The best question investors never ask
There is one question every investor should ask when faced with any financial decision:What will this cost me 鈥� all expenses considered?聽Yet I can鈥檛 remember ever being asked that question in 40 years in the financial services industry.
Instead, I hear from clients, 鈥淗ow much does it yield?鈥� Or, 鈥淲hat kind of returns has it produced?鈥� Or, when they鈥檙e told I charge by the hour, 鈥淲hat is your hourly rate?鈥�
That last question sounds like it鈥檚 about cost, but it鈥檚 really about聽price, which is not the same thing. To understand the difference, consider another question: Who is more expensive 鈥� 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鈥檛 surprising that investors don鈥檛 ask about total costs when it comes to聽聽for investment advice or management. Some won鈥檛 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 鈥渂uy one, get one free鈥� convince us we鈥檙e 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).
聽and 鈥渕arkups鈥� are often included in a product鈥檚 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鈥檙e not being charged or that the salesman is paid by a third party.
Even sophisticated buyers might think they鈥檙e getting a 鈥渇reebie鈥� if they don鈥檛 have to see the bill. Dan Ariely, author of 鈥淧redictably Irrational,鈥� asks whether, after eating at a nice restaurant, you feel better if your spouse pays with his or her聽聽instead of you paying with yours. People generally do 鈥� even when the money is coming out of the same joint account.
Asset management fees on聽聽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 鈥� to an advisor, to the IRS or to anyone else. Ariely calls this 鈥渢he pain of paying.鈥� So while you may pay less to an hourly advisor, you could feel greater pain.
Painful or not, it鈥檚 important to do the math. Cost matters more than just about anything else when it comes to returns. A smart investor calculates聽all聽investment costs, including commissions, surrender charges, CDSCs (contingent deferred sales charges), withdrawal penalties, transaction costs, taxes, asset fees and mutual fund expense ratios. While this information is available, it鈥檚 not always easy to find. And just because you don鈥檛 see a charge, don鈥檛 assume you aren鈥檛 paying one. Ask the question.
Controlling costs is a critical component of successful investing. The easiest, quickest and surest way to raise your investment return is to eliminate unnecessary expenses.
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