Why Capitalism is Bad at Giving Advice

By Stephen Gandel | @stephengandel | March 11, 2010 | +

I have a story up today on the website of our sister publication Fortune.com. It is part of Fortune’s excellent redesign issue. The story is focused on a study by Sendhil Mullainathan of Harvard that finds a disturbing truth about financial planners:

Experts have long counseled against using financial planners who charge commissions, given their incentive to simply sell products that pad their paychecks.

Now a new working paper concludes there is another risk — one that afflicts advisers of all stripes. The problem: Financial planners are yes-men and -women, asserts a report co-authored by Sendhil Mullainathan, a Harvard professor and top behavioral economist.

Most planners, his report finds, reinforce our bad investment behaviors instead of fixing them. And the problem, he says, may be harder to solve than the fee issue.

The story and the study are focused on financial planners, but I think it reveals a larger truth about capitalism and our system’s ability to create reliable advisers, financial or otherwise. I wonder if we need a new model for paying advisers. Here’s why:

So the problem that the study points out is that when individuals hire people to give them advice, the advisers they have a strong incentive to tell you what you want to hear. If they don’t do that, then you probably won’t hire them. No matter how impartial we think we are. We come to every topic with some inherent beliefs. If someone tells you something that doesn’t jive with those beliefs, you are likely to think they are either incompetent or just not smart.

That’s a problem for financial planners, as the study points out, but I would image it is a problem in other professions as well. Therapists I would image run into this problem all the time. Most probably don’t tell people on the first session that their mother is to blame, unless of course they think that is easier to hear than just to tell the patient the truth that the real problem is them.

It is also bad news for the economy in general. Consumers have to deal in markets all the time that are regularly prone to failures. Much of them happen because of a lack of information. So the thinking is that a well-incentivized intermediary could help consumers make better decisions and get better outcomes in markets that have had runaway costs like say health care or education. But if these advisers can’t be trusted because their incentive is to land your business and then keep you as a client, then they do nothing to halt you from going for that unnecessary MRI or putting all your money in technology stocks.

And I image this Yes-man problem had a role in the financial crisis. Bubbles form because of echo chambers. And Yes-men only make those echos louder. So I wonder if anyone has come up with another model for giving advice, where the advice seeker does not have as big a role in influencing the advice they end up getting. Anyone? And please don’t just tell me I’m right.

Related Topics: Economy & Policy

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seandougherty

When the success of the enterprise is dependent on a third party. If the advisor tells you what you want to hear, and that turns out to be something stupid, the advisor will fail in his or her goals and be fired.

The reality is that this isn’t a black-and-white issue. The best salespeople can tell people what they need to hear while making it sound like what they want to hear.

I work in public relations and folks who can do that are the most successful practitioners.
markwolfinger

Make the advisor your partner.

They are paid for results. Perhaps beating a benchmark; perhaps meeting a specific objective set by the customer; perhaps a negotiated level of performance.

Partnership. No meet goals; no fee.
pneogy

Either you are knowledgeable enough and confident enough to make your own decisions. In which case you should use your financial advisor as a sounding board and a source for information that you might have missed, and make your own decisions after consultation.

Or, you are neither knowledgeable nor confident enough to make your own decisions. In that case hire the best advisor you can afford, let him make the decisions, and fire him if he doesn’t live up to your expectations..
http://newdecembrists.wordpress.com epicureandealmaker

I’m not sure this is the answer you’re looking for, Stephen, but it’s an answer nonetheless.

http://epicureandealmaker.blogspot.com/2010/03/psychiatric-help-5-doctor-is-in.html
laudens

We see the same effect with celebrities and politicians all the time. Actually we see it in any situation where an individual is surrounded with people who get paid to say yes.

While it’s not comfortable, everyone needs a staffer who is willing to say no sometimes without fear of getting fired.

Remember event the greatest Roman generals had some whisper in their ear, “Remember, thou are mortal”.
efirmage

It is similar to the problem described in Freakonomics, in which real estate agents get higher prices for themselves than they do for you. Their goal is similar to yours in some ways: they want to get as high a price as possible. But they would be much more likely to take a lower price quicker because they don’t have as much on the line as you do. A 10% price difference for you could mean 10,000 dollars. But for them it’s only 1,000.

So you pay according to performance, and make short term steps your goal, rather than the larger goals you probably had in mind when you hired them. But if you have many people involved in decision making it’s hard to pin down what lead to what. Was it the economy that killed your new adverstising campaign? Or did it just not attract consumers?

I don’t think it’s in any worse in capitalism than it is in any other system however. There are always going to be differences in goals and in how much each party has invested in a given project.
waltwriston

It’s about time this issue is brought; as it’s long over due! When the market hit the bottom, which I saw the liquid being drain out on mid-06 is suggested to people to buy-but and buy! So they get on the ol phone with their so-called expert brokers putting orders in and whatnot. There was one that was really notable Citi was @ .98 and I was asked if they should pick it up, of course I said yes and did so myself. But afterward the person called and instead of picking a few thousand of that they were talked into a few of MYL @ 11.50; the broker used investments 101 a defensive stock (wouldn’t have been bad @ 5.50 it low) and touted how C was going to go broke. The stock hardly moved only then did he sale and picked C up at 1.70. That’s when I jumped on the phone an accused him of churning, and needless to say he was fired and we then switched over to their online service and only getting clipped for 15 buck instead of 50 for their so-called “full service.” Every one of the “experts” picks were flat-out losers or made maybe 2% at best, mine on the other hand have turnover roughly 200-400% since March 09. Let the brokers eat dog food for lunch instead of your cash paying for fish ala crap!

I also hate when brokers are mute on buying into the place they work for. I realize they really can’t give advice but when BAC was @ 2.80 the broker (Merrill Lynch) didn’t say squat and one person who was very risk adverse picked up only a few hundred as opposed to the thousand he had in mind. I couldn’t persuade him to buy a multiple of what he already bought because of the broker!
waltwriston

I hate to be such a haggler on this but if there’s one thing that should be put in Time Magazine in the Curious section it’s this or something like. Does Time Magazine still publish Curious anymore in their Magazine haven’t seen it in a while?

But my point is that people trust these advisors far more than what they should. I know people who say their brokers are good people, family people etc… It’s horrible and I think borders on criminal. That broker couldn’t care two cents about you his job is to make commissions for himself and the firm: period. I have lost count on the amount people I’ve told this to and strangely they all follow the trend George Goodman made in his best selling book The Money Game, in it I’m my personify is Mr. Thatcher. Goodman’s also right that most small investors: they just want to talk to them i.e. the want to be “In the know” it’s an addiction they simply to feel that they’re a part of what’s going on.

If some people only knew how close brokers actions are to the brokers on the movie Boiler Room and the book Liar’s Poker they’d faint!

And if they knew how much muscle is against their investments to the banks and brokerage firms propriety trading they’d be aghast! Goldman Sachs states this explicitly in their fine print, something along the lines of “your investment objectives may run contrary Goldman’s investment objectives:” now that takes a lot of chutzpah to state!