One of the reasons we formed Cadence back in 2010 was to rid ourselves of the embedded conflicts of interest that are inherent in large, profit-seeking public firms. I’m not suggesting that profit-seeking is bad, after all, it makes our economy go, jobs available, and is a genuinely positive aspect of the American way of life. But what we see every day working in financial markets is that there are immense pressures put on public companies by shareholders and Wall Street to increase profits quarter after quarter to fuel rising stock prices. Stock options within public companies, in many cases comprising a much larger form of compensation than salaries, provide additional motivation to maximize profit and keep share prices rising. One can commit any number of infractions and indiscretions when the largest part of his compensation depends on him doing so. On Wall Street, which is to say within large publicly traded companies, profit ultimately drives behavior. This incentive drives the potential for conflicts of interest with the consuming public, and the sheer scale and level of profits involved, which tends to correspond with the size of the Washington lobby for a particular business, fosters the potential for regulatory capture. Bank CEOs escaping jail time post Great Financial Crisis in 2007-2008? Big banks settling with the government on giant fraud charges for a fraction of their overall revenue? Big pharmaceutical companies repeatedly paying relatively small fines after harmful drugs are released to the public based on fraudulent trial data (Vioxx to name one of many)? This is capture at the tail end of consumer-damaging business practices that are driven by profit incentives and conflicts of interest.
As I mentioned, there is nothing inherently wrong with incentives that drive money-making activity. In fact, this is a key ingredient for a dynamic, innovative economic system. It is important, however, that the “system” or rules of the game align the success of the enterprise with that of the consumer. For example, banks shouldn’t make loans embedded with clauses and features that they know customers have a good chance of defaulting on…without recourse. Auto manufacturers shouldn’t be able to sell cars they know have potential warranty issues or faulty parts…without recourse. And drug companies should be responsible, in a big way, for knowingly manipulating trial data to make a harmful drug look good. When there are no consequences for bad behavior, we get moral hazard, and conflicts of interest almost every time. It’s simply human nature.
The way we view the world of global finance here at Cadence is through this lens. In practice, we aim to minimize those conflicts, real or perceived, so that we are always in a position to view financial markets honestly and objectively, formulate strategies according to that untainted view, and communicate them without fear of reprisal or recourse. This flexibility to look anywhere, and think anything, can sometimes lead to some uncomfortable findings. For example…
- Buying and holding doesn’t always work. There have been times in history where investors had to wait much longer than 10 years to regain market losses.
- Stocks don’t always return more than bonds.
- Lower interest rates don’t necessarily lead to inflation.
- High interest rates don’t always crush the economy and lead to disinflation.
- Deflation isn’t bad like the government and its agencies and advocates tell us it is.
- The Fed doesn’t control the economy nearly to the extent most think it does.
- Government bonds are not conservative investments.
- A typical diversified portfolio can lose much more money than most think.
- The U.S. government will not pay off its debt and this will have consequences.
These observations might not sound outlandish to our clients, since we talk about these things quite a bit, but to those watching a good amount of CNBC or working with a typical Wall Street firm, they’d probably border on heresy. We almost certainly would not be invited onto CNBC to opine on anything with these views. Why is that?
The answer to that question lies in the answers to the following:
- Who are the primary purveyors of financial information?
- How do they make money (financial incentives)?
- Who pays them (advertisers)?
- What are the financial incentives of those who pay them?
- Who are they regulated by?
- Do those regulators have relationships with those they regulate?
- Are there financial incentives in place that lead to conflicts of interest?
Let’s dissect the common Wall Street guidance of buy and hold investing, and the tendency for the media to have a perpetually positive outlook for the stock market no matter the conditions. I always found it odd that you’d rarely see a guest on financial television or read an opinion piece in a prominent financial journal where the outlook was clearly negative for stocks. You’d also almost never hear a forecast for a negative performance year for the market from mutual fund companies or other investment firms we’d come into contact with. After experiencing two bear markets in the 2000s, it became crystal clear as to why. For the firms selling mutual funds and other investment products, there were strong financial incentives to make sure clients were always invested. For the financial media, a very large percentage of their advertising revenue came from investment product companies, so their messaging was effectively controlled by the financial interests of those advertisers. If they, or their guests were too honest about the risks they saw in financial markets, and it cost their advertisers fee revenue, then the threat of cancelling an advertising relationship loomed. Is this criminal? No. Does it lead to skewed messaging and a one-sided assessment of financial conditions and opinions? Yes, most definitely it does. These are all conflicts of interest that directly affect investors and support mantras like buy and hold investing.
And the regulators? Let’s put it this way. If the financial firm is large enough, and offers ample incentive either now or in the future for a regulator not to regulate, then a lack of regulation is what we get. This is true across industries and is far more common than most think. We find former energy executives within the EPA, former pharmaceutical executives embedded within the FDA, former Goldman Sachs executives (like Hank Paulson) heading the Treasury. The same is true in reverse, with retiring public sector regulators and officials finding work with the very companies they were charged to regulate. Former Fed chairman, Ben Bernanke working with Citadel, one of the largest hedge funds in the world after wrapping up public service is a good example of this on the financial side. This cozy relationship between the public and private sector is simply a reality in our world and it makes folks all the wiser and keener once they know about it.
So What?
I share this because it’s central to how we view the world and manage your money. We believe strongly that over time, the degree to which we successfully spot conflicts leading to bad behavior and business practices, and avoid them, can help us avoid unnecessary risks, and find more lasting opportunities. The more clearly we see the world and financial markets that power it, the better off our clients are. In addition, there’s so much overlap between the things we need to research and fully understand in the world in order to invest client money wisely and the things that are affecting us daily in our personal lives. Where most people view an issue through the lens of politics, we tend to view it agnostically, through our human impulse lens of incentives, conflicts, and capture. The very nature of politics is to obscure the full context of an issue in order to appease a particular constituency while placing the blame on another. Thus, most issues that people view in a political way, sometimes emotionally, are actually being driven by big players with vested interests; by big money. When that happens, you get a narrative campaign lacking full information and context designed to leave you feeling one way. In my world, that’s buy stocks and hold them despite the risk of doing so. In other industries, it can lead to far more emotional viewpoints and consequential outcomes. It’s gross, and I’m confident everyone would agree that if the divisive rhetoric, finger pointing, and narrative-crafting completely abated tomorrow, we’d all be happier and much better off.
But it won’t end tomorrow, and there’s also a good chance that things get worse politically after November 5, despite which candidate comes out ahead. In anticipation of this – the prospect of vicious claims, accusations, and information campaigns to come – we could either just accept what comes at us as completely true or think about things more agnostically and dispassionately. Personally and professionally, we’ll be keeping an eye on the money, whose interests are in play, and on a case-by-case basis, the embedded incentives, conflicts, and capture. This should continue to keep our goggles free of disorienting fog and serve us and our clients very well as we likely move into increasingly turbulent times in the weeks and months ahead.
Editor’s Note: This article was originally published in the November 2024 edition of our “Cadence Clips” newsletter.
Important Disclosures
This blog is provided for informational purposes and is not to be considered investment advice or a solicitation to buy or sell securities. Cadence Wealth Management, LLC, a registered investment advisor, may only provide advice after entering into an advisory agreement and obtaining all relevant information from a client. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Past performance is not indicative of future results. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses and is not based on actual advisory client assets. Index performance does include the reinvestment of dividends and other distributions
The views expressed in the referenced materials are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
