Monday, November 09, 2009

Why finance professionals earn so much...for knowing so little

About five years ago I applied for a job as a financial advisor with a large, reputable financial services firm. I have a strong aptitude for math and a strong background in customer service, so I thought this would be a good fit for me personally as well as highly lucrative. I made it through a couple rounds of the process, but was confused by one thing: nobody seemed the least bit interested that I had no background in finance. While I felt confident that I could learn this field quickly, I didn't understand why I was never asked to provide all the answers I had prepared to justify my suitability for this position without a finance background. I finally asked an interviewer how I was supposed to provide the services I was selling when I had little formal background and the training period was only about a month.

His response: you don't need to know anything. We'll provide you the basics to sound informed. You just have to project confidence and sell the product. Once you pick up clients and have money to play with, you'll figure it out as you go along.

I couldn't handle the ethical implications of selling myself as a "professional" or "expert" so I could get other people's money to play with and figure things out. It's too bad, I might have made a lot of money. Instead, I decided to take my interest in economic and financial issues and pursue a career that seemed more genuine. I chose accounting.

Interestingly, as I was recently reading Nassim Taleb's "Black Swan", I came across a chapter on the "expert problem". Basically, some fields have true experts and some don't. Some "experts" have a lot of facts, but don't have a genuine understanding that translates into better results than what a non-expert would get through simple chance. Other experts (think surgeons, farmers, engineers) are genuine experts who will consistently deliver results far more useful and accurate than a non-expert could produce. Taleb confirmed my impressions of financial advisors and accountants by putting financial advisors squarely in the "expert" category, and accountants in the expert category. There's plenty of empirical evidence to back this up, of course...80% of mutual fund managers aren't able to beat average market returns; in the years prior to the (now obvious) meltdown of securities, most advisors were recommending buy-and-hold for stocks, and buying as much home as you can finance; just to name a couple of the more obvious examples.

So the question is, why are financial advisors and analysts and others in the "expert" category compensated so much better than accountants and others in the expert category? Why do the people who are unable to demonstrate any level of skill beyond what's easily explainable by pure chance demand so much more compensation than the people who can actually explain what they're doing and why and how it works?

And recently I realized why there is a disparity. And it's precisely because accountants practice a consistent method while financial advisors practice alchemy.

One of the pitfalls of the human brain (Taleb, among many others, discusses this at length) is our weakness for the narrative fallacy. We want a theory, a story, a narrative to explain every phenomenon. Even when the best theories are proven wrong over and over again, if nobody suggests anything better, we will assume the best narratives are accurate (even when proven wrong) until something better comes along. We are unable to simply accept that sometimes the only correct answer is, "Nobody knows."

In accounting, the best practices are known and have been understood and refined for many centuries. As a result, these practices have become broadly taught and can be practiced very systematically. Therefore, many people have been trained to be accountants, and they nearly all deliver consistent results.

In finance, the best practices are unknown. There is no proven strategy that has consistently been proven to perform better than average (of course, such a strategy is impossible, but that's another discussion). As a result, everybody comes in with their various ideas and narratives about how the market works. Through sheer luck, some will wind up doing much better than average. However, because of our human tendency to see order where there is none, we will attribute this success not to luck of the draw, but the accuracy of the person's methods and ideas. Over time, most will experience runs of bad luck as well as good, but a small number, by sheer luck, will have a long run of success. If humans were rational, we would see these "successful" stockbrokers, advisors, and analysts for what they are: lucky. But instead, we believe there must be an explanation behind their string of luck, it must be because they are extremely talented. And because this "talent" is so rare (runs of good luck are rare things, after all), the market is willing to pay extraordinary prices for this rare "talent".

Of course, to somebody considering whether to go into accounting or finance, the decision is easy if you only look at top salaries (or even average salaries for those who've been in the field for many years since, after all, only those who remain relatively lucky overall stay in the field). However, if you average in all of those who have "failed" at finance by being unlucky, and therefore left the field altogether, the picture might be very different. Either way, the wisdom of entering one field or the other ultimately boils down to one characteristic more than any other: luck.

Just goes to prove the old adage: It's better to be lucky than good.


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