Wall Street is an interesting place and certainly a magnet for ambitious finance graduates from the best business schools in the country. Harvard Business School or Columbia Business School, two of the top educational institutions in the United States, regularly send a respectable number of graduates to Wall Street firms which then seek your investment business.
So, with well-educated and ambitious finance professionals telling you how to invest your money, nothing can go wrong right?
Not so fast.
Investors need to understand a very important concept that has a tremendous influence on investment performance: Interest alignment. Yet, many investors have never heard of it. And that should worry you.
The concept of "alignment of interest" can best be explained by utilizing an example from the fund management business.
Assume you invest in a plain vanilla mutual fund, which charges you a fixed management fee for its services, independent of achieved performance results.
In other words: Whether the fund does well or not doesn't matter. It earns the management fee, which often amounts to a couple of percent of assets under management.
Put differently: The fund and its management couldn't care less if it made money for you, because it is getting paid either way. Not exactly a sweet deal for investors who would reasonably assume that the fund managers are incentivized to do well.
Compare this, for instance, to a hedge fund that charges only performance fees. If the fund does well, so does the fund manager because he gets a bigger paycheck for delivering strong results and a smaller paycheck if he messes up. Interests between investors and fund managers are strongly aligned.
It is noteworthy that not only investors' relationships to fund managers are characterized by an improper alignment of interests. Relationships to other finance professionals may also be influenced by misguided incentives to the detriment of the investor.
Therefore, investors need to make sure they understand the incentives these professionals have, which is often to get your dollars first and put your investment success last.
Interest alignment problems also exist with respect to stockbrokers.
Stockbrokers benefit when you make transactions. The more you trade, they more they earn. This is a good value proposition for them, but not for you. Having someone encourage you to trade in order to benefit from your provisions, is not only bad business practice and unethical, but also not helping your returns.
Investors again need to understand that interests in the stockbroker business are not aligned with those of investors and that they might not get the best advice from such professionals.
The Foolish Bottom Line
Investors with relationships to Wall Street institutions, whether its asset management and private wealth management businesses, mutual fund companies, or stockbrokers, need to get a thorough feel for the underlying incentives which govern Wall Street's business practices.
Make sure, that anybody who wants your money is properly incentivized to work for you.
Investors should only listen to Wall Street's financial advice if they can be sure, that client interests will be put first or, better yet, that their interests are aligned with the interest of the advisor.
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