In this 5 minute TED talk, psychologist Dan Ariely ruminates on the way that conflicts of interest encroach on even the best of intentions. It’s an issue that is endemic to the world of finance – and an area where communication technologies can assist. Let me explain by first referencing a simplistic model of how the investment world works.
In this model there are three moving parts, going through these we can start to see how the conflicts emerge and where the opportunity to create an alternative point of view may reside.
So we have Earnings – the elemental building blocks of any investment. Into this balloon is grouped everything that drives the fundamental earnings of individual companies – it’s a rich interplay between interest rates, inflation, demographics, innovation, legal process, tax treatments etc. The net result is a single number that defines the return on any investment. Needless to say, when we extrapolate this number into the future, the resulting ‘forecast’ earnings can be plagued with uncertainty – this is a big part of the risk bit of any investment.
Flows determine arguably the cleanest dataset in the capitalist world – price. Through the process of buying and selling an asset, good or service, a clearing price is set. And while prices can be distorted by fair means or foul, they can also be directly measured, compared and analysed. Price is the clearest expression of the herd as regards expectations for Earnings – so while interpretation of movements in flows and prices may be subjective, the underlying data is not.
The net outcome of flows is Valuation. It is the amount that the market is prepared to pay for the expected earnings on an investment – and is a result of the demand and supply of that investment on the market. Note that unlike earnings or flows, valuation is a derived, it is not directly observable as a distinct element in its own right. The implied valuation of an investment may change according to movements in its price but it is uncertain as to whether this is a result of changes in investor’s risk preferences, earnings expectations or some completely unrelated factor.
Circling back, how does this help addressing conflicts of interest in finance? Taking a leaf out of Dan’s book, we can use the model to take the first step and recognise what the conflict looks like. Then once we understand where the conflict emanates from we can look at alternatives that do not suffer from the essential conflicts or may help to address them.
So what does the conflict look like? There are a essentially two issues here:
1) Access to information – As we have seen, in order for investors to be derive informed views about earnings expectations and how the market is pricing these, they must have easy access to the information. The accessibility to information varies by country and market – for example in the US, information is relatively more mobile than in the UK or Australia. In these latter jurisdictions, some market platforms are conflicted by a profit motive which leads to asymmetric distribution of information.
2) Alignment of interests – The majority of people do not have the time nor expertise to directly manage their on-market investments – they require assistance. The conflict arises from within that the industry structure that has grown to provide this expertise. The issue is one of alignment with the end investor.
Typically, an analysis of the investment industry conflict will look to the remuneration structure of financial planners – but the issue is much broader than that. A quick example from my own experience might illustrate (ie. if I’m pointing a finger at anyone, it is at myself).
Let’s take a look at valuation. An investment banker when structuring a new investment offering looks to relative prices to determine valuations. The thing that really matters is whether this investment compares favourably to the rest of the market. Any such valuation is based on my expectations for earnings and how the market will price those earnings into the future. Remember I get paid to sell you this investment, not to make sure it performs according to my forecasts.
Now we could similarly look at how funds management is a relative business, or how independent research companies are compromised by their remuneration structures, the point is that there are few mechanisms that promote the alignment of participants with the interests of investors.
So how can information technologies assist? In short, through promoting accountability and by enabling the establishment of a truly aligned research and analysis model.
Make information more freely available
In an age where data is mobile at negligible cost, there should be no material impediment to allowing market data to move freely. We should be able to analyse flows as well as price and integrate analysis of economic data and other variables with relative ease.
In short, there is a public good to ensuring information is made widely available to all. It is one way that artificial distortions in price can be addressed. The extraction of monopoly profits for ‘ownership’ of such market information is clear evidence of undue influence by established interests. This is the simplest conflict of interest that can be addressed.
Encourage people to become more independent
Communication technologies are leading to a rapid evolution in the approach to education through online resources. The increasing sophistication of video tutorials and interactive real-world examples opens the way for real alternatives to be developed that will enable those that have the desire to increase their expertise when it comes to the finance sector. This is another way of promoting greater accountability.
Encourage truly independent analysis
Cheaper and more efficient communication can also assist by establishing alternatives for accessing research and analysis from within the current investment industry structure. Social media technologies offer the scale for more ‘aligned’ solutions to become viable. For example, there is the opportunity to establish an alternative research and analysis model that is not subject to conflicts because it is not reliant on income from those that sell goods and services for its survival. For those investors that require assistance, there is at least one truly independent source of research and analysis.
The emergence of product-comparison and swarm-purchasing-power sites is but the start of a move towards shifting more power to the consumer. As the technological blow torch gets applied to more information based industries, the likelihood is that those that rely on the current industry structure to protect their franchises will be challenged. I’m hoping the initiative we are working on will be part of the new landscape…
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