Monthly Archives: July 2016

The kind of investment risk

I recently attended the Garrett Planning Network conference near Denver, CO. What a nice break from the Texas summer heat! One of the sessions highlighted an issue many of us are dealing with right now: frame of reference risk.

We usually think of investing risks as external events that could impact performance. But frame of reference risk refers to the possible negative impact on investing performance of something we might do to ourselves!

Think about what your frame of reference is. For most of is, it’s the US stock market. It’s the Dow Jones or the S&P 500. But then think about what’s in your portfolio. Hopefully, it’s a lot more diversified than just the US stock market.

When the US stock market is doing poorly (like during 2007 – 2008 or the early 2000s), you’re really happy to be diversified. You’re hearing horrible reports on the news about how the Dow is down 10%, 20%, or more. You’re looking at your portfolio, and it’s down, but not that much. So you feel wise, and you’re happy to commiserate with your friends about the market’s performance and your diversification strategy.

But now think about what we’ve been living through over the last 6 years. Or in the second half of the 1990s. The US stock market has been going gang-busters. US stocks were the top performing developed market country for the last 2 years in a row. And how is your diversified portfolio doing now? Less well. If it includes some bonds, some international stocks, and possibly some other diversifiers, those holdings have been a drag on your performance. So when you hear another stellar report about the the S&P 500 or the Dow, you feel a little sheepish. It’s one thing to have your diversified portfolio under-perform for 1 year or 2 years, but when it becomes multiple years in row, it becomes a little hard to take.

And this is what frame of reference risk is.

It’s the risk that we might abandon our diversified portfolio strategy at exactly the wrong time because we just can’t stand to not do as well as the benchmark against which we’re judging ourselves.
 It’s human nature to compare. And human nature to want to act on that comparison.

But this is a time when we need to let science and history be our guide. Remember back to those that abandoned their diversified strategy in the late 1990s and went all-in to US stock just before the dot-com bubble burst. Their portfolios were massively damaged.

You Should Know About Investors

There is one question every investor should ask when faced with any financial decision: What will this cost me — all expenses considered? Yet I can’t remember ever being asked that question in 40 years in the financial services industry.

Instead, I hear from clients, “How much does it yield?” Or, “What kind of returns has it produced?” Or, when they’re told I charge by the hour, “What is your hourly rate?”

That last question sounds like it’s about cost, but it’s really about price, which is not the same thing. To understand the difference, consider another question: Who is more expensive — an experienced, effective advisor who charges $300 an hour, or an advisor who charges $150 an hour but may take twice as long or is less competent?

It isn’t surprising that investors don’t ask about total costs when it comes to fees for investment advice or management. Some won’t even bring up the subject to avoid seeming impolite or, worse, cheap. But the whole subject of cost (and price) is loaded with behavioral and framing biases.

We are also vulnerable to pricing manipulation. Gimmicks like 99-cent pricing and “buy one, get one free” convince us we’re getting a good deal when we may just have been conned into paying more or buying more.

The manipulation may not even be deliberate. Our own human nature can lead us to misperceive or miscalculate costs, and the way we pay for goods and services can cause misunderstandings. This is particularly true with investment advice because of the difficulty in comparing commissions (which are transaction-based) to annual asset fees (for ongoing engagements) to hourly rates (which can be both).

Commissions and “markups” are often included in a product’s price (for example, with load mutual funds or municipal bonds). Commissions must be noted in the prospectus, and the salesman is required to disclose costs, but that detail can get lost in the sales pitch. Unsophisticated buyers could assume that they’re not being charged or that the salesman is paid by a third party.

Even sophisticated buyers might think they’re getting a “freebie” if they don’t have to see the bill. Dan Ariely, author of “Predictably Irrational,” asks whether, after eating at a nice restaurant, you feel better if your spouse pays with his or her credit card instead of you paying with yours. People generally do — even when the money is coming out of the same joint account.

Asset management fees on brokerage accounts are charged quarterly and deducted automatically. Clients see only one-quarter of the annual fee on a single section of every third monthly statement. An example of out of sight, out of mind?

Hourly or project fees, on the other hand, are usually paid in a lump sum, and no one likes to write a big check — to an advisor, to the IRS or to anyone else. Ariely calls this “the pain of paying.” So while you may pay less to an hourly advisor, you could feel greater pain.