When I started on Wall Street, and for many years after that, brokers were subject to New York Stock Exchange Rule 405, otherwise called the “Know Your Customer” rule. This was a suitability rule intended to ensure that brokers would know their clientele well enough to make or recommend only investments that a “prudent person” would find appropriate for each particular customer.
The rule implied a fiduciary attitude, if not a legal responsibility, and my observation back then was that most stockbrokers and money managers did exhibit that attitude. Probably as a result, opinion surveys of the time showed that stockbrokers were among the most trusted members of their communities.
Today, “Brokers Are Trusted Less Than Uber Drivers,” headlines The Wall Street Journal (7/28/2015), and money managers can’t be too far behind. What has happened?
Know Your Crooks?
For one thing, there has been a steady and alarming decline of ethics in the financial profession; this has been amply chronicled in books and the media, and does not require further elaboration. But there also has been a significant dilution of the meaning of the phrase, “Know Your Customer,” and it is not far-fetched to think that, soon, the personnel in charge of implementing so-called KYC procedures will ignore, or have forgotten, the original intent of those initials.
In 2011 NYSE rule 405 was replaced by FINRA rules 2090 and 2111(1). Since the date coincided with an intensification of anti-money-laundering and counter-terrorism efforts, KYC procedures became overwhelmingly aimed at checking the legal background of new customers and at tracing suspect money flows.
Atypically for me, I actually find FINRA’s efforts to educate the industry on money-laundering practices through compulsory seminars quite useful. Most of the personnel in both front and back offices of financial institutions are relatively uneducated in these matters and somewhat naïve about them, while the perpetrators are very creative and constantly upgrading their schemes.
Nevertheless, there is a large disconnect between the bureaucratic procedures put in place to implement today’s KYC rules and the original notion of actually knowing one’s customer.
Know Your Categories
Under the new rules, there remains an obligation for brokers and investment advisers to recommend or purchase only investments that are suitable for their customers. Unfortunately, the market for financial advice has become so standardized and impersonal that knowledge of a client today falls far short of the close familiarity that “Knowing Your Customer” used to imply.
I find evidence of this in the questionnaires that major banks and investment-management organizations require new clients to complete. Now, the whole purpose of such questionnaires is to classify prospective clients into categories that can then be matched to a menu of products concocted by marketing departments.
Some institutions are using highly sophisticated methods to achieve this goal. For example, a major bank recently hired a cultural anthropologist to discover that wealthy people fall into categories such as the following:
Trillionaires, who see their money as a means to splurge on fabulous objects and experiences;
Coolionaires, who are in pursuit of sensory stylistic environments;
Realionaires, the thrifty "millionaire next door" types;
Wellionaires, who will spend freely to look good, feel healthy, and think positively; and
Willionaires, for whom wealth brings a responsibility to improve the world. (2)
I wonder if, armed with this precious knowledge, new-era financial advisors really expect to discover what investment products will make their clients not only prosperous (which presumably they already are), but also happy and fulfilled.
In fact, a professional coach to advisers targeting the high-net-worth market unwittingly illustrated the inherent contradiction in this aspect of today’s KYC philosophy by concluding that, “This approach to segmentation…provides a framework for working with clients – and selling them new products and services” (2) (my italics).
I stumbled onto another “Customer Investment Profile” questionnaire aimed at establishing a prospective customer’s general attitude toward investment risks. Respondents are classified into six “Risk Profiles” – Risk-Averse, Conservative, Moderate, Moderately Aggressive, Aggressive, and Very Aggressive – and are then offered “a range of investment products that fit your own classification.” But how many prospective customers really know how to classify themselves?
The customer does not always know best
Supermarket chain Stew Leonard’s is recognized as one of the companies providing the highest level of customer service. Stew’s mantra is etched in stone at the entrance to each of his stores. It states:
Rule #1 – The customer is always right.
Rule #2 – If the customer is ever wrong, reread rule #1. (3)
The intention is good, but as far as patrimonial matters are concerned, I beg to disagree. My experience is that most new clients define their financial goals in vague concepts like “making money but without taking too much risk.” Professor Dan Ariely has studied the way clients answer typical financial-industry questionnaires and comments: (4)
We asked people the same question that financial advisors ask: How much of your final salary will you need in retirement? The common answer was 75 percent. But when we asked how they came up with this figure, the most common refrain turned out to be that that’s what they thought they should answer. And when we probed further and asked where they got this advice, we found that most people heard this from the financial industry [a rule of thumb that they had heard from financial advisors]. You see the circularity and the inanity: Financial advisors are asking a question that their customers rely on them for the answer. So what’s the point of the question?!
We then took a different approach and instead asked people: How do you want to live in retirement? Where do you want to live? What activities do you want to engage in? And similar questions geared to assess the quality of life that people expected in retirement. We then took these answers and itemized them, pricing out their retirement based on the things that people said they’d want to do and have in their retirement. Using these calculations, we found that these people (who told us that they will need 75 percent of their salary) would actually need 135 percent of their final income to live in the way that they want to in retirement.
So we have an industry that asks one question it’s giving the answer to, and a second question that assumes that people can accurately describe their risk attitude (which they can’t)…
…Money, it turns out, is incredibly hard to reason about in a systematic and rational way (even for highly educated individuals). Risk is even harder. Financial advisors should be helping their clients with these tough decisions…. It’s possible that the best financial advisors already do help in this way, but the industry as a whole does not. It’s still centered on the rather facile service of balancing portfolios, probably because that’s a lot easier to do than to help someone understand what’s worthwhile and how to use their money to maximize their current and long-term happiness.
The necessary return of the Homme d’affaires
[Note: I have met some brilliant Femmes d’affaires, but for the purpose of this paper, political correctness yields to history, and I will use the original, masculine terminology.]
In a 2011 letter I lamented the near-extinction of the Homme d’affaires of the 19th and early-20th centuries, who has been supplanted by new marketing-oriented family offices whose main ambition is to be portfolio allocators gathering AUMs (Assets Under Management) rather than to become all-around confidants. (5) In a 2012 article, Andrew Nolan, of the Stonehage Family Office, announced “The return of the Homme d’affaires.” His title was more optimistic than mine, but the analysis just as critical. (6)
Nolan starts with a necessarily long, but very accurate, definition of the Homme d’affaires:
The Homme d’affaires was a true adviser with real wisdom drawn from deep and broad experience of the world, including business, investment, families, the law, and even philanthropy. The Homme d'affaires was thus a reliable and impartial sounding board for nearly every major decision his client had to take. This might range from business acquisitions and investment to succession and inheritance, from personal relationships to dealing with awkward situations such as divorces within the family…
…This does not mean that he would advise on the technical detail of every issue, but he would know enough to apply his experience, wisdom, and common sense to ensure the decisions made were not only based on sound technical advice [but also] on a proper understanding of the overall context.
Nolan’s article then makes a number of other relevant observations, from which I will extract a few in no particular order:
• It can be argued that the focus of the specialists has become so narrow that they are less able to appreciate the broader context in which they operate, or the relevance of their advice to the overall picture. Over the last 30 years, the remorseless trend towards specialization has caused us to overlook the generalist. This generalist is someone who pulls it all together, is able to look across all aspects of a situation and make judgments and recommendations that bring together the advice of all the specialists.
• In other words, it is now not just desirable, but increasingly essential, that all advice on major issues is channeled through someone who really understands the whole picture. Not only is this essential for proper coordination and risk-management; it can also help reduce costs as the sophisticated generalist can much better commission, coordinate, and evaluate the more detailed advice required from specialists.
• Private banks and wealth managers have for a long time been marketing the concept of a trusted adviser, but they have too often undermined their own promotional literature by fielding relationship managers who lack the experience or gravitas for the trusted adviser role – personnel who clearly are trained and motivated as salespeople rather than advisers.
• It is one thing to articulate a need and another to meet it. Partly because of the product-sales approach of many private banks and wealth managers, there is a massive shortage of people who genuinely merit the Homme d’affaires title.
KYC = Keep Your Customer
Over the years, I have observed that holding onto advisory clientele was more difficult than attracting new ones. But keeping clients on the basis of services rendered is much more rewarding on a personal level; in my experience it also constitutes a more sustainable business strategy than constantly luring new prospects with well-phrased promises.
We also should not forget that a large majority of private clients tend to stick with their advisers and not look elsewhere unless they become very dissatisfied – usually because of perceived inattention on the part of the adviser. Desirable new private clients therefore are rarely available.
On the other hand, it is not difficult to identify potential new private clients among individuals who are constantly chasing recent performance or popularity. But experts in behavioral finance often label such short-term-performance-chasers “dumb money” because they tend to lose money systematically over time – on mutual funds, for example, by buying high and selling low. These easy-to-find investors also tend to join advisers after these advisers’ periods of peak performance and just before periods of subpar returns, which means they are unlikely to become loyal clients. An adviser’s efforts are thus better spent on maximizing the quality of service to his or her existing clients.
In fact, I believe that the difference between luring new clients and keeping existing ones can be traced directly to the difference between the marketing of slogans and the constant exercise of thoughtful care and attentiveness.
Well-conceived and well-executed, a true “Know Your Customer” discipline should result in “Keep Your Customer” success.
January 19, 2016
This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.
1. NYSE: New York Stock Exchange; FINRA: Financial Industry Regulatory Authority
2. “Advisers Mine Clients' Personality Types” (The Wall Street Journal, 6/24/2006)
3. Michael Herz, Finance Professionals' Post, New York Society of Security Analysts (4/19/2010)
4. “Advisers ask the wrong questions”– Dan Ariely, professor of psychology and behavioral economics, Duke University (8/30/2011)
5. “Goodbye Family Office, Welcome Hommes d’affaires” – Tocqueville (2/20/2011)
6. Andrew Nolan in Australia’s FS Private Wealth (Vol.2, 2012)