Perceived Value vs. Actual Value

Perceived Value vs. Actual Value

There have been studies that show that when people pay more for something, they believe the product is better.

For example, people rate wines better if they are told it is expensive.

Based on this study, the wine doesn’t actually have to be better, they just have to believe it’s better (more expensive).  When the isolated variable is price, people were forced to assume that the higher the price, the higher the quality.

Many advisory firms these days charge in the ballpark of 1% of assets under management.  This is in no way exclusive, but common enough that the general public expects it.

So, how do we know when one firm is better than another or when one portfolio is better than another?  Ponder that for a few minutes and we’ll come back to it.

I haven’t been able to locate a study on investments that shows that price paid correlates to a feeling of higher value, but I can only presume it to be true.  Otherwise, why would so many investors stick with complicated and overpriced portfolios if the perceived value wasn’t there?

Since there are so few ways to show empirical evidence of value, many firms stick with perceived value.  This should be obvious considering so many advisory firms pedal the same baloney.

To expand on this idea of perceived value, let’s look at the following two advisory firms:

Firm #1:

We charge 1% of assets under management.  Our investment management team (IMT) uses our best-in-class proprietary research to identify, evaluate and invest in assets that are best suited to ever-changing market conditions.  We seek to invest in undervalued companies with market caps over $1 billion.  Our IMT provides research and advice for your personal advisor to construct a custom portfolio that is suitable for your long-term goals.

Firm #2:

We charge 1% of assets under management for a custom portfolio of index ETFs and behavioral coaching.

So, What Do You Think?

The above two examples are paraphrased from actual advisory firm websites.  At first glance, which firm would you choose to manage your money?

Since the firm’s respective fees are the same, you are forced to focus on the other variables.

Firm #1 sounds fancy and makes you feel warm and fuzzy.  It seems complicated and exciting.  It seems like they are probably very smart and hands-on.  They are watching the markets on an everyday basis.  And on top of that, who doesn’t want a team working on their behalf?

Firm #2 seems overly simple.  Index funds are boring, and “Do I really need behavioral coaching?”  Could those two things possibly be worth the same fees as Firm #1?

Quite simply, in a side by side comparison, Firm #1 has more perceived value.

But, let me save you the suspense: Perception is NOT reality.  Even if Firm #1 thinks they are providing more value, they probably won’t because they probably can’t.  In fact, Firm #1 is likely going to underperform Firm #2 by a nice margin.

Firm #1’s value proposition is window dressing.  It’s designed to sound complicated and special.

Wall Street loves to use confusing terms to make you think only they can do what they do.  – The Big Short

Despite the DOL rules that are coming out, firms actually appear to be doubling down on making it sound complicated to justify their fees.  See more on this and how to combat the issue by reading Advisor Firms Be Crazy.

People seek perceived value when what they really want is actual value.

In investing, perceived value and actual value are rarely correlated.

More Complex = More Perceived Value

Less Complex = More Actual Value

Higher Price = More Perceived Value

Lower Price = More Actual Value

More Trading = More Perceived Value

Less Trading = More Actual Value

Need proof?  Look at how the indexes have done versus the average active fund manager in the past however many years you want to look at the data.

More complicated, higher fees, and more trading ended up drastically underperforming.

This is not to say that all active managers are bad or that individual active managers can’t outperform.

It’s that we don’t know in advance who those managers are going to be.  And don’t forget that they’ll have to outperform by more than they are charging for this service.

We cannot justifiably say that without noting that all index funds underperform their index by the fees charged, so outperforming isn’t even an option if you are an indexer.  But you’ll at least get market-ish returns.

You have a choice given the SPIVA study above.  Are you willing to take the overwhelming risk of significantly underperforming by using an active strategy to have the opportunity to beat the market?  It’s your money, so it’s your call.

It’s not impossible, it’s just unlikely.

Back to my question above, how can we tell when one firm is better than another firm?  Or when one investment product is better than another investment product?  The answer is to look at the evidence.

Don’t listen to the story or fall for window dressing and fancy wording.  Find a firm that will tell you the pure, unvarnished truth and invests in a way that is evidence-based and fee conscious.  They should be able to describe a very clear, evidence-based approach that resonates with you.

Never confuse perceived value with actual value.  In the world of investment management, you often do not get what you pay for.

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