How Lower Investment Costs Hurt Investors
When the price of a good or service goes down, it is almost always a good thing. We all love sales, myself included. Getting a “deal” on something can activate the dopamine receptors in our brain and give us a temporary high. Recently, there has been many new “deals” in the investment realm, from low cost advisory services to a reduction in online trading commissions. Let me explain how these could be bad for investors.
Personal Advisory Services
There are a few institutions that offer investment management, financial planning and access to a Certified Financial Planner professional for around 0.30%. That is a significant discount to the traditional advisor model where the cost may be closer to 1.00% – 1.25%. Money is flocking to these institutions because of great advertising and very low cost. But at what price?
If investors were rational, it would be a no brainer. But we know that all humans act irrationally (make errors in judgement and influenced by emotions). Let’s be honest – the #1 detractor from investor performance is the investor him/herself. In other words, it’s the choices made, not the fee of the program or underlying investment. There is ample evidence to back this up.
How do firms offer comprehensive services at such a discount? It’s called scale. And when you scale something, the personalization and individuality suffers. Sure you get a plan, but how robust is it? You have access to a CFP, but how many hundreds or thousands of people have been assigned to that same CFP? When things are going well it isn’t an issue, but when the inevitable shoe drops, will that advisor have the bandwidth to hold your hand, listen to your concerns and coach you along the way? Not if they have to do that for hundreds or thousands of others. Low prices are always better than high prices, when all else is equal. But in this case, all else is not equal – and therefore the adage of “you get what you pay for” should be considered.
A few major online brokerage firms recently dropped the cost of trading a stock or ETF. Again, this is generally a good thing. But whenever you drop the cost of anything, you promote its consumption. In this case, a low trading fee may result in more trades. And research has found a strong negative correlation between trading frequency and returns. Meaning the more often someone trades, the less they tend to earn. With fees so low, there is no need to consider the wisdom of the investment because you can always blow out of it for next to nothing.
If we were all rational this would be a great thing. Now, how would your behavior change on a $10,000 investment if instead of paying $5 to make the trade you had to pay $500? Odds are you would think very carefully before making the investment. You would also likely extend the holding time to several years rather than several days. In other words, you would view this decision as a long-term investment in a company rather than speculating on the price of a stock. And isn’t that what most investors claim to be – long term? Yet many of them end up watching the market constantly and speculating on prices.
The Take Away
I’m all about lower costs and getting the best bang for your buck. I write this blog to encourage investors to consider how economic incentives may change their behavior. In some cases, lower costs truly translate into less quality or a reduced personal service. In other cases, lower costs may promote overconsumption, leading to reduced returns. The main goal of investors should not be to reduce investment costs, it should be to maximize the investor’s return. And given that investor behavior has the greatest influence on investor return, it is something worth considering.