If you’re a data nerd like me, I’ve got a book for you: Freakonomics by Steven Levitt, an economist at the University of Chicago, and Stephen Dubner, a former New York Times reporter, who through brilliant data mining blow up conventional wisdom on subjects ranging from criminology to commerce and from politics to parenting.
An unconventional economist to say the least, Levitt describes himself this way: “I just don’t know very much about the field of economics. I’m not good at math, I don’t know a lot of econometrics, and I don’t know how to do theory.” Instead, he uses the powerful tools of economic measurement to deal with more interesting issues than the standard economic fare.
Why did the crime rate fall precipitously in the early 1990s, despite predictions by all the experts that it would continue to skyrocket as it did in the ’80s? Does having more money really win elections? How much do good schools matter?
In Freakonomics (the authors are said to be working on a sequel, and run a blog at www.freakonomics.com) Levitt answers these and dozens more penetrating questions. His steadfast adherence to measurable facts, without regard for any social agenda, political view, or even the implications of his conclusions is like a shot of Vitamin B12 to those of us who are sick to death of spin doctors and disinformation. What’s more, his methodology provides insights into questions far beyond his topics, including the current state of the financial services industry.
While Levitt’s specific analyses are mind-blowing, the thing that makes his book truly great is that his approach is so simple we can all use it to better understand our own worlds. His work is based on five basic principals, two of which you’ve probably surmised by now: “Conventional wisdom is often wrong,” and “Dramatic effects often have distant, even subtle, causes.” His overriding premise is: “Knowing what to measure and how to measure it makes a complicated world much less so.”
Why You Should Care
The last two ideas are more directly applicable to our world of financial advice. “Incentives are the cornerstone of modern life, and understanding them–or, often ferreting them out–is the key to solving just about any riddle….” This would be just as true if we were to substitute “the financial services industry” for “modern life.”
Levitt provides myriad examples of incentives at work, including obstetricians doing more revenue-generating Caesarian sections during economic slowdowns, and teachers helping students to cheat on standardized tests when their compensation depends on the results. His most powerful and relevant analysis, which combines both incentives and expert use of information, happens to concern the real estate business.
Most people believe their real estate agent will get them as much for their house as possible because his commission is based on the sale price.
But according to Levitt, the data shows that real estate agents are actually given incentives to use their expert knowledge against their selling clients. The proof? When real estate agents sell their own homes, they keep them on the market for 10 more days and sell them for 3% more, on average, than clients’ homes.
If agents make more when a house sells for more, why wouldn’t they use their obvious expertise to maximize client sales? The answer is simple economics: On a client’s $500,000 home, the commission is 6%, or $30,000. That’s split first between the buyer’s and seller’s agents, and then split again between the agent and her broker. So the seller’s agent would get $7,500.
Now, if the agent negotiated the deal the way he would do it for himself, and got the seller $515,000, he’d get $7,725. Which is economically better for the broker: to work on the sale for an additional 10 days and get $225 more; or close the deal as quickly as possible at whatever price, and do another $7,500 deal? As Levitt puts it: “Like a stockbroker churning commissions, [the real estate agent] wants to make deals and make them fast.”
Where do we start with parallels to the business of financial advice? Advisors (in the broadest definition) have far greater informational advantages than real estate brokers. Then there’s the fact that most clients believe their advisors are legally and ethically on their side, whether they’re insurance agents, stockbrokers, or RIAs.
We all know that “advisors” have huge financial incentives to use their expert knowledge to their own–and their firm’s–advantage, with potentially devastating long-term consequences to the client. Selling high-commission products, selling products with high expenses, and selling unnecessary or inappropriate products are all ways “advisors” take advantage of unwary clients.
Prostitutes and Architects
Despite this pot of gold at the end of the rainbow of client abuse, in recent years the financial services industry has actually reduced the incentives for its salesforce to misuse its informational advantage. Securities commissions have been replaced with asset management fees, the NASD has outlawed many sales perks and contests, ridiculously high-commission annuities have all but disappeared, and uncompetitively priced proprietary products, while still the tout at a few firms, are for the most part a thing of the past. What’s gotten into these former champions of financial caveat emptor?
Levitt gives us some insight into this conundrum as well, by way of exploring why prostitutes make more money than architects. Economic theory tells us that there are typically four factors that determine how much somebody makes. First, how many people are willing to do a particular job? Since many kids grow up wanting to design buildings but virtually no one aspires to prostitution, the labor supply for the oldest profession is relatively small. Then there’s specialized skills and the unpleasantness of the job. With the risk of AIDS and physical harm, prostitutes have to take this one as well.
What’s this got to do with financial services companies eschewing lucrative incentives? The same simple supply and demand equation. Sales is hard; few people are good at convincing people to do things (particularly things that may not be in their best interest), or can live with the high rate of rejection. That’s why wirehouses historically post turnover in their retail sales forces in excess of 80%.
Financial consumers seek expert help because they’re afraid of not being able to retire, or just losing their money. They don’t want to be sold, they want to be advised.
Over the past 15 years, independent advisors have had a very good ride, largely due to burgeoning numbers of financial consumers looking for real advisors. But lately, I’ve noticed a disturbing trend that would have been unthinkable only five years ago: Independent RIAs and reps going to work as in-house brokers at wirehouses. They are doing this in part because clients aren’t demanding that they stay independent.
Of course, there’s a huge difference between in-house “advisors” whose incentives are set by a brokerage firm with its own agenda and independent advisors who set their own incentives according to what their clients need. The question facing independents is whether financial consumers will continue to see and demand the difference.
Bob Clark, a former editor-in-chief of this magazine, sagely surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at email@example.com.