Determining the ideal elementary school class size has been a hotly debated topic for a number of years. The prevailing wisdom is that smaller is better. But is that always true? In his book “David and Goliath,” author Malcolm Gladwell uses the “Inverted U Curve Principle” to demonstrate the ideal class size.

I’d argue that the U Curve provides interesting insights into the ideal size for a broker-dealer, and suggests which BDs will survive in the current market and regulatory atmosphere.

But first, let’s explore Gladwell’s research.

Gladwell explains that there are three parts to the inverted U curve, and each part follows a different logic. On the left side of the curve, doing more or having more makes things better. On the flat middle, doing more does not make much of a difference. On the right, doing more or having more makes things worse.

According to Gladwell, it turns out that 18 students is the perfect class size. This is because there are enough bodies in the room so that no one feels vulnerable, but everyone can feel important. A class size of 18 also divides nicely into groups of two, three or six. At this size, the teacher can attend to each student when needed. When you get to 24 students, the class verges on having the energetic mass of an audience instead of a team. If you add 6 more students, for a total of 30, the energetic connections weaken to the point that even the most charismatic teacher cannot maintain the magic.

Out of a decade teaching, my wife recalled her first year having 38 students in a fourth grade class. She referred to that first year as her baptism of fire. Four students in the class had behavioral issue problems, with one of the students threatening to take a crowbar to her head and addressing her with numerous expletives. She spent the majority of her time managing these four students, while the rest of the class suffered with virtually no support from the principal.

Gladwell points out how many wealthy parents send their children to private schools thinking that small class size will be to their child’s benefit. However, when you go small, say down to 12, you have the Last Supper. A group of 12 is small enough to fit around the holiday dinner table but too intimate for many students, who may wish to protect their autonomy and are too easily dominated by the bombastic or bullying personalities in the group.

When you get down to six students, there is no place to hide, and not enough diversity in thought and experience to add the richness that can come from numbers. The small class is as difficult for a teacher to manage as the very large class. As one teacher put it, when classes get too small, the students start acting “like siblings in the backseat of a car. There is simply no way for the cantankerous kids to get away from one another.”

Gladwell uses the inverted U curve to make a compelling argument regarding optimal classroom size. I find that the principle also applies to broker-dealer size.

The U Curve and Broker-Dealers

We see a similar inverted U curve when looking at the size of independent broker-dealers, with midsized broker-dealers reflecting the sweet spot for overall satisfaction. Note that when I refer to independent broker-dealers, I am not including BDs that have both retail and independent channels because that model yields an apples-to-oranges comparison.

If you look at broke-dealer surveys, you see a clear pattern of rankings for overall satisfaction that is concentrated in the midrange, with the low-end of midrange being broker-dealers having approximately \$50 million of revenue. On the top end of midsized BDs, we see satisfaction start to decline when they reach the size of 2,500-3,000 reps.  All the firms with very high satisfaction levels also have average production per advisor numbers on the higher end for our industry, which is about \$200,000 or higher.

When you have numerous smaller producers within a firm, the phone lines tend to get tied up because these advisors are on a learning curve. When larger producers call in, they can’t get through in a timely manner. Firms with numerous small producers also tend to have compliance policies that cater to the lowest common denominator. At a firm we know well that has a high satisfaction ranking, average production per rep is in the \$400,000 range. This firm’s comment on compliance is, “We don’t have compliance that caters to the lowest denominator because we don’t have lower denominators. We don’t bring on advisors unless they have over \$200,000 of gross dealer concession.”

How Revenue Affects a Firm’s Response to Regulation

The low end of midrange broker-dealers with approximately \$50 million of revenue is probably the minimum level of revenue for managing the increasing burden of regulation and achieving good satisfaction results. At \$50 million to \$75 million of revenue, firms are less concerned with their ability to handle staffing costs and are able to maintain robust net capital levels.

At the \$100 million level, concerns regarding regulation are minimal to nonexistent as the company scale enables them to easily manage proper staffing levels. For the smaller firms, the obvious strength is service and their ability to have deep relationships with the advisors. Where these smaller firms come up short is access to capital, ability to supply services that will help advisors grow to the next level and the ability to compete for recruits in the marketplace when they are not able to offer competitive amounts of transition money.

Smaller firms can also end up being repositories for advisors that other firms won’t take due to a range of issues, including compliance problems, skewed product mixes, credit issues and low production. The irony is that small broker-dealers can least afford the regulatory heat these issues potentially bring to broker-dealers. To counter this, small firms have the ability to know and supervise their advisors on a more personal level than large broker-dealers are capable of doing.

As one smaller broker-dealer president put it, “Larger firms are going to need more net capital because they are going to spend it on a greater frequency of litigation. We know and are able to track our advisors much better than advisors at firms where they get lost in the forest of trees.”

While there is some truth to this, smaller firms also have less room for error. The advisors at these smaller firms are insecure due to the fact that their broker-dealer is potentially only one arbitration away from a net capital violation.

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In the second part of this exploration of how the U Curve applies to broker-dealers, we’ll look at Gladwell’s Rule of 150 and what it suggests about the prospects for small, midsized and large broker-dealers.