Fiduciary Responsibility and the Paradox of a Rebound

One of the market mechanisms that will likely help or hurt a stock market recovery (not to be confused with real economic recovery) is going to be the role of fiduciaries.

Fiduciaries are those people who directly or indirectly manage money or provide advice on behalf of others.  Some of these people consult to some of the largest public and private funds on the planet, a larger number consult to individual investors.  Their obligation of course is to maximize risk-adjusted returns for their clients.  That’s the fancy way of saying they are tasked to make as much money for the level of risk their client is willing to take.

Sifting the wheat from the chaff of advisors to those with some experience, intelligence, integrity and perspective, there is a perverse incentive for them to hold clients back from catching a falling knife of rapid and unexpected declines in asset values, even if doing so might offer out-sized returns.

There are strong and well documented agency problems between an advisor and his or her client.  These include the role of advisory fees, and the transparency and incentives of product pricing, but it also includes the relationship incentives between an advisor and her client.

A good advisor, and a good business person realizes that the way to build a successful business is to build a book of faithful clients.  Integral advisors are willing to give up short term profits for long term relationships with the understanding that annuity revenue from a client who remains loyal over decades far outweighs the opportunity from a short term bet that might make the adviser money, but might put the client at undue risk.

That said, most retail investors fall into the not-looking-to-jump-out-of-a-plane-without-a-parachute risk profile.  In economic terms, those retail investors who are not speculators, fit somewhere between conservative and moderately aggressive on a risk profile.

Most advisors (the wheat not the chaff) have an unspoken concern, particularly at the start of a new relationship, to proceed with caution, heavily conscious of showing a client their first statement after a new investment decision.  These advisors would much rather be able to show a client a modest profit over the first term of a new working relationship than to take undue risks.  At times, good investments are avoided if making them poses a risk to the credibility of the relationship at the next client review.

This psychology is going to make it much more difficult to get a lot of the cash now on the sidelines back into risky assets.  Advisors would rather invest a client’s money when the have a better prospect of showing a statement with a modest positive return than with the prospect of a large gaping loss, regardless of the high quality of the investment.  After all, most advisors don’t have Warren Buffett’s track record or street-cred, and as such will choose principal protection over risk-taking in fear of having to report another 20% drop in asset prices.

Even if the advisor’s investment recommendation is a good one in the long-run, in volatile markets an adviser may be concerned with client longevity over good investment recommendations.  A good investment showing poor performance could mean little to a nervous client.  In these markets clients will be changing advisors more than they have in the last five years.  Thus, many fiduciaries are incentivized to pile on only after a major rebound has already occurred, delaying the entrance of a lot of the dry powder that could help lift and stabilize the equity and debt markets.

As an aside, this is one of those moments in time where individual investor’s risk profiles are tested.  During bull markets, retail investors generally overestimate their appetite for risk, and in bear markets then tend to exaggerate their fear.  The best investors (Buffett, again as an example) take a long view, and remain committed for the long haul.  Market timing can be dangerous, but many people don’t think of it that way when they are selling or buying on emotion.

A good test of your risk profile is how well you are sleeping at night.  If market volatility keeps you awake, you’ve probably had a risk appetite larger than your stomach.  In the long run, good assets will rebound, so selling today, if you don’t need to, doesn’t make much sense.  But when things recover, it would be good to remember the sleepless nights and upset stomachs so next time someone asks you about your appetite for risk you can answer with more perspective.

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