The Emperor Wears No Clothes, Part 6: The Customer is Always Right?
Although I have questioned many fundamental aspects of the investment industry, it is only fair to point out that many investor problems are self-inflicted. Often, the industry simply reacts to customer demands, giving you what you want but not necessarily what you need or what is right for you. So here’s a short list of just a few of investors’ contributions to shortcomings in the investment world.
Let’s start with performance chasing. To some people, savvy investing means identifying hot managers, mutual funds, stocks, or asset classes. Unfortunately, numerous studies suggest that they are doomed to failure. One reason is the notion of “reversion to the mean.” Things tend to operate in cycles. If something has outperformed for a period of time (e.g., it’s been hot), the pendulum is increasingly likely to swing back the other way, at least to the equilibrium point if not beyond.
Unfortunately, the media abet performance chasers by ballyhooing recent hot performers. Investment product manufacturers pile on by peddling more of what customers want to buy. Greed causes more investors to jump on the bandwagon without considering whether it is careening out of control.
When the reversal comes, customers yield to fear and jump off at the worst time. The classic example is the boom-time investors in 2000 that rode the market down and then got out entirely, only to miss the subsequent rebound.
The best investors have the fortitude to put money in things that are out of favor (when prices are low) and take money out of things that are hot (when prices are high). But it sure is difficult psychologically and most don’t do it. In a previous column I pointed out some shortcomings with rebalancing, but it at least forces you to add to asset classes when their value is down and take out when the value is up—but only when the customer doesn’t get in the way and prevent it either out of fear or greed.
Market cycles tend to be longer than customers’ patience. Investors too often select a manager only to abandon him after a short period of underperformance. The manager may be sticking with his investment discipline, but the market swings the wrong way temporarily and you abandon him just before the market swings back in favor of that discipline. (Conversely, I do see customers inexplicably willing to stick with managers who have a demonstrated, long-term record of failure.)
Customers also take risks for which they are not adequately compensated. One example is failure to diversify. The market does not compensate you for putting too many eggs in one basket. “Single stock risk”—putting too much money in a single stock—is a common example. Corollaries include concentrations in an investment style, industry, or asset class.
Then we have the common assumption that a big-name service provider has the best products and services and is the safest place to entrust your hard-earned money. Most customers fail to consider the possibility that brand panache may have more to do with great marketing and salesmen than great performance or safety.
Another problem is investors who obsess on expenses, rather than after-expense returns. Your focus should be on risk-adjusted returns net of expenses. There is nothing wrong with paying more if you have reason to expect higher returns, better service and/or less risk. I’m not advocating overpaying, but the cheapest service provider won’t necessarily generate the best net results.
So one of the industry’s biggest problems is you, the customer. Frankly, the customer is not always right. In some ways, perhaps one of the industry’s primary failings is its lack of willingness to stand up against your weaknesses.
Ross Nager is Senior Managing
Director of Sentinel Trust Company of
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