Practical analysis for investment professionals
29 June 2020

Create Trust!

Susan Spinner, CFA, recently interviewed Rhodri Preece, CFA, about “Earning Investors’ Trust,” the new study from CFA Institute.

For a long time, many financial sector actors believed in a truncated interpretation of Adam Smith’s insight that the pursuit of personal gain promotes the common good. However, after the global financial crisis (GFC), this mindset is no longer tenable. If it ever was.

The World of Adam Smith

“It is not the charity of the butcher, brewer or baker that makes us expect our dinner, but that they seek their own advantage,” Smith observes in The Prosperity of Nations.

Although the book is a classic of liberal economics, the author wrote it as a work of moral philosophy. Smith sought to show that the common good is better served when each member of society pursues their own goals rather than common ones set by a planning body.

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Smith lived in a fairly manageable world compared to ours. First, it was easier to assess the goods produced under the division of labor and traded on the market. Their quality could be checked at the time of purchase: The buyer could see, smell, and feel whether bread and meat were fresh or old and rotten. And second, Smith was guided by the conviction that our inherent sympathy for one another would set the standard for morally correct actions.

Of course, there was lying and cheating in Smith’s world, but the liar and cheat were understood to know that what they were doing was wrong. Smith therefore assumed that people were limited in the pursuit of their own goals not only by state laws and regulations, but also by moral standards and the social influence they exerted. The honorable merchant not only observed the laws, but also did not take advantage of their trading partners even when a skillful interpretation of the laws, without direct transgression, made it possible.

As a moral philosopher in a Christian social environment, Smith assumed the existence of honorable merchants.

The World of Today

In contrast, our current era is both more complex and more complicated than Smith’s. It is more complex because our goods are more diverse. Economists distinguish between three types: search, experience, and credence goods. With search goods, you know what you are getting before you buy them. For example, you try on clothes before purchasing them. Experience goods can be judged soon after purchase. You will know whether you like the wine you bought by the third sip.

But credence goods are much more difficult to judge. Whether the doctor provided the correct diagnosis and prescribed the proper therapy to deliver a cure is unknown. You must trust the doctor. Financial investments present a similar conundrum. For laypeople, financial markets are often a mystery, and whether they can trust a financial adviser is up to the stars.

And our world is more complicated, because as religious morality and close community ties fade, the empathy Smith expected can no longer be assumed. For where morality is politically defined, empathy reaches its limits.

While Smith justified the pursuit of self-interest based on a morality determined by mutual sympathy, today self-interest is mostly understood as the individual maximization of benefit without higher meaning and as an end unto itself. Where societal rules that originated through a commonly accepted moral doctrine are no longer binding, the possibility of individual utility maximization can become practically boundless.

After all, what prevents me from taking advantage of my business partner if it’s legally permissible? This question is particularly important with credence goods, because the buyer can only judge whether the seller has taken advantage some time after the transaction, sometimes long after, if ever. This makes taking legal action against fraud in the trade with credence goods very difficult.

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When Trust Is Lacking

Nobel Prize-winner George Akerlof describes what can happen when information about a product is “asymmetrically distributed,” when, for example, the seller knows much more than the buyer. Akerlof illustrates the dilemma through the used car trade.

A new automobile loses much of its value immediately after purchase. Why? Because used car buyers have a hard time assessing the car’s quality and value, Akerlof theorized. Since the automobile may very well be a “lemon,” the buyer sets their bid accordingly low. The seller knows much more about the car. If it is in good condition, they won’t want to sell it at a high discount. If it is a lemon, the low price offered might still be a good deal.

So Akerlof concluded that lemons displace quality cars in the used car market, and that many deals for good cars are never completed.

The same logic applies to financial investments. Who will the financial advice benefit, you or the adviser? If you don’t understand the products and mistrust the advice, you have no basis to judge and are better off staying away from financial investments altogether.

The financial industry and government officials have disregarded the standards of honorable merchants. When German state-owned companies — Volkswagen, Preussag, Veba, Deutsche Telekom — were privatized, politicians lured inexperienced savers into the cluster risk associated with investing in a single stock. They had honorable intentions but the consequences were severe.

As the dot-com bubble expanded, financial advisers sold technology stocks to inexperienced retail investors. And in the run-up to the subprime crisis, banks sold structured loans packaged as financial certificates to their ordinary customers. As a result, disappointed investors lost trust in the financial sector and withdrew from it. (Today, only 28% of German retail investors trust financial service providers. In developed countries, only in Canada are they trusted by more than half of retail investors, and there by just 51%.) This might be seen as a fair punishment for the financial services industry, if investors themselves were not also penalized.

In today’s world of zero and negative interest rates, people suffer financial losses when they leave their savings in bank accounts instead of investing in financial assets. And those lured into equity investments by rising markets but without trusted advice bail out in panic when markets fall.

The Future of Investment Management

How to Create Trust

Trust can be built if providers of credence goods are liable for the appropriate supply of the customer. By comparison, the provider’s reputation, increased competition, and government regulation are less effective.

But the liability principle cannot be applied to all credence goods. For example, the financial markets are too unpredictable to hold a financial adviser liable for the performance of their investment recommendations. For this reason, in markets for certain credence goods, the moral behavior of market participants should be prioritized and perhaps even made a prerequisite for entry.

In concrete terms, this means that the provider should act first and foremost in their customer’s interest — they should fulfill a fiduciary duty in finance. (The divergence of interests between customer and supplier is the “principal–agent problem.”)

This echoes the self-assessment of providers. In a survey of 1,716 financial advisers conducted by the Flossbach von Storch Research Institute, 99% felt that personal customer relations are “very important or essential” for creating trust. Personal closeness promotes mutual human “sympathy,” which underlies Smith’s expectation of ethical behavior, and it ensures respect for the interests of others. More than four in five (81%) of those surveyed said a provider’s ethical obligation was at least as important as minimum professional standards.

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A Hippocratic Oath for Financial Services Providers?

If, in the spirit of Adam Smith, financial service providers want to increase public utility while still pursuing their own benefit, they must strengthen trust in their services. To do this, they have to meet two conditions: They must demonstrate their professional competence and commit themselves to honest behavior.

The former can be acquired through appropriate training and proven by passing relevant examinations. There is a comprehensive range of public and private educational opportunities for this.

On the other hand, there is as yet no broadly accepted framework for a commitment to honest behavior. There is no equivalent to medicine’s Hippocratic Oath. Since state regulation cannot enforce honest behavior, either because action and effect are temporally separated or not clearly related, the financial sector itself must act.

It would be nice if every financial professional committed themselves to honest behavior like Smith’s honorable merchant. Of course, not everyone agrees on just how the honorable finance professional should behave, and some fear that if they act “honorably” and fail to “howl with the wolves,” they will put themselves at a disadvantage.

That’s why a framework for honest behavior in the financial sector, created by the financial industry itself, would be both useful and long overdue. Professional associations are best placed to drive this, so that ethical instructions and their monitoring are clearly distinct from industry and corporate interests. Furthermore, this structure should include an arbitration tribunal to which clients could turn if they believe they’ve been taken advantage of.

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No Business without Trust

The simplified reading of Adam Smith’s insight that the pursuit of personal gain promotes the common good has been abused by too many financial professionals. So long as it was within legal regulations and their resourceful interpretation, everything became permissible. If rules could be circumvented legally — “regulatory arbitrage” — doing so was “legitimate.”

The fictional corporate raider Gordon Gekko, played by Michael Douglas, summed up this attitude in Wall Street:

“The point is, ladies and gentlemen, that greed — for lack of a better word — is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all its forms — greed for life, for money, for love, knowledge — has marked the upward surge of mankind.”

Though it wasn’t the intention of the film’s director, Oliver Stone, the speech glorified and popularized blatant self-interest in the eyes of many moviegoers.

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Shortly after the worst of the GFC, Lloyd Blankfein, then head of the investment bank Goldman Sachs, even attributed higher morals to the pure pursuit of self-interest — for which his company stood:

“We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle . . . We have a social purpose . . . I am doing God’s work.”

What Gekko and Blankfein fail to acknowledge is that the pursuit of self-interest generally increases the common good only when it occurs within a rules framework that protects one party from exploitation by another. Where such rules cannot be formulated or compliance with them enforced because — as in the financial sector — action and effect diverge in time or cannot be clearly connected, ethical obligations, such as adhering to a professional code of conduct, must take their place. Absent this, the customer can be ripped off by the provider and will lose trust and withdraw from the sector.

Therefore, every financial services provider needs to know that without a commitment to honest behavior, there is no trust and thus no basis for their business. The obligation to act honestly and with competence must be the core of every financial service.

Those who do not comply with this obligation may be successful in the short term, but they will destroy their own credibility and future business in the long term and undermine all other market participants.

For more on this topic, don’t miss the CFA Institute study, “Earning Investors’ Trust,” and check out the Susan Spinner, CFA, interview with Rhodri Preece, CFA.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Satoshi-K

About the Author(s)
Susan Spinner, CFA

Susan Spinner, CFA, is the CEO of CFA Society Germany, the largest professional association for investment experts in Germany. To this role, she brings almost 25 years of experience in the investment industry, with a focus on international capital markets and portfolio management and analysis. In Germany, Spinner has worked in senior roles for various Commerzbank entities in Frankfurt, for the Landesbank in Hamburg, and for Dresdner Bank in Berlin. In addition, she was a Director for Global Financial Products for the Bank of Montreal in Chicago. Before assuming the role of Managing Director for CFA Society Germany, Spinner was a founding board member of the society in 2000. She conducts ethics trainings at various German universities and lectures at Goethe Business School for the master of finance class "Ethics in Finance.“

Thomas Mayer, PhD, CFA

Thomas Mayer, PhD, CFA, is founding director of the Flossbach von Storch Research Institute. Before this, he was chief economist of Deutsche Bank Group and head of DB Research. Mayer held positions at Goldman Sachs, Salomon Brothers, and before entering the private sector, at the International Monetary Fund (IMF) and the Kiel Institute. He received a doctorate in economics from Kiel University in 1982. Since 2003 and 2015, he is a CFA charterholder and honorary professor at University of Witten-Herdecke, respectively.

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