Millions of investors hand their money over to Wall Street experts in the hopes that professional management can obtain better returns on their money than they'd be able to generate on their own. What they don't realize, however, is that whenever you let anyone have access to your money, you introduce the potential for a conflict of interest. To avoid getting a nasty surprise, it's essential that you understand where those conflicts are and how they could endanger your life savings.
One of the biggest conflicts is due to the fact that professional money managers have incentives to think short-term rather than long-term. Let's take a closer look at how short-term thinking can lead to decisions that aren't in your best interest in the long run.
Dealing with career risk
One thing that many people never stop to think about is the fact that the people who handle their money face the same financial pressures as the rest of us. Each of them wants to succeed at their job, and most of them have employers looking critically at their performance and evaluating their future prospects, with huge ramifications for their long-term career path.
As several speakers noted at last Friday's Columbia Student Investment Management Association Conference, money managers constantly deal with conflicts between the decisions that they would make to maximize long-term returns and the compromises they make to keep their funds in business and keep their jobs managing them. Many of the major institutional clients that money managers serve share this conflict, as their investment committees are judged over short time frames and therefore need to demonstrate short-term results -- even when they come at the expense of long-term returns.
What happens to those who step out of line?
Managers who have the courage to take career risk by bucking Wall Street's short-term thinking often pay the price. One manager who stayed out of high-flying stocks during the run-up from late 1997 to early 2000 saw his fund shrink by two-thirds, as investors fled to find better returns from competitors willing to buy tech and Internet companies. In the end, the manager outperformed greatly by avoiding the tech bust and attracted huge amounts of assets once he'd reestablished his long-term outperformance.
More recently, Fairholme Fund manager Bruce Berkowitz is another example of someone who took on Wall Street's short-term thinking with disastrous consequences for asset levels within his fund. Convinced that financial stocks AIG (NYSE:AIG) and Bank of America (NYSE:BAC) were ridiculously undervalued, Berkowitz took concentrated positions in those and other financial stocks, leaving his overall fund portfolio exposed to adverse events in the financial industry. Berkowitz turned out to be early in his positive assessment, and the fund therefore suffered huge losses during 2011 as a result of his big bet on banking and insurance. Investors took billions of dollars out of his fund, but Berkowitz persevered, and last year, he recovered a substantial part of his money as Bank of America more than doubled and AIG finally got out from under the umbrella of the U.S. Treasury's ownership of its shares.
Although he doesn't run a mutual fund or hedge fund, Warren Buffett is another example of the way that short-term trends can lead investors to abandon long-term thinking. Buffett too eschewed tech stocks during the late 1990s as being too complicated, and shares of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) suffered as a result. Skeptics argued that Buffett was unable to adapt to changing conditions in the investing world and was doomed to underperformance as a result. Yet Berkshire bounced back during the 2000-2002 stock market swoon and surpassed its former all-time highs by 2004 -- years before many stocks even approached their pre-bust levels.
All of these investors managed to overcome the pressure to think short-term, but countless less-experienced money managers don't have the luxury of a second chance and therefore won't always succeed. If you want to be successful in meeting your financial goals, you can't afford to fall prey to short-term thinking. Keep your eyes on the people who manage your money, and make sure they're not costing you huge long-term returns with short-term decisions.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.