A powerful bias exists which has asymmetric effects: Most people’s beliefs are biased in the direction of optimism. Optimists exaggerate their talents: this is why more than 80% of drivers believe they are above average. Many of them must be mistaken.
Optimists also underestimate the likelihood of bad outcomes over which they have no control, especially evident when they pile client's money into complex asset allocations which typically carry higher risks than clients can tolerate or require.
Finally, optimists are also prone to an illusion of control (i.e., they exaggerate the degree to which they control their fate). They tend to underestimate the role of chance in human affairs and market behaviour, and to misperceive games of chance as games of skill.
The combination of overconfidence and optimism is a potent brew, which causes people to overestimate their knowledge, underestimate risks and exaggerate their ability to control events, putting your hard earned High Net Worth at High Risk. It also leaves them vulnerable to statistical surprises. As we see next, however, people are often not as surprised as they should be by events they have failed to predict.
- Keep track of instances of your adviser's overconfidence.
- Be mindful of your adviser's propensity for overconfidence when he/she is making statements to you as clients.
- Is your adviser making you and other clients aware of the uncertainty involved with investment decisions?
- Do not let advisers project their own overconfidence onto you. If you do, you will create an unreasonably high standard of performance that will lead to short-lived and ever changing investment decisions, rather than a focused holistic strategy.
Short and Long Views:
Investors who own growth assets (e.g. shares, real estate, art, etc) must commit themselves psychologically to stay with their investments for some time. The amount of time probably varies greatly for different individuals. One expression of this commitment is the frequency with which the investor monitors the investment and checks how well it has done. Some nervous investors check very frequently; others are less concerned with short-term fluctuations. Research shows that this characteristic of investors is reflective of their experience in the market and it may determine their preferences for risk.
For an extreme case, imagine an observer who chooses an allocation of assets to stocks once a month, on the basis of the experience of the past month and expectations for the immediate future. Lets say that shares made money during 60% of the months over the last seventy-one years, and the average loss was 99% as large as the average gain. A loss-averse investor with a one-month horizon will not like this gamble and will keep all his money in a safer asset one month at a time, hence forever. In the meanwhile, the inflation will erode the value of his Net Worth.
Now imagine an investor who decides to be committed to an allocation for the next ten years. The review of the same long-term history will look much better from the point of view of this investor; let's say shares made money during most of ten-year periods, and the average loss was only, say, 70% of the average gain. Even a loss-averse investor will invest in shares, if only she is willing to adopt a long-term view.
Investment decisions made by High Net-Worth Clients have both emotional and financial consequences over time. There is potential for worry and for pride, for elation and for regret, and sometimes for guilt (such as when one has gambled and lost money that was saved for a particular purpose). A financially optimal decision (the one that a fully rational investor would make) is of little use to an investor who cannot live comfortably with uncertainty. And the optimal decision is certainly irrelevant if it is one that means the investor is likely to change course at the wrong time.
Those prone to regret are also likely to blame their financial advisers for what they perceive as mistakes. The combination of hindsight bias and regret creates a powerful toxin.
A 1998 survey by Kahneman and Thaler asked more than a hundred wealthy investors to bring to mind the financial decision that they regretted the most, and to identify whether the decision they regretted had been to do something or not to do something. This study shows that people who regret the opportunities they missed tend to take more risks than people who regret attempts that failed.
Simplicity is often best
For more than 17 years, Bernard Madoff has operated what was perceived as one of the most successful investment strategies in the world. This multi-billion dollar strategy ultimately collapsed in December 2008 in what financial experts are calling one of the most detrimental Ponzi schemes in history. Your hard earned High Net-Worth deserves simplicity!
Ross Clare at ASFA found the complexity of some fee structures can make it difficult and costly for HNW individuals to collect information on fees and to make comparisons. While financial planners can assist with considering available investment options and strategies, very often their own remuneration is one of the complicating factors in comparing fees and charges.
Is Your Adviser Creating a Gravy Train?
In Australia adviser remuneration is more likely to end up in the expense ratio of retail funds because of the entry and trail commissions that are paid by the fund.
Australian master trusts also have been characterised by some commentators as being relatively more expensive by world standards, but it is not hard to find fee levels which are equivalent in the USA. For instance, a report on Wrap and Managed Account Issues prepared by Cerulli Associates indicates a typical asset-based fees for a US mutual fund wrap of 1.25%. This fee covers client profiling, account monitoring and portfolio rebalancing. Managed fund fees would be on top of this. Where customised investment management, rather than use of a standard mutual fund, is provided by way of a consultant wrap, the asset-based fee can reach 2.5% to 3%. However, such services when provided on line over the Internet have fees between 1.35% and 1.75%.
The USA also has wrap solutions provided by third part vendors which are very similar to the wrap platforms made available by certain Australian financial institutions for badging by advisory groups. The pricing in the USA for such products is between 0.4% to 1.3%, depending on vendor and services provided. In summary, while there are more low cost mutual fund options in the USA market than in Australia, the average fees paid are not that dissimilar when the full range of investor costs and the range of mutual fund products are taken into account.
These platform-based products typically are those directly distributed, amongst other methods, but which have an entry fee and trail component built into their pricing. The ones in Australia predominately rely on their brand image to attract business on those terms.
The pricing structure for superannuation products sold through master trust platforms tends to be along the lines of platform fees being between 1% and 1.5%, with investment fees depending on the manager used and level of investment. Typically such fees will be just below or just above 1%. Very small balances and/or more exotic investment mandates can attract higher charges.
Of the platform charge of between 1% and 1.5%, around 50 basis points appears to be actual costs of administration, with the remainder trail commissions and profit derivable from establishment of the brand and distribution service. Some dealer groups have established their own distribution platforms, or badged the platforms of others, so as to be able to take advantage of that gap between 0.5% and the net fees charged for use of the platform after trailing commissions are paid.
A banana industry case, published in the Guardian newspaper (UK) on November 6, 2007, illustrates the point.
The total value of international trade in bananas exceeds US$50 billion a year. The three companies that dominate this trade use secrecy jurisdictions to shift profits by means of packaged intellectual property rights, thus minimising tax payments and maximising profits. Almost half of the final retail price of a banana produced in Latin America and purchased in Europe is accounted for by ‘costs’ inserted into the value chain by subsidiaries in secrecy jurisdictions. For every 100 pence worth of bananas sold to UK consumers, 8 pence goes to a Cayman company for use of the purchasing network, 8 pence to Luxembourg for use of financial services, 4 pence to Ireland for the use of the brand, 4 pence to the Isle of Man for insurance and 17 pence to Bermuda for use of the distribution network.
Only 13 pence remains in the producing country, of which a mere 1.5 pence is paid for labour costs which is no economic substance to any of the activities booked in these tax havens.
If the actual cost of bananas is 1.5 cents, do you feel you are getting the value?
While there has been some growth in relatively inexpensive index products, this has been from a low base. Why? Because index funds have no inbuilt trails. No gravy train. Financial planners remain the gatekeepers to entry to most retail investment products, and they have a strong preference for active managers, who may advisers for selling them. Have a look at the Management expense ratios (MER) of your existing portfolios: you are probably paying 2.5%-3% in MERs plus other expenses on top of Adviser fees. Instead, a MER for an index fund is about 0.4% on average.