The Toilet Paper Paradox
Too Much Toilet Paper – Or “The Paradox of Choice”
Have you ever experienced the pain of having to make choices in the toilet paper aisle of any North American supermarket? The psychologist Barry Schwartz extensively researched the issue and came to a controversial conclusion in his 2004 book “The Paradox Of Choice – Why More Is Less”: Eliminating choices can greatly reduce anxiety!
While we wish for no more than three easy to remember – and to distinguish – brands of toilet paper for quick, repeatable and painless decision making in the paper products aisle, there is something extremely important to learn from the toilet paper dilemma for the performance of our investment portfolios: How we tend to make irrational decisions when faced with overwhelming choice can significantly impact our long term investment returns.
Allow us to elaborate: When faced with overwhelming choice, humans typically do not make a PhD out of the situation by scientifically evaluating all choices to filter out the best choice. Instead, we tend to use heuristics, i.e. shortcuts, to save time and effort. This is where trust, the great human shortcut, comes into play. In the absence of expert knowledge on how to evaluate the array of choices, humans tend to use a complex emotional mechanism we refer to as “trust”.
Interestingly, the manipulative science of “marketing” has very effectively managed to exploit the human trust shortcut. We are brainwashed into making trust decisions based on brands even if in reality the biggest brands can be the least trustworthy. Think we are crazy? Consider the following examples.
In 2008, Carden Capital’s Gavan Duemke found himself in the beautiful city of Beirut, Lebanon, immersed in overwhelming choice of local eateries with arguably some of the best food on the planet. Yet, he chose McDonald’s.
Wouldn’t happen to you? We know entire families that drive cars of only one brand. Entire families that use the same brand sneakers. Or take our obsession with matching consumer electronics: The iPhone, according to our understanding of Apple’s strategy, is the “gateway drug” to other Apple devices.
In terms of the financial services industry it is easy for the unsuspecting non-expert to fall into the carefully orchestrated brand trap. Let us help you out with a quick checklist on how to evaluate the overwhelming choice of investment managers. Just to be clear – the following list is based in scientific data evaluated in a 2014 study by Finstad:
Myth #1: Size Matters
In fact, you could not be more wrong. There is extensive empirical evidence that smaller firms with no or little brand recognition outperform large, well-known firms. Investment managers with entrepreneurial type qualities outperform managers who are institutionally owned. The moral of the story: Choose a small, entrepreneurial firm to manage your money.
Myth #2: My Money Isn’t Safe With A Small Firm
Many investors are reluctant to let a small firm manage their money because they have question marks around the safety of their money with a small firm. This fear is based on a misunderstanding of how our industry works. In fact, your money is just as safe with a small firm as it is with a large firm because your money isn’t actually with either firm! Surprised? Instead, your money is located with an entirely different firm that is called the “custodian.” The money manager, large or small, simply directs how your money is invested through a limited power of attorney. Large or small, we cannot put money into your account or take money out. All we, large or small, can do is direct how it is invested. Paradoxically, most small money management firms use the same custodians as large money management firms. The moral of the story: Choose a small investment management firm and a very safe custodian.
Myth #3: Large Institutional Firms Outperform Small Employee Owned Firms
Here is how this myth comes about: Look, this large well-known firm has all these amazing resources to do all this even more amazing research to make the very best decisions for me and my money. Yep, that’s what they want you to think. Trouble is, nothing could be further from the truth. Most research done in our industry is total junk and here is why: The science of financial markets is quite young and we still understand very little. For reference, in 2013 two entirely contradicting theories on how financial markets work both won the Nobel price – in the same year! Thus, all the unscientific busy work of large firms is entirely overrated. The moral of the story: Look for low personnel turnover and high employee ownership! You might even dare asking: Are you, Mr/Mrs/Ms Financial Advisor, actually personally invested in the same strategy you are proposing to run with my money?
Myth #4: More Experience Equals Better Performance
Interestingly enough, that isn’t true either. The worst performing managers are those with in excess of 20 years of experience. As a matter of fact, at a certain level of seniority, most managers are preoccupied with preserving the business they have built instead of constantly working hard to keep outperforming. The moral of the story: Look for experienced, hungry managers but stay away from those who have put building their business in cruise control and appear fat and happy.
Myth #5: Portfolios With Many Different Holdings Are Better
We analyze portfolios put together by large competitor firms all the time. Here is what we typically find: A maze of different (often high fee) stuff that gives the impression that the ever so smart investment manager did a lot of hard work which is – beyond any doubt – worth the high fees they are charging. Nothing could be further from the truth! There is significant empirical evidence that portfolios containing less rather than more positions perform better. The moral of the story: Look for managers that don’t blow smoke screens with overly complex portfolios to make it look like they work hard for you. You might be surprised that we are finding maximum diversification benefits with just four tax efficient ETFs.
Myth #6: Large Firms Offer Superior 24/7 Customer Service
Really? Have you ever tried to have a real conversation with anyone at those call centers? We find ourselves submitting to their brainless processes because there is no point in fighting it. Anyone is just a number and it is pretty clear that those call center folks have no incentive to care. In smaller firms, you can often talk directly to the owners, 24/7, and iron out any issues. Who wouldn’t want to talk to a decision maker right away?