Having just opened a Native American jewellery store in Arizona, the owner was having trouble selling some of her turquoise pieces. Despite the jewellery being high quality, and it being the peak of the tourist season, they just wouldn’t sell.
She’d priced the jewellery reasonably. She’d tried placing them in a central display location. She’d even asked her staff to “push” them.
Finally, she gave up. She was going to unload the pieces, even if it meant taking a loss. On her way out of town for a business trip, she dashed off a note to her head saleswoman – “Everything in this display case, price x ½.”
So it was no surprise when the owner arrived back at her shop to find that all the turquoise jewellery had sold. But what did surprise her was that they’d sold out not at half the price, but double the price. Her saleswoman had misread her hastily-scrawled note (reading the “½” as a “2”), and doubled the price of each piece rather than cutting it in half. Doubling the price meant they went from un-sellable to sold-out.
She’d solved her problem not by adhering to the textbook rules of micro-economics and lowering the price, but by accidentally appealing to her customers’ behavioural biases and raising it.
When it comes to deciding how much we should pay for something, we’re a long way from the perfectly rational homo economicus.
The tale of the jewellery store owner is the opening paragraph of Robert Cialdini’s superb book on the psychology of persuasion Influence. In this article, I’ll be looking at a few reasons why investors end up paying a high price for their investments, referencing Cialdini more than once. This article (and the next) will act as an introduction, setting the scene for a new series on why I favour passive investing over active – the first part of which will be on why paying less in fees is so important.
The following explanations for why investors end up paying a high price for their investments are based on my personal experiences working in investment management. Some demonstrate investors acting irrationally (like the jewellery store customers), and some explanations show investors paying up in a completely rational way.
I’ve said it before, and I’ll say it again. People always underestimate the importance of fees.
This is the first reason investors end up paying a high price for their investments.
A 2% fee sounds innocuous enough, and it’s easy to write off such a small number as having little effect on your portfolio – especially when you’re promised high returns which justify the fee. (See ‘The salesman’ section for why this is a bad reason to pay high fees.)
The chart below, taken from this post, shows £1 growing at 7% per year with fee levels varying from having no fees deducted, up to a 3% annual fee:
After 40 years, your £1 could be worth £15 if no fees are taken, or under £5 if a 3% fee is charged. And what’s even worse is that most of us will be investing for much longer than 40 years, assuming you start paying into a pension at 21 and remain invested for the rest of your life. Fees make a huge difference.
If we take a typical 2% annual fee, this 2% fee halves the value of the end portfolio after 40 years.
Fees really do matter.
One of the main reasons people underestimate their importance is the more general idea that compounding as a concept is often hugely underestimated.
I’ve written a whole post on compounding (here, for those interested), and you can see compounding in action by using this compound interest calculator (UK). But the short version of the story is that if you do something small enough for a very long time, it becomes enormous.
If you lift weights every day, you’ll end up with muscles like Arnie. If you eat healthily every day, you’ll end with a body like Joe Wicks. If you read every day you’ll end up with a brain like Charlie Munger.
The same goes for money. Invest a little every month and you’ll end up with a huge portfolio. But the inverse is also true. Pay a small amount from your portfolio every month and steady drip of fees destroys the value of your portfolio.
People tend to underestimate the power of compounding because nobody teaches us about it. The exponential function is rarely focussed on in schools, and almost never explained in terms of investing. By the end of university, most students will have forgotten their school maths lessons anyway. When we first start employment and are given the option to contribute to a pension scheme, there’s often no training on the benefits of investing, how to invest, risk tolerance, or anything in the way of guidance. It is hardly surprising that financial literacy levels in the UK are so low.
A second reason we don’t fully take advantage of compounding is that it’s not intuitive. Working out 6+6+6+6 in your head is easy, but 6x6x6x6 is almost impossible. Our brains are naturally wired to think in terms of linear progression, but struggle when confronted with exponential growth. Physicist Albert Bartlett noted that “The greatest shortcoming of the human race is our inability to understand the exponential function”.
Paying for a relationship
A second reason why people pay a high price for their investments is they value the relationships that come with a more expensive investment portfolio.
If you want a human being on the end of the telephone who you can ring up and ask about the markets, or chat about stocks, or ask to withdraw some money from your portfolio, then that’s going to cost more. If you place a value on receiving a higher level of service – aware that better service does nothing to improve your portfolio’s returns – then that’s a rational reason for paying a premium for your investments.
It’s not something I’d ever advocate paying percentage-based fees for, as the cost of relationship management over the course of an investing lifetime can be astronomical. We’ve already seen one chart on the effect of fees, and here’s another one:
A 1% fee means a 31% lower final portfolio value, a 2% fee means a 53% lower value, and a 3% fee means a 68% lower portfolio value.
For an increasing number of investors, especially younger/new investors, relationship management is a hangover from the days of their parents, and there will be no human contact in their investing journey at all. Technology has evolved to the point where setting up an investment account can be done easily and painlessly online and via investing apps, with no need to ever pick up the phone to a human being. Customer service is improving so quickly that any problems can now be resolved through a company’s instant messaging service, or quick-response emails.
As a result, investors are happy as they have a broader array of services to choose from all over the internet, and companies are happy as they’re able to effectively scale their businesses without providing expensive relationship management to every client.
But there will always be some people who value speaking to a traditional relationship manager. Whether it’s for the peace of mind of knowing there’s another person on the other end of the phone, a distrust of technology, or the social cachet of having someone at your beck and call, there will always be a demand for human interaction.
One important caveat: a relationship can add value when it helps you avoid making bad decisions. When someone’s able to prevent you selling during a market crash, or reduces your proclivity for performance-chasing and fund-switching, then that can be a valuable service. I can see the value in having a trusted third party in place to prevent you from making decisions you could regret. I personally believe that most investor behaviour can be improved through education – but even where it can’t, it can be improved through the use of a fee-only financial planner, who you can schedule time with when you’re thinking about making changes to your investment content. There’s no need to pay percentage-of-AUM fees purely to improve your behaviour.
This is the big one.
The explanations we’ve seen so far for why investors pay a high price for their investments have assumed the investor is the only person involved in the decision-making process.
In reality, they’re making the decision with the help of a company salesman business development manager, who works for the investment management company. Their job is to convince the investor that the higher fee is worth paying.
I won’t go into all the sales tactics used to sell investment management services (there are many), but let’s have a look at one of the most common.
One of the easiest ways to convince someone to buy an expensive investment is to show them a graph, which usually looks something like this:
To drive this point home, the sales pitch usually goes something like this:
“We might be expensive, but we’ve beaten the market. Price is one way of judging an investment, but we think that what really matters for investors is net returns [i.e. returns after fees]. You don’t want to confuse the value of an investment with its price and, as you can see, our returns are much better than cheaper options – even after deducting our fees.
Opting for a cheaper passive fund guarantees average returns, when our returns are clearly much better than average. They’re also not able to protect you when the market crashes, which we’re able to do because we’re able to choose which companies we invest in. When we see a crash coming, we can adjust our portfolios to safer assets, which means you’ll lose less money when the crash comes.
Also, passive funds buy all companies in an index regardless of their quality or valuation. Why would you want to own every company, and not just the high-quality ones? We selectively choose only the highest-quality companies with the best potential for higher returns. That’s how we’ve managed to outperform.
Our interests are also aligned with yours, because as we generate higher returns for you and your portfolio grows, then we also do well.
Finally, although we usually charge a 1% management fee for this service, because of the size of your portfolio we’re able to offer it to you at a discounted rate of 0.75%.”
It’s hard to understate just how strong that sales pitch is. A graph showing outperformance and some combination of the arguments above is enough to persuade 99.9% of people to invest.
It’s incredibly easy for investors to fall victim to the authority bias here (another of Robert Cialdini’s behavioural biases from Influence), where we’re far more likely to do something if someone in authority tells us to. If we’re willing to administer electric shocks to someone until they die because someone in authority told us to, it’s very likely that someone authoritative will be able to persuade us to invest with them.
It’s a great example of question substitution (explained in the section below). “Is this a good investment?” becomes “Does this person sound like they know what they’re talking about?”.
And with a sales pitch like that, it’s easy to convince people you do.
It doesn’t just work on inexperienced investors either – you’d be surprised how many highly qualified, seasoned investment professionals invest on the basis of that graph alone. Often the analysis is dressed up using suitably arcane-sounding statistics like ‘Sortino ratios’, ‘Jensen’s alpha’, and ‘Treynor ratios’, but given the stats all look good if performance has been strong, the decision is still ultimately based on one line going up more than the other.
It’s a great sales pitch, and I’ve seen it work many times. Unfortunately, it’s also misleading. It’s misleading for a number of reasons, but I’m afraid I’m going to have to leave you on tenterhooks, dear reader, to find out what those reasons are because this article has gone on far longer than I’d planned already.
I’ve got a huge pipeline of material for new articles, with one series currently titled “Debunking the myths of active investing”, which includes examining many of the statements made in the sales pitch.
Before we get to that point though, I do think it’s worth taking the time to focus on the graph itself. “This investment outperformed” is the meat of the sales argument, and of the 99.9% efficacy rate of the full pitch, in my experience the graph accounts for at least 80% of it.
I originally had a whole other section here on how to critically assess a graph claiming outperformance, but as I mentioned, I think this is long enough already. So I’ve stripped the section out, will beef it up during the week, and it’ll form the basis for my next article. Stay tuned…
Other behavioural biases
In this final section, my original draft of this post had a large segment all about how our behavioural biases steer us towards buying expensive over cheap.
I argued that people invoked the ‘question substitution effect’ when deciding on investments. This is the tendency, made famous by Daniel Kahneman in his book Thinking, Fast and Slow, to substitute a difficult question for an easy one. Usually we substitute the difficult question: “Is this product good?” with the easy question “Is this product expensive?”.
Other examples of question substitution include:
- “What do I think of this political issue?” becomes “What do others in my tribe [political party/city/family/friendship group/workplace] think of this political issue?”
- “How much should I donate to this charity?” becomes “Do I know anyone affected by this issue?”
- “Which programme should I watch on TV tonight?” becomes “What programme is everyone else watching?”
It’s the reason our jewellery store owner in the opening paragraph was able to sell her turquoise jewellery – by making people assume they were high quality because they were expensive.
This ‘price=quality’ heuristic works well in most other areas of life, but does it also apply to investing?
The chances of us falling back on this particular mental shortcut are maximised in two situations 1) when we’re deciding on something unfamiliar, or 2) when we’re trying to minimise the chances of a worst-case scenario.
I originally thought this was relevant to investing decision-making, but I’ve changed my mind.
I wanted it to be true because it was interesting to think about and fun to write about. But in reality I don’t think the traditional behavioural reasons people buy expensive products apply to investing (aside from the ones exploited by the salesman in the section above – here I’m talking about decision-making without any “help” from a third party).
To start with the obvious, there’s no status element to buying an expensive investment portfolio. A £10,000 watch might scream “I’m successful” to your friends, but a portfolio costing 3% a year doesn’t quite have the same effect. Costly signalling only works when others can see it, and an investment portfolio a) isn’t visible, b) is boring to most people, and c) it’s likely the investor themselves doesn’t know how much they’re paying. So there’s definitely no costly signalling going on here.
Other traditional ways people justify buying expensive products, such as scarcity and social proof are also not relevant to investing. Scarcity is only invoked when you’re being scammed (“Invest now before it’s too late!”), and social proof is only relevant when you’re buying into a bubble (“Invest in beanie babies – everyone else is!”). These two aren’t (and shouldn’t) be reasons people justify buying expensive investments.
As for the points I mentioned above about people paying a high price for their investments because 1) investments are an unfamiliar environment for most people, so tend to rely on price as an indicator of quality, and 2) people tend to choose an expensive item in situations where the primary aim is to avoid the worst-case scenario (losing all your money, in investing’s case), I don’t think these apply either.
Although an unfamiliar environment tends to increase the likelihood of people falling back on heuristics such as “price = quality”, it’s because investing is so unfamiliar that this heuristic doesn’t work. Investing is so alien to most people that it’s difficult to understand what classifies as “expensive”.
For example, if I was asked to make a decision on which bouquet of flowers to buy for my fiancée, I’m instantly out of my depth. I have no idea what makes a high-quality bouquet of flowers – they all look basically the same to me. But I fall back on the heuristic of “price = quality” because a) I don’t know how to assess the quality of flowers in any other way, and b) I can easily understand what’s expensive and what’s not.
With investing, it’s impossible for most investors to use this heuristic because it’s difficult to figure out a) how much you’re paying (which becomes especially difficult the more intermediaries are involved), and b) whether the amount you’re paying should be considered “expensive”.
To make life more difficult, the investor’s buying an intangible good with an uncertain future payoff. When I’m buying flowers, I know I’m receiving the benefit of an expensive bouquet immediately, so my benefit (in the form of a happy fiancée) comes today. With investing, the benefit of paying more comes in the future, so is an unknown. The investor can’t reliably tell at the point of purchase whether what he’s paying for will result any additional benefit because nobody has a crystal ball which can foresee the investment’s performance.
Because a) it’s difficult for people to figure out the cost of an investment, b) it’s difficult to compare costs between investments, and c) the benefits of buying an expensive investment are in the future and highly uncertain, I don’t believe investors rely heavily on the “price = quality” heuristic. These are all unique aspects of investing, which means the decision-making processes for investing end up looking quite different to how decisions are made with most other tangible consumer goods.
Although some residual effect of this decision-making process might hold true for asset allocators deciding between hedge funds (“This fund is so ludicrously expensive it must be good”), for most retail investors I don’t think it’s the case.
But there’s one behavioural bias which does affect the price people pay for their investments.
The saying goes that you’re more likely to get divorced than to switch banks, which is depressing on several levels. While an investment portfolio is probably less sticky than a bank account, I would bet that most people stay with their same investment provider for at least a decade.
The thought of having to plough through account closure forms, in-specie transfer forms, new account opening forms, AML/CDD forms, proof of your 11+ Common Entrance results, and the form to say you’ve completed all the forms is understandably enough to put people off switching investment providers.
The main reasons people end up paying a high price for their investments are:
- Compounding isn’t an intuitive concept, and can lead people to underestimate the importance of the compounded effect of fees on their portfolio.
- Some investors are willing to pay a premium to receive a higher level of service.
- Many investors are persuaded to invest into an expensive portfolio by a well-honed sales pitch (more on that to come).
- After committing to a portfolio, the power of inertia means investors are likely to be paying the agreed fee to the investment provider for a very long time.
I’ve assumed here the investor’s aim is to maximise risk-adjusted returns, and is investing for financial gain. Investors can also pay over the odds if they’re not interested in maximising risk-adjusted return – for example, with ESG investing. This is one area where investors are willing to pay a higher price, as they’re (mostly) investing for ethical reasons, with financial returns as a secondary benefit. The same goes for social/impact investing and anything in the same vein where financial returns are less important.