Uncertainty and the ‘Best Interest’ Standard

On a recent episode of Last Week Tonight, comedian John Oliver made the stuffy topic of financial advisors’ fiduciary duty to their clients both entertaining and informative. To be sure, his analysis skims many of the important nuances of the debate over the fiduciary standard in favour of comic effect. Nonetheless, the point is loud and clear: regulatory changes are needed to mitigate the conflicts of interest between incentives for financial advisors and the financial well-being of their clients. 

In the United States, it is estimated that these conflicts of interest cost investors $17 billion each year in the form of fees and other kickbacks paid to financial advisors. Until the new Department of Labour rules come into full force, it is legal for some financial advisors to recommend high-commission products to their clients, even if these products are not in their clients’ best interest. Add to this the lack of financial literacy among the general population, and it is clear that the average financial consumer requires greater protections.  For example, researchers find that financial advisors encourage their clients to take high degree of risk, while failing to provide customized advice despite charging their clients high fees. And fees eat up a significant portion of an investor’s returns. 

Under the new ‘best interest’ standard, most financial advisors in the US will be considered fiduciaries of their clients. This means that advisors have a legal obligation to make investment decisions in their clients’ best interests. Fiduciary duty involves a higher standard of responsibility than what is provided to a client through a contract.

It seems hardly surprising that some are advocating for this same legal concept to be applied to Canadian wealth advisors. According to Morningstar, Canadian mutual funds have some of the highest fees in the world, and pervasive conflicts of interest in the Canadian wealth advisory industry are widely documented.

But the most recent round of Canadian Securities Administration consultations reveals a nation divided, with regulators in Ontario and New Brunswick both in favour of the principle and Alberta, Manitoba, Quebec and Nova Scotia expressing strong reservations. British Columbia is outright opposed to the adoption of a fiduciary standard. 

Among the regulators that support the adoption of a best interest standard, it is argued that requiring advisors to make decisions that are consistent with the best interests of the client is necessary under conditions of uncertainty. A fiduciary standard can “guide registrants in addressing situations not covered by a specific rule.” 

Interestingly, the same appeal to uncertainty is used by those regulators that oppose the adoption of a best interest standard: The British Columbia Securities Commission is concerned that “the introduction of a regulatory best interest standard over and above the proposed targeted reforms is vague and unclear and will create uncertainty for registrants.” Their point is that the relationship between clients and their financial advisors is often complex. Consider the following example:  “Would an advisor have a fiduciary obligation to disclose to his or her client that a competing advisor offers the same services at a lower cost?” 

So which is it? Does fiduciary duty serve to guide financial advisors’ in an uncertain environment, or does the best interest standard contribute to creating uncertainty for these same advisors? It is probably a little of both. But the more relevant question is who is better able to manage uncertainty?

In the absence of a fiduciary standard, financial consumers will continue to make important decisions about their personal wealth in a cloud of uncertainty. To be sure, disclosure and transparency rules are an important step in the right direction. But these rules are not sufficient. This is because many financial consumers do not have the competencies to make use of this information to make better decisions. Moreover, studies suggest that the average consumer is unable to determine the extent to which advisors are offering them biased advice

Adopting a fiduciary standard means shifting the uncertainty burden from the (mostly) financially illiterate consumers to the financially savvy advisory industry, which is arguably better equipped to manage uncertainty. And at this point it is important to recall that the goal of regulators is to protect consumers, and not to protect the business model of the wealth advisory industry. 

At the heart of this debate then is the question of whether the fiduciary standard would have adverse impacts for financial advisors that would be passed down to their clients. 

One way that these unintended and negative impacts of fiduciary standard could be passed down is by increasing advisors’ compliance costs. It is frequently argued that a best interest standard would significantly increase monitoring and operational costs to ensure compliance. Compliance costs would create a less efficient market structure, where only the largest advisory firms would be able to stay in the market. The end result, it is argued, is that advisors would no longer find it financially viable to serve less wealthy clients, thereby cutting off their access to financial services.   

There are several reasons to be skeptical of these claims. A study of the US market for financial advice finds that despite the difference in adoption of fiduciary standards across states, there was no significant difference in competitiveness of advisory firms, nor does fiduciary standard prevent access to less wealthy clients to financial advice.  In other words, there is no evidence that the fiduciary standard leads to negative impacts for advisors or their clients.  Some advisory firms are even voluntarily adopting the fiduciary standard. And as financial consumer advocate Elizabeth Warren unabashedly points out, some of the most vocal critics of the standard contradict themselves in statements to their shareholders by claiming that fiduciary duty does not present significant challenges to their business model.

Another concern often raised by its critics is that fiduciary duty would adversely impact clients by contributing to a false set of expectations. In a brief summarizing the CSA consultations, it is noted that “clients may expect that all registrants have an unqualified duty to act in their best interest, not understanding that some conflicts would still be permitted.” The brief goes on to note that “it is not possible to require a salesperson of proprietary products only to act in a manner that is truly in an investor’s best interest.”

But this criticism makes forcibly the case for why a fiduciary standard is necessary in the first place; financial advisors should not be regarded as salespersons. We trust our financial advisors with our plans for retirement, our children’s education and our first house. Buying a mutual fund is not the same as buying a vacuum. We share with advisors our most intimate dreams and hopes for the future and we trust our advisors to guide us through a complex set of decisions in order to make them a reality.  Financial advisors must be strongly encouraged to regard themselves as stewards of their clients wealth and aspirations, and not as salespersons. 

Future posts will consider the ways in which financial advisors acting as stewards can add value for their clients and the implications of adopting a fiduciary standard for the availability of socially responsible and impact investment products. 



For an excellent review of literature on the topic, see Punko, N. (2015). Should Canada’s Financial Advisors be Held to a Fiduciary Standard?


Poetry and Finance

For most people poetry and finance reflect two intellectual extremes. The former represents the evocative use of symbols and aesthetics to express layers of meaning. The latter represents the scientific use of symbols and technology to express convergence of meaning.

In this post I argue that financial decision-makers have a lot to learn from poets. In particular, investors can improve their decision-making by drawing attention to the layers of meaning and the problems and opportunities of interpretation in finance.

Poetry is celebrated for its layers of meaning and the challenges it poses for interpretation. As with any discipline, there are competing schools of thought about what counts as knowledge.

For some literary scholars, interpretation problems can be resolved through the common sense approach of deferring to the author’s intentions. So when faced with with a confusing and abstract verse, students of poetry are advised to think about the author’s context and intention in order to make sense of the prose. There is only one ‘right’ way to interpret the poem.

Other scholars reject the author-as-authority thesis. In particular, the new criticism tradition emphasizes the importance of focusing on the text and ignoring historical context and the intentions of the author. This view invites a significant degree of scepticism into poetry reading. What one verse means to you may mean something very different to me, and that is ok. There are several ‘right’ ways to interpret the poem.

Somewhere in between the common sense view and the sceptical view lies ambiguity. Ambiguity allows the poet to elicit the reader’s imagination and to communicate complex ideas and tacit knowledge. Ambiguity in a poem is not meant to be resolved. Nevertheless, “ambiguity is not satisfying in itself, nor is it considered as a device on its own, a thing to be attempted. It must in each case arise from and be justified by the peculiar requirements of the situation”.[1] There is no right answer, but this does not mean that everyone’s interpretation is right. There are limits to what counts as a reasonable interpretation, but there is still room for different interpretations.

Consider the famous poem by Robert Frost, the Road Not Taken. The poem is most often interpreted as a reflection of our desire to attribute meaning to our actions. Frost is celebrating non-conformist values associated with forging one’s own path.

Two roads diverged in a wood, and I –

I took the one less traveled by,

And that made all the difference.

While uncertain about what lies ahead on both paths, the traveller is guided to the one right answer by appealing to the value of taking the path less travelled.

A closer and less appreciated reading of the poem reveals there was no right answer. The evidence for which path was least travelled was ambiguous. Consider the verses below.

And both that morning equally lay

In leaves no step had trodden black.

Though as for that the passing there

Had worn them really about the same,

The traveller had to invent a reason to justify her choice to herself and to others after her choice was made. This second interpretation of the poem evokes a dramatically different sentiment than the first interpretation. Rather than a celebration of non-conformity, this second interpretation evokes a godless sense of having to choose without some underlying value to guide us. The use of ambiguity over the relative worness of the two roads allows the poet to communicate this deeper layer of meaning; that is, the irreconcilable conflict between our desire to attribute meaning to our actions and our sheer lack of ability to do so.

A student of finance might be tempted to suggest the traveller could improve her position of uncertainty to one of risk by gathering more information. The traveller might survey other travellers to learn about the relative worness of the two roads. But reducing uncertainty is not the same as reducing ambiguity (indeterminacy). This new information might make the traveller less uncertain about how worn the two roads are. But the new information would still not help the traveller determine which road to choose. This is because the traveller lacks a guiding value for choosing a road in first instance.

It is only after the traveller is recounting her tale to friends that the value of non-conformity is adopted. By attempting to resolve uncertainty and ambiguity (indeterminacy) into one, we overlook the confused state of mind that Frost is trying to convey. That is, by trying to resolve ambiguity, we overlook this interpretation of the poem. The question of which road to choose is an ambiguous one; that is, there is no right answer. But we still must choose. And that is the point.

Questions of this nature fall into a category that conventional finance theory has deemed irrelevant. That is, a question that has no right answer is not worthy of scientific inquiry.[2] For example, what does it mean to be an ethical investor in public equities? What distinguishes a long-term investment from a short-term investment? How can investors manage risks of climate change when fossil fuels are deeply integrated into modern life? How do investors distinguish an impact investment from a conventional investment when the counterfactual (e.g., not making the investment) cannot ever be known?

These questions have no right answers. But these are precisely the type of questions that institutional investors are confronted with in increasingly complex and interdependent global financial markets. It is only by staying with the indeterminacy – by acknowledging the layers of meaning – that investors can make sense of these questions and chart a meaningful way forward.

[1] William Emspon (1947:235) Seven Types of Ambiguity, New Directions: New York.

[2] Fraser Sampson, G. (2014) The Pillars of Finance. Palgrave.

The Perception of Certainty

“The demand for certainty is one which is natural to man, but is nevertheless an intellectual vice.” – Bertrand Russell

Sustainability issues present multiple and often conflicting problems for firms and investors. Environmental, financial and social issues interact across different time horizons, geographies and logics and it is possible to interpret their significance in multiple different ways. It is increasingly accepted that managing successfully in this environment requires professionals to have a high degree of ambiguity tolerance. Indeed, ambiguity tolerance among business leaders has been correlated with positive outcomes including improved financial and market performance and an increased willingness to take risks, break with routines and devise innovative solutions by resisting the temptation to choose between the choices that are given to them.

Despite the widely appreciated benefits of ambiguity tolerance, empirical research suggests that in general, decision-makers are poor at remaining open to alternative interpretations of the same information. Sometimes, our attempt to resolve ambiguity is a conscious process. We intentionally close off our interpretation process by looking to convention, norms and standards to guide us to the right answer. In other instances, we may not even realize that we are trying to resolve ambiguity. We may unintentionally fixate on a particular interpretation, depending on our emotional state or the context in which the information is presented to us, and shut out other possible ways of seeing the same information.

Why do we seek certainty, even when we are aware that a belief in certainty is not good for us? Insights drawn from cognitive and brain science research often informs theories of how decision-makers process complex and ambiguous information.

Cognitive biases influence our decision-making in two ways. The first is by directly affecting the components that make up our decision-making frameworks, such as belief systems, values and judgment. The second is by affecting the inputs for decision-making; that is, by shaping our perception of external stimuli.

Perception is the process of identifying, organizing and interpreting sensory stimuli. Cognitive sciences explain how perception interacts with decision-making frameworks in complex ways. Insights from cognitive research are considered by conventional finance to be ‘soft science’ and reserved for those working on the margins of finance.

In contrast, conventional finance relies on brain sciences to form the core of its conception of human decision-making. While detailed expositions of neurological processes rarely appear in finance papers, the strictly physical system of processing information is almost always assumed. The brain receives signals from external sensory stimuli and assigns to them unambiguous meaning to inform the most appropriate or rational response. Beliefs are probabilities that are formed by observing frequencies of events. We can update our beliefs with new information (the facts) and we can enhance the confidence in our beliefs with repeated observations. Subjective and objective beliefs respond in the same way to new information. Individuals’ perception and emotion have no bearing on aggregate market outcomes.

A unique branch of cognitive and brain sciences study the way that humans process ambiguous information – that is, stimuli that induce multiple stable perceptions. The majority of this research focuses on visual stimuli. Most people will be familiar with the image below. Can you see the duck? Now what about the rabbit? Researchers have used these Gestalt images to understand what explains reversals in our perceptions of multi-stable sensory stimuli. That is, why do we switch between seeing the rabbit and the duck?

duckThe predominant view in the literature suggests visual sensory functions, referred to as lower-level processes (physiological structures in the brain), are responsible for changes in our perception. The ability to perceive multiple interpretations of the same image is the result of a process referred to as reciprocal inhibition. This process works to suppress all but one of the interpretations of an ambiguous image. Over time, the brain grows physically tired of suppressing one version and the balance in the sensory network reverses to bring into cognition the alternative interpretation. This is described as a random process.

The interaction between cognitive and brain sciences offers a richer explanation for why decision-makers tend to fixate on one interpretation and deny the possibility of other equally valid interpretations. In particular, some researchers conclude that it is the interaction of our higher-level functions – those cognitive functions responsible for processes such as analytical thought, belief and planning – with the lower-level sensory (physical) processes that allow us to alternate between interpretations of the same sensory stimulus. Put another way, the sensory area of the brain is guided and influenced by higher-level cognitive functions. Moreover, the process of reorganization in the brain that is required to alternate between different perceptions of a stimulus is itself an expression of behaviour. In this way, perception is not an automated and random response to sensory stimulus but rather, an active response that can be conditioned and controlled, to some extent.

What researchers find that we are poor at doing is to combine the alternative perceptions into a single hybrid image. While we may be capable of perceiving both the rabbit and the duck, we cannot see both at the same time. Our brain has one conceptual frame for a duck and another frame for a rabbit. Similarly, when presented with binocular rivalry, where each eye is shown one of two mutually incompatible images such as a letter and a number, participants were found to fixate on one of the stimuli and eliminate the other completely from consciousness.

This tendency to fixate on one interpretation at a time has been explained by the idea that the brain works in categories, concepts and analogies, colloquially described as ‘chunks’ by cognitive scientists. These chunks allow us to perceive information in a way that constitutes a complex but coherent system. Once we build up complex concepts into simple unified wholes, we lose sight of their internal components. Scholars often use the example of Wikipedia. We can convey this complex concept in a single word without having to think about its constituent parts, such as encyclopedia, networks, peer editing, publishing and computers.

Because we think in conceptual chunks, cognitive scientists believe that changes in our perception occur as a unified shift from one global concept to another. For example, when shown a series of sketches that progressively change from a dog to a cat, researchers were able to identify the point at which most participants switched from claiming to see a dog to claiming to see a cat. Similarly, when we move to a low interest environment, the conceptual edifice shifts with it (e.g., inflation, increased investment). We economize on thinking by using conceptual chunks to stand for a whole range of complex and interdependent concepts.

This difficulty in perceiving multiple stable stimuli is particularly relevant for finance. In finance we are not dealing with the multi-stability perception problems of the duck-rabbit variety. Financial data are complex, with many different inflection points that could lead to a change in perception. The ability to continuously alternate between different interpretations of the same sensory stimulus is necessary to ensure we are adopting the most robust interpretation, within a given context.

To be sure, it is important that at some point we close off the interpretive process and act. This process of closing off allows us to respond to the situation. If we did not close off, it would be impossible to act. But the notion of a single ‘best’ interpretation in a complex and ambiguous decision environment is elusive. We must balance openness with the need to periodically close off the interpretation process in order to act, only to open back up again once decision is taken to alternative subsequent decisions.

While this is by no means a comprehensive review of the cognitive and neuroscience literature, the point is to highlight the scientific basis for explaining how perceptual changes occur when decision makers are presented with ambiguous stimuli. Perceptual change is increasingly understood to be the result of the interaction between cognitive and brain processes. The interaction between cognitive processes in the mind and the physical sensory processes in the brain is a promising area for new research in the decision sciences and its applications for complex sustainability problems.