Thursday, April 2, 2015

Incentive cause bias: the most common pot hole

The incentive cause bias is rationalization by the professional that what is good for the professional is good for the client (and maybe the world) as well. This is rampant in the financial services industry. The article on avoiding IPOs is a prime example of this kind of bias in the financial world. Trusting your broker or for that matter any financial institution blindly can cost you a lot of money. A financial institution serves its own interest by making money on financial transactions. At the same time you believe that the financial institution is acting in your interest. The interest of the financial institution and yours can only go hand in hand if the institution through systems and processes ensures that it is a win-win situation for both parties. This is very rarely the case. 

An example of this incentive cause bias is portfolio management fee based on the amount of assets. Now if the asset manager is compensated for assets rather than returns, it will naturally lead to more emphasis on marketing rather than investing. As long as the funds under management (or AUM) grow the fund manager is compensated well – irrespective of the returns. This is rationalized by many as the best of the bad available alternatives as the fund will not be able to survive without some fixed management fee. While this may be true to some extent the quantum of such fees has gone way out of hand and has lead to several investors losing lots of money. Several other examples of this bias are present in the “Financialintermediaries & the principal agent problem” article.