Why my friend invests in an insanely expensive fund and why I don’t

September 19 44 Comments latest by What's an Expense Ratio? | Green Panda Treehouse

I was working on my asset allocation this weekend — something I haven’t written about in detail yet — and had something interesting happen.

One of my friends works in finance and was hanging out with me. He told me that I should look at look at one of his company’s funds, which was doing really well. I checked it out and saw a 4.5% (!!) expense ratio, which means they charge a ton of fees. I felt ill. By comparison, some of my funds have a .18% expense ratio.

I told my friend that fund was nuts. For individual investors, passive management crushes active management over the long term. (I’ve written about Warren Buffet’s opinions on that here.) And yet my friend responded with something fascinating: “Working in the industry I’m in, you’ll never convince me of that.” To him, it really is about how “smart” the portfolio manager is. I covered “experts” here, here, and here.

To tell you the truth, the fund is doing great. But so are most funds over the last five years. And a 4.5% expense ratio is insane for the long term. Why don’t I just hand over my money in a God damned wheelbarrow, adding all of my pens on top too as icing on the cake, and have it couriered over to you in exchange for the chance to have my money managed by you? Oh, because I prefer not to hand my most treasured possessions over in exchange for seeming cool and for gains of questionable sustainability.

Interestingly, while my friend may have an understandable reason to believe what he does — he works in finance and works with Very Large Institutions — there’s an additional wrinkle. I asked what kind of funds his 401(k) offers. Surprise, surprise: His company only offers company funds to choose from. That means his funds charge a 4.5% expense ratio to him, too. So while there may be a difference between institutional investors and individual investors, in this case I wanted to see how he’d resolve the dissonance of having to choose an insanely expensive investment. I didn’t find a satisfactory answer because the fund’s been doing so well. But wait a few years until double-digit returns aren’t the norm and I’ll report back.

If everybody thinks something is true…
… chances are they’re right. When you think your performance — or the performance of someone you’re associated with — is likely to be wildly above others, you’re probably wrong. I mean that statistically, not pejoratively. As we know from Psych 101, “the Lake Wobegon effect is the human tendency to overestimate one’s achievements and capabilities in relation to others” — which we do in spades.

I read a site called Overcoming Bias, which recently featured a fascinating story by Kahneman and Lovallo:

In 1976 one of us (Daniel Kahneman) was involved in a project designed to develop a curriculum for the study of judgment and decision making under uncertainty for high schools in Israel. When the team had been in operation for about a year, with some significant achievements already to its credit, the discussion at one of the team meetings turned to the question of how long the project would take. To make the debate more useful, I asked everyone to indicate on a slip of paper their best estimate of the number of months that would be needed to bring the project to a well-defined stage of completion: a complete draft ready for submission to the Ministry of education. The estimates, including my own, ranged from 18 to 30 months.

At this point I had the idea of turning to one of our members, a distinguished expert in curriculum development, asking him a question phrased about as follows:

“We are surely not the only team to have tried to develop a curriculum where none existed before. Please try to recall as many such cases as you can. Think of them as they were in a stage comparable to ours at present. How long did it take them, from that point, to complete their projects?”

After a long silence, something much like the following answer was given, with obvious signs of discomfort: “First, I should say that not all teams that I can think of in a comparable stage ever did complete their task. About 40% of them eventually gave up. Of the remaining, I cannot think of any that was completed in less than seven years, nor of any that took more than ten.”

In response to a further question, he answered: “No, I cannot think of any relevant factor that distinguishes us favorably from the teams I have been thinking about. Indeed, my impression is that we are slightly below average in terms of our resources and potential.”

Facing the facts can be intolerably demoralizing. The participants in the meeting had professional expertise in the logic of forecasting, and none even ventured to question the relevance of the forecast implied by our expert’s statistics: an even chance of failure, and a completion time of seven to ten years in case of success. Neither of these outcomes was an acceptable basis for continuing the project, but no one was willing to draw the embarrassing conclusion that it should be scrapped.

So, the forecast was quietly dropped from active debate, along with any pretense of long-term planning, and the project went on along its predictably unforeseeable path to eventual completion some eight years later.

Brutal honesty is hard. Instead, we choose to ignore the hard facts and keep plowing ahead. It’s sexier to buy high-cost investments backed with a Big Brand Name that cost lots of money and trust that a Very Smart Expert will get you market-beating gains. It’s even more complicated when you get great returns for the past five years. But stop for a second. Did you systematically ignore the fact that most other funds have had a great run? Did you sit down and calculate how much that 4.5% expense ratio is actually costing you? Did you model out how much it will cost you for the next 30 years? If you haven’t done that, then why on earth would you pay such high fees? As always, would you rather be sexy or rich?

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44 Comments latest by What's an Expense Ratio? | Green Panda Treehouse