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The Investment Illusion

The asset management community has moved from investing to speculating. From focusing on reliable long-term returns from residual income and economic growth, to chasing short-term price fluctuations in unpredictable markets. This move has created a lot of ‘financial’ activity that is detrimental to the return for the ultimate investors.

The math is simple: corporations generate profits, which in principle are available directly to their investors. However, a whole layer of brokers, fund managers and advisors, or ‘helpers’ has emerged to reroute and redistribute these profits, even though the ultimate group of investors has not changed. All costs incurred by these parties are deducted from the corporate profits before they reach the ultimate owners, the investors. The group of ‘helpers’ and their income has been growing continuously. Unfortunately, the more the asset management industry takes, the less the investor makes.

Costs of investing vary between brokers, funds and countries and depend on the liquidity of the security involved. This makes it challenging to determine the exact level of costs ‘in general’, but reasonable estimates can be made. To the average investor the cost of ‘intermediation’ may not look significant on an annual basis, but compounded over a longer period the impact can be devastating. For a European investor who works with an advisor, the average annual costs are estimated to be around 3% of the assets under management. The average gross income on stocks (dividends plus capital appreciation) between 1900 and 2009 was 8.6% globally. The average investor starts saving about 40 years before retiring. A sum of $1,000 invested at the global historical rate will grow to $27,100 over this period. However, deducting the annual cost of 3% reduces the sum to $8,800, just 33% of the market return. Comparing results to the market is not completely fair, as some level of frictional costs to purchase and hold a diversified portfolio of stocks is inevitable. However, 3% is not just ‘some level’. It is a value-destroying amount that should and can be avoided. As John Bogle puts it: “the wonderful magic of compounding returns is overwhelmed by the powerful tyranny of compounding costs.”

Of course costs to the investor equals revenues for the asset management industry. Herein lies the core of the problem. It is in the industry’s interest to promote as much activity as possible, as this allows them to charge the investor the maximum amount, both for the high level of transactions and for their perceived ‘added’ value. After all, why pay someone who doesn’t do anything? That is why the whole marketing machine of the industry is focused on spawning more investor activity. The industry is supported in this endeavor by the financial media, and the biggest advertisers in financial media are? ... exactly.

The core message of the asset management industry is that we, the individual investors, can use them, the managers of assets, to outsmart and outperform the other investors. In convincing us that this is possible, most ‘advisors’ focus on three investment activities, or games, as we will call them:

     1) stock picking,

     2) fund picking, and

     3) market timing.

The notion that you can beat the market by participating in these games is what we call the “Investment Illusion”. Since billions of marketing dollars and countless media hours are spent on promoting this illusion, it takes a wise person to resist. Unfortunately most of us end up playing along and the harm to our financial wealth can be significant.