The power of incentives

Rob Macdonald, Head of Strategic Advisory Services, Fundhouse

Rob Macdonald has held several senior positions in the investment industry. At Fundhouse, he acts as a consultant and coach to financial advisors and develops and facilitates training programmes in behavioural coaching and practice management. Before joining the financial services industry, Macdonald was MBA director at the UCT Graduate School of Business. He has written the book The 7 Pillars of Financial Health and is co-author of the book Rethinking Leadership and has consulted, written and spoken widely on a range of topics. Macdonald has a Master’s degree in Management Studies from Oxford University and is a CFP® Professional.

Late last year, the world lost one of its great investment brains with the passing of Charlie Munger, Warren Buffett’s long-time investment partner. Perhaps distinctive to Munger was his interest in the human side of investing, the essence of which he first captured in a speech entitled “The Psychology of Human Misjudgement” in 1995 at Harvard University.

   Central to this misjudgement are 25 cognitive biases that he believed lead to poor decisions, and consequently poor outcomes.

  Neither Munger nor Buffett has ever shied away from observing when investors are exercising poor judgement. Most recently, Buffett referred to Bitcoin as “rat poison squared” and at the Berkshire Hathaway AGM in 2000, Munger said of the late-1990 dot.com bubble that “if you mix raisins with turds, they’re still turds”. Even though two of the smartest investors ever offer such insights, many investors don’t take note.

  In March 2000, the dot.com bubble burst, while investors still pursue Bitcoin with vigour, some luckier than others.

  South African investors recently suffered the collapse of the BHI Trust run by Craig Warriner in which up to R2.7-billion of investors’ money may be lost. Despite being an unregulated investment, licensed financial advisor Global & Local put clients’ money into it. Ironically, the name “BHI” refers to “Berkshire Hathaway Investments”, Warriner clearly leveraging credibility off Buffett and Munger’s legendary listed investment vehicle.

 The first of Munger’s 25 biases is the “Reward/Punishment Super Response Tendency”. Munger believed that the power that incentives and disincentives have on the actions of others cannot be overstated. One assumes that there was an incentive for Global & Local to put clients’ funds into an unlicensed investment vehicle. And clients were undoubtedly incentivised by the promise of high returns.

The dust is yet to settle on the BHI debacle and yet another one is already playing itself out. No surprise it’s in the form of an unlicensed investment vehicle. GSPartners promotes and distributes an investment product called “MetaCertificates” which promises returns to international investors ranging from 2.5% to 4.15% per week,^[1] while in South Africa the promised returns are as high as 22% per week.^[2]

   To put that into perspective, the long-term real return on South African equities is 7% per year, significantly less than the weekly return promised by GSPartners! The FSCA issued a warning late last year for investors to be wary of GSPartners, while cease and desist orders have been issued against it by several jurisdictions in the US and Canada.

   Munger’s first bias suggests that these schemes will repeatedly rear their ugly head; after all, they always have incentives, both for promoters and investors. Believing in unrealistic returns is a cognitive error – not understanding what’s realistic, and an emotional one – greed.

   Both are great incentives, nevertheless. But there is also the social incentive. GSPartners has been actively promoted in South Africa by well-known sports personalities such as Victor Matfield, Herschelle Gibbs, Lucas Radebe and Toks van der Linde. It’s not just about the money, it’s about being part of this celebrity group.

   When making decisions, investors repeatedly fall foul of the three elements of what I call the Bermuda Triangle of Investing: cognitive errors: emotional responses and social influences. All three play a role in Munger’s Reward/Punishment Super Response Tendency. Central to a financial planner’s value is helping clients to navigate these three elements on an ongoing basis. Making this job easier would be that whenever you get a sniff of an investment that looks like “rat poison” or a “turd”, don’t only keep your clients’ noses out of it, alert the public and the regulator too. I believe professional financial planners have a collective incentive and responsibility in this regard. And no doubt, Charlie Munger would approve.