Do Licensing Regulations Work?
The Essentials of Risk and Reward
It is commonly accepted that professional licensing by State agencies will assure the public that practitioners are prepared to perform their duties responsibly. The premise is false, but it sounds good. By imposing standards of knowledge and ethical conduct, regulatory systems presume consumers are better protected from potential malpractice or incompetence. The presumption is not true, but it’s better than nothing, right?
If any of you have participated in dozens of continuing education (CE) courses that are conducted online and required by your compliance department, you know they are an exercise in checking the boxes. If any of you have participated in dozens of hours of CE seminars to fulfill state board certification mandates, you know they are an exercise in punching the clock.
Activity for the sake of activity is just that. But not for this blog. It is focused on proven investing principles. So, to apply the first paragraph to retail investment advisors, professional licensing begins with the Series 6 exam that governs the sale of mutual funds and variable annuities. And the Series 7 governs that plus the sale of stocks, bonds and option contracts.
In essence, the testing authorities reward memorization and disregard understanding in the same way that government mandated schools “educate” children - and for the same reason. Conformity.
In consideration of the hours of study needed for the rigorous Series 7 exam, the Introduction to The Moneyball Method states: “The presumption is the reader has knowledge and experience with the basics of common stocks, corporate and government bonds, money market funds, mutual funds, ETFs, REITs, and some alternative investments.” To a reasonable person, that describes all registered representatives. If there’s any doubt, the next sentence in my Introduction specifically includes them.
To test that theory, I created a series of open-ended questions and sat down with a Series 7 licensed advisor who represents a major independent firm. My intention was for the first four questions to be soft balls to warm up the conversation. The risk was these questions might offend a seasoned pro because of their simplicity:
Your clients pay you for investment strategy advice. What is the benefit of diversification?
What is the difference between stocks and bonds and how does that affect your recommendations?
Your clients pay you for fund manager selection. What are the top two features of a mutual fund and how does that affect your recommendations?
Your clients pay you for risk management advice. What are the top four investment risks and how do they affect your recommendations?
The questions come under the category of “practitioners are prepared to perform their duties responsibly” and a cogent answer to each of these four questions should not be a challenge. Of course, the top two mutual fund or ETF features and the top four investment risks may differ among skilled advisors, but the important thing is the principles that back up their priorities.
But what about you? What is the essential benefit of diversification, or difference between stocks and bonds, or the top two features of a mutual or ETF, or the top four risks to manage? Most simply, for the first three questions, respectively: the higher reward of efficiency, profit sharing vs. guarantees, and diversifiable risk mitigation plus liquidity. But only an objective investor can relate all of them to their strategy decisions. And for the last question, the answer will differ greatly among traditional, rate of return investors and objective, wealth investors.
Last year I was invited to meet with two independent, registered advisors who wanted to learn more about capital market assumptions (CMAs) and the best way to use them for random market simulations. That is a great sign, but before responding directly, I thought it was best to establish a baseline understanding of the nature of CMAs (median return, standard deviation, correlation) and the purpose of random simulations.
That understanding was needed because good theory is always good practice. Put another way, if it only sounds good in theory, it is not good theory. But the best advice comes from philosopher Ayn Rand: “Whenever you think you are facing a contradiction, check your premises.” Accordingly, the conversation included the following subjects:
The Efficient Market Hypothesis and the price mechanism
Modern Portfolio Theory and the Efficient Frontier
Capital market assumptions as defining attributes of asset classes
Capital market assumptions as potential assumption errors
The abuse of Median Return as a projection
Correlation as a tool for diversification
The relationship between Median Return and Standard Deviation
The reliability of long-term historical CMAs compared to any alternative
Rolling returns vs. calendar year returns
In the end, their knowledge of these subjects was weak and their willingness to change long-held beliefs about market forecasts and backward-looking performance was nil. As a result, they will not be able to calculate risk capacity for their clients.
More broadly, the point of this is to understand prices, to respect markets and to understand causality. Yet, we live in a culture that avoids precise definitions and disregards cause and effect. That perpetuates a mentality of the vague and the approximate. In turn, package deals of ideas that conflict with reality will find their way into every institution and every profession.
And when principles are replaced with pragmatism in the investment management profession, investors get conservative rate of return projections that demand more aggressive investment or cash flow strategies and risky diversification. Those are contradictions, but they became standardized as “best practices” thanks to regulation.
To learn more, please click https://www.amazon.com/Moneyball-Method-Middle-Class-Manifesto-Objective/dp/1696009111/