Views on improving the integrity of global capital markets
25 April 2013

Using the Asset Manager Code to Distinguish between Ethical Investment Advisers and Magicians

What do magicians and the black sheep among investment advisers have in common? Well, for the purpose of this blog, a lot. Both magicians and notorious investment advisers make their money by selling illusions. But how are these two groups different? In the case of the magician, you know that his magic is an illusion or a clever trick. Investors are less amused with investment advisers when their money disappears and fails to reappear.  As you will see, however, there is a way to make sure that you don’t fall for this trick.

Unlike in the magician’s line of work, the investment industry is heavily regulated, and there are several reasons why this is the case. These regulations protect individual investors from unethical advisers by limiting theirpotential to unlawfully benefit from the information advantage that they possess. An investor’s expectations may be exaggerated in the absence of appropriate knowledge and sufficient relevant information from the investment adviser. In contrast, there is no need to protect a magician from the audience (we all know that the lovely magician’s assistant is not really being cut in half, right?).

Magicians and investment advisers take vastly different approaches to safeguard their professions. A good magician never reveals his secrets. And while magicians withhold such information, investment advisers are expected to disclose all relevant information to their clients.

The issue of misrepresentation is also treated quite differently among these two professions. A magician earns credibility by  successfully creating false impressions through his tricks. This is not the case when an investor entrusts an investment adviser with his or her funds. In this case, misrepresentation is neither expected nor accepted.

There are quite a few similarities between magicians and irresponsible financial advisers, too. Both divert their customers’ attention, exploit human error, place emphasis on irrelevant aspects, and hide important facts.

Much literature exists on the research of human behavior and its impact on investment decisions. At the forefront of contemporary research is Glenn Klimek Professor of Finance Meir Statman, who wrote a book in which he advises his readers on how to improve their investment decisions by being aware of their own weaknesses. Statman’s book lists a number of human errors that individuals typically make in situations where they are about to make investment decisions, and he gives tips on how to overcome these cognitive errors. One example would be so-called hindsight error. Hindsight error is the belief that whatever happened was bound to happen, as if uncertainty and chance didn’t exist. An example Statman gives is that “if stock prices decline after a prolonged rise, it must be, as we have known all along, that ‘trees don’t grow to the sky’ and if stock prices continue to rise, it must be, as we have equally known all along, that ‘the trend is your friend.’”  The black sheep among investment advisers know very well how to exploit such errors.

Of course, not all investment advisers resort to tricks, and the vast majority are very ethical in their approach. But how can you distinguish between ethical and irresponsible advisers? One way is to make sure that the asset management firm you deal with has a culture in place that is characterized by a high degree of ethical behavior. One indication of this would be whether the firm formally claims compliance with a widely respected code of professional conduct, such as the Asset Manager Code of Professional Conduct. By voluntarily complying with the Asset Manager Code of Professional Conduct, the firm demonstrates its commitment to high standards of ethical and professional conduct. “Act in a professional and ethical manner at all times” is one of the general principles of this code. And in the context of asset management, this means that the investment advisers at such firms are not magicians.

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About the Author(s)
Alexander Flatscher, CFA

Alexander Flatscher, CFA, is a former director of professional standards at CFA Institute. He was responsible for promoting the ethical standards, policies, and positions of CFA Institute in the Asia-Pacific region.

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