Pavlov's Brokers

Nobel Prize winning physiologist Ivan Pavlov is best remembered for his work on what psychologists call “classical conditioning”.

Classical conditioning refers to a learning process connecting a specific stimulus to a specific response.

While any number of responses to stimuli are innate (jumping in response to a loud noise, for example), Pavlov demonstrated that responses can also be learned, or conditioned.

Pavlov’s discoveries about classical conditioning centered on his experiments with dogs. During his work exploring the canine digestive system, Pavlov learned that dogs salivate when presented with food, a reflex that aids their digestion. Observing the animals in his lab, he noticed that the dogs also drooled when they saw a worker in a white lab coat. Ultimately, he realized that, because the dogs were fed by workers in white lab coats, they had come to associate white lab coats with food and they salivated in response. Interested to see whether he could induce the same reflex with another stimulus, Pavlov began ringing a bell before presenting dogs with food. Within a relatively short period of time, the dogs associated the ringing of the bell with the stimulus of food and began to salivate at the mere sound of the bell, even when Pavlov did not present the food. In this fashion, Pavlov produced a learned – or conditioned – connection between an environmental event previously unconnected to a reflex (the bell) and a reflex (salivation).

Pavlov’s work was instrumental to our early understanding of learning. Conditioning drives a great deal of behavior, a fact well known both on Madison Avenue and Wall Street. Commercial advertising, for example, is designed to train the recipient to connect positive feelings with a product. Think of a massive Clydesdale and an adventurous little Golden Retriever puppy striking up an unlikely friendship and what product pops into your head along with a warm “Awww, cute” feeling? Budwiser: The King of Beers. Classical conditioning at its finest.

On Wall Street, classical conditioning is evident in its advertising for sure, but equally in the conditioning of trader and broker behavior.

Commission-based compensation systems are the foundation: a simple reward system in which you sell and you make money. There’s nothing inherently wrong with these systems. It is important to understand what overlays them, though: the intentional fostering of a competitive, emotional environment for sales. A bell rings at the opening of the New York Stock Exchange and the competitive frenzy begins. “Ringing the bell” is a euphemism for making a sale because some brokerage firms literally used to ring a brass bell every time they made a sale, enhancing the already powerful impact of earning sales commissions with powerful emotional feedback from public approbation and victory over one’s peers.

The fostering of these strong emotional responses to sales can be so intense in the financial services world that they can even overtake the importance of commissions. I’ve known brokers who have made so much money that even they acknowledge they don’t need more – but they stay in the game because they are addicted to the sound of the bell or the sight of their names at the top of a league table.

Where does this emotional conditioning of brokers leave the best interests of the investor? Somewhere apart from the stimulus/response link at least. Wall Street knows that much about its bell-ringing commission culture should be changed, but as a senior executive once told me, “It’s very hard to get the commission needle out of our arm. It just makes us too much money and feels too good.”

The stimulus that made me start writing this post was a recent report by the Ontario Securities Commission (“OSC”) about the adverse effects of commission-based broker compensation systems on mutual fund investment performance.

Acting on behalf of the Canadian Securities Administrators, the OSC commissioned The Brondesbury Group (“TBG”) to review existing research on mutual fund compensation. While I won’t go into it in detail here, addicted as I am to good data, TBG’s research is impressive. Their disclosures are comprehensive (they discuss their own potential biases), they offer both sides of the argument, and they back up their findings with solid academic research.

Here are some of their conclusions:

  • Funds that pay commissions to brokers underperform compared to funds that do not have these expenses.
  • Funds sold in the broker channel (defined as commission-based) underperform direct channel funds (no commission) even before deducting any distribution-related expenses.
  • Research studies repeatedly find that commissions (load, 12b-1, etc.) and expenses are key drivers of relative fund performance. Quite simply, any payment that raises costs tends to lower return on investment.
  • Funds paying more to brokers realize lower returns than comparable funds that pay less.
  • It is incontrovertible that compensation affects fund flows. The literature on compensation and fund flow provides sufficient evidence to conclude that embedded commissions influence broker advice and, at times, that advice serves the interest of the broker and the product provider rather than the client.
  • At the bottom of this post I have listed links to some of the research that TBG used in reaching their conclusions. Many of the titles tell stories unto themselves.

    The existence of commission-based systems alone could be the source of the TBG findings, but I think conditioning in the industry is at least as much if not more of the issue. There’s nothing inherently wrong with the idea of products sold on commission, just as there’s nothing inherently wrong with the idea of commission-based compensation systems.

    As BTG’s research shows, however, these products and systems aren’t necessarily producing the best outcomes for investors and the intensity of the competitive environment in which they are being sold surely plays a role.

    So when you hear the next exciting investment pitch, remember that the things that your broker is excited about may have a lot more to do with Pavlov, and the ringing of the commission bell, than with your portfolio returns or peace of mind.