is a hype machine. Promotion is what attracts assets and money in motion is what fuels both bulls and bears worldwide. For financial advisors, the key business metric is “assets under management.” How much money an advisor attracts is more a function of promotion than of performance. Advisors package their hope and then hype it to the max; that is how they acquire assets under management. Most investment professionals want their prospective consumers to make an emotional decision (that doesn’t necessarily mean irrational! Although sometimes it is), i.e., one driven by the hope that the hype has instilled in the buyer. After all, it’s much easier to create hope, and sell hope, than it is to demonstrate how much you know or care.

You need to see through the hype and discover if the advisor really has paid attention to, and understands the nuts and bolts of what he is selling.

Third; YTB – you are likely wondering, “what in the world does YTB stand for?” This is a simple, and common acronym that ultimately drives most everything that goes on in the financial world – Yield to Broker; or, in black and white; who gets paid, how do they get paid and, most importantly, how much do they get paid. Ultimately, that’s what Wall Street is about, YTB. Doesn’t matter if it’s a no-load mutual fund, A, B or C shares, a hedge fund, a wrap account, a stock, a bond, a private REIT or a variable annuity – it’s about getting paid, and the investor is the one who pays. When you take someone’s advice, they are getting compensated – and you are paying. If it’s a phone call to a no-load fund family, they get paid when you entrust them with money. If it’s purchase of a load fund, the selling broker gets paid. If you are investing in a hedge fund, the manager gets paid. If you’re reading a blog for advice, the writer, most likely, is getting paid.

You need to know who gets paid, how they get paid and how much they get paid when you trust them with your money.

Here’s a true story that illustrates how Hope, Hype and YTB can be a nasty triple play. Back in the mid-90’s, Alliance Capital (huge mutual fund family) began promoting a mutual fund designed to deliver 300% of a money market fund’s return with “little” risk (this was an actual term used by their wholesalers) to principal. [Note: a wholesaler is a salesperson/promoter whose job it is to persuade investment advisors – also referred to as “retail brokers” in some circles – to place clients’ funds in the wholesaler’s investment products]. Without going into too much detail, the investment premise was that Alliance Short Term Multi-Market Trust would purchase short term money market instruments issued by governments of countries with poor credit ratings – the government equivalent of junk bonds. Rates in these countries often were 3 to 4 times what AAA rated government paper would pay. There is a tremendous amount of currency risk in these markets; typically, the high rates are paid to offset the fact that the currencies are constantly losing value vs. the dollar. Sometimes these currency risks can be hedged. In the case of the currencies used by the fund, hedges were either unavailable, or prohibitively expensive. Alliance’s financial wizards had determined that by using layers of cross-hedges, they could engineer out the currency risk. Without going into mind-numbing detail, let me just say that the viability of the hedges they wanted to use depended on the relationship between certain currencies staying quite stable over time. When the wholesaler presented this to a group of us, using phrases like – “they’re selling the hell out of this all over the country!” – I remembered some case studies from graduate school where companies had actually gone bankrupt trying to hedge using these exact same strategies. When I asked the wholesaler about principal risk, he assured me that the “experts” had removed the risk from the fund. When I pressed the point, he turned to the others in the room and with a “wink, wink, nudge, nudge” and commented that “they’re selling the hell out of this all over the country!” and that it was almost a money market fund with “Three times the yield! Only a moron couldn’t sell this!” Those aren’t exact quotes, but are representative of his presentation. I guess I was a moron, I never presented this idea to a single client. A year later, the fund had lost more than 40% of it’s value due to several currency crises and devaluations. Even after the huge yield, this “almost no-risk” quasi-money market fund (they even offered check writing privileges!) delivered a total return that was a precursor of the dotcom era. As the value of his clients’ investments in the fund plummeted, one of my former colleagues called the wholesaler, demanding an explanation. The wholesaler’s response: “I told everybody to get out of this dog weeks ago! Where were you?” Incidentally, you can’t look the fund’s name up now and get a price; or even research it’s history — it has disappeared, swallowed by another Alliance Fund.

So, let’s tie this all together. Industry wide, turnover among clients of investment professionals is about 30% per year. When your investment advisor looks at you, he or she understands that there’s a 30% likelihood that you will take your money elsewhere in the next year. A corollary to that is that he or she understands that, on average, their entire clientele will turn over every three years. Here’s the significance to that – the impact on how the advisor approaches you and your portfolio – the “moral hazard” that impacts your financial wellbeing. Like the general managers referred to above; the advisor knows that they are likely on a short leash. Most advisors are more interested in marketing, acquiring “assets under management” and keeping a fresh stream of new clients than they are in the performance of their clients’ investments. The advisor knows that clients will leave. This conviction leads to two types of behavior. The advisor either:

    1. Presents investments that maximize his or her revenue at the time of purchase

OR

    1. Adds risk (sometimes referred to as beta) to a portfolio, understanding that if the risk pays off, the client is more likely to stay and that if the risk does not pay off, clients leave anyway and new clients will be found.

Actually, these 2 things are not mutually exclusive. In my experience (and I have reviewed thousands of portfolios over the years), unfortunately, I have seen a number of portfolios where the advisor has done both – maximized the up front revenue and taken outsized risks.

Hope, Hype and YTB, as an investor, you investor should understand how these impact you before you write a check.