Let’s do a simple thought experiment. Say, I am a hotshot fund manager that is known to have spotted many multibaggers in the past. And say, I stumble upon a stock that is definitely going to go up 10 X in 5 years. Death, Taxes and this stock going up 10 X are the only certainties in life.

Since I am 100% sure, I would invest all my money and borrow some more to invest in this stock idea. If I can borrow at 10% but generate 60%, nothing like it, right?

And you are a prospective client that is looking to invest and earn a good rate of return. Your next best option is to invest with that other fund manager who promises you a 25% y-o-y return. (FYI: At 25% annualized returns, your returns are 3 X over 5 years, at 30%, it’s 3.7 X and at 60% it is 10 X .)

Both you and I are rational and greedy.

Given the above premise, what would I do and why? Before you answer, think about rationality, incentives and opportunity cost.

Do you think I would invest your money in the same stock, so that you too can get 10 X returns in exchange for my regular fees?

Or, would I invest your money in the same stock idea, but structure my fees such that I take 63% of the profits? That is, if the stock goes up 10 X, you get to keep 3.7 X and I get to keep 6.3 X.

Why am I likely to go with the second option?

A. Incentives. I earn more in the second option than in the first. So my actions are going to be aligned with where my incentives lie. Remember what Charlie Munger said — “Show me the incentives and I will show you the outcome”.

B. Opportunity Cost. The unfair deal gives your 3.7 X whereas your next best option gives you only 3 X returns. So I would want to structure the deal such that I beat the next best option, but only by the smallest margin that would make you invest with me. Why would I want to part with any more than that? Reminds me of the guy below who said —

“If you’re good at something, don’t do it for free”

C. Rationality. If you let you emotions get in the way, you will end up with what seems like a fair deal on paper, but one that will give you inferior returns. On the other hand, if you keep aside your emotions and think rationally, you will see that my deal is actually better for you and hence you should take it.

Remember we started with a few assumptions. That you and I are rational. And I am 100% sure of this outcome. In reality all of these assumptions don’t hold good.

Don’t pay too much attention to what your stock adviser is saying. Even the advisers that come on TV. If they were so sure of their stock tips themselves, they wouldn’t give it away, would they? Probably the ones they give out are the ones they aren’t sure of themselves.