Pavlov’s Brokers

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Recently, I noticed a Tweet from Josh Brown (like me, a Reformed Broker) and a follow-on note from Dan Egan, who I had the pleasure of working with in the past at a brokerage firm (maybe he should be called the Reformed Behaviorist).

Both focused on how incentives and stimuli can influence investor behavior.

It got me thinking about a post I wrote a while ago that links these thoughts to the Nobel Prize winning physiologist Ivan Pavlov.  The following is a summary of what I called, “Pavlov’s Brokers?”  This time I took out the question mark.

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, hence the picture at the top of this piece.

During his work, Pavlov learned that dogs salivate when presented with food. 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.

Pavlov produced a learned – or conditioned – connection between an environmental event previously unconnected to a reflex (the bell) and a reflex (salivation).

His work was instrumental to our early understanding of learning and how conditioning drives a great deal of behavior. Information that sales and marketing professionals have known for decades, and still use daily.

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. What product pops into your head along with a warm “Awww, cute” feeling?

Budweiser: The King of Beers. Classical conditioning at its finest.

On Wall Street, conditioning can often be found in advertising, marketing and sales presentations.  Heck, some photographers have probably made careers out of supplying investment firms with emotional images of sail boats, couples holding hands on beaches and grandparents with their families. This, however, is for another day.

Back to the title of this piece, brokerage firms (now often called Wealth Managers – titles can influence decisions as well) are also very adept at conditioning broker behavior.

Commission-based compensation systems are the foundation: a simple reward system in which every time you sell, you then 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 in the past, some brokerage firms literally rang a brass bell every time they made a sale, enhancing the already powerful impact of earning sales commissions with powerful emotional feedback in the form of public recognition as top dog.

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’ve made so much money that they acknowledge they don’t need it any 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.

A question that more are asking these days is the following:

How does this emotional conditioning impact the best interests, or not, of investors?

I have some strong feelings about this (for more click here), but for now I’ll simply repeat this important phrase: Caveat Investor or investor beware.

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.” I wrote about this in another post, Talking Heads where you can find quotes from what I call the “Honest Asset Management CEO” and “Honest Global Chief Investment Officer.”

The stimulus, however, that made me originally write this piece was a study done by the Ontario Securities Commission (“OSC”).  It didn’t get much attention in the United States, which is a shame.  It provides excellent insights into the adverse effects of commission-based broker compensation systems.

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, TBG’s research is impressive. Their disclosures are comprehensive and even discuss their own potential biases. They offer both sides of the argument, and back up their findings with solid 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.

  • Advisors push investors into risker funds.

  • Funds paying more to brokers realize lower returns than comparable funds that pay less.

  • It is incontrovertible that compensation affects fund flows (yes, many funds are not bought, they are sold).

At the bottom of this post, I have listed a link to the full study and other research that TBG used to reach their conclusions. Many of the titles tell stories unto themselves.

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 TBG’s research shows, however, these systems don’t seem to be producing the best outcomes for investors. In addition, their findings back-up my real-life experiences. The intensity fostered environment of some investment firms and how it conditions wealth advisors (no one calls brokers “brokers” anymore) plays a role.  And remember, the fancier the title the broker has been given as a reward, the better conditioned salesperson they’ve proven themselves to be (click here for more on this from my friend Blair duQuesnay).

Bottom-line, the next time you hear an exciting investment pitch, indeed beware:

The things that your impressively titled 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.


TBG Study and References:

“Mutual Fund Fee Research – The Brondesbury Group”

Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry

Mutual Fund Performance and the Incentive to Generate Alpha

“What do Consumers’ Fund Flows Maximize? Evidence from Their Brokers’ Incentives”

Potential Conflicts of Interest in Mutual Funds

Violations of the Law of One Fee in the Mutual Fund Industry

Out of Sight, Out of Mind: The Effects on Expenses on Mutual Fund Flows

The Many Faces of Mutual Fund Revenue Sharing


Preston McSwain is a Managing Partner and Founder of Fiduciary Wealth Partners, an SEC registered investment advisor committed to forming fiduciary wealth partnerships with clients, professional colleagues, and the community. To see more of his posts, and follow him on social media, please visit the following:

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