By Victor Haghani and James White ¹

“What we obtain too cheap, we esteem too lightly.”
  – Thomas Paine, 1776

A physician thinking about investing with Elm asked us: “If I hurt my knee, I’m going to find the best orthopedic surgeon available and I’ll expect to happily pay top dollar. Why is hiring an investment manager any different?”

Great question.

Alas, identifying the “best” investment managers isn’t so easy. Daniel Kahneman discusses this in “Thinking Fast and Slow”, asking the question “When can you trust an experienced professional who claims to have an intuition?” His answer is that the skill we are looking for should develop “through prolonged practice” in “an environment that is sufficiently regular to be predictable…[and providing] immediate and unambiguous feedback.” Many (if not most) crafts provide an excellent environment for developing unambiguous expertise, and it’s reasonable to expect to pay more for accessing that evident expertise.

Not so with investing; it’s hard to imagine a domain more irregular, unpredictable and ambiguous. And not only is it challenging for investment managers to consistently develop such unambiguous skill, but for the consumer, it is very difficult to distinguish true skill from good luck with the amount of historical data typically available to investors.² In our paper What’s Past is Not Prologue, we suggested that even 20 years of historical performance data isn’t normally enough to distinguish with high confidence between skilled and average mutual fund managers.

Investment products aren’t the only ones whose merits are difficult for consumers to assess. However, with most other products, better quality normally goes hand-in-hand with a higher price, and so we can use price as a filter to narrow down the choices when trying to find the best service or product. For example, at Elm we recently upgraded one of our laptops. We needed a higher-performance machine, and it was pretty easy to know how to identify one: we looked for higher-price laptops, and we were quickly able to narrow the options down to the few best. This heuristic doesn’t work with hiring investment managers though – partly because the difficulty of judging skill hinders price efficiency, and partly because the quality of the product and the price paid in fees are not ‘separable.’

When buying a car, the car’s quality and the money you pay for it are separable. A very wealthy person (or an extreme car enthusiast) might pay 10 times the price of a standard car for one which is only 10% better, and still be happy with their decision. Investing is different from most other consumer choices in that what you get and what you pay both come in the form of dollars, so they’re not separable. “What you get” is risk-adjusted excess return in dollars, and “what you pay” are the fees in dollars. No matter how wealthy a person is, she will never knowingly pay $2 to get $1 of extra wealth.³

The uncertainty surrounding the “what you get” part of investment services can pave the way for us to unknowingly make a wealth-reducing exchange. In choosing a doctor, even if we fail to find the best doctor, an average doctor with the relevant medical qualifications is still pretty likely to do a good job. However, as we know from Sharpe’s “Arithmetic of Active Management,” the zero-sum nature of the investing game means the average investment manager is expected to deliver below average results.

Despite all these obstacles, many investors and their advisors still persevere against the odds in the quest of identifying the “best” investment managers. Behavioral economists would explain this by citing our natural tendency to over-extrapolate from small samples of data, combined with our proclivity to be overconfident in our abilities and decision-making.

Bill McNabb, former CEO of the Vanguard Group, explains that many of our consumer instincts about price and value lead us astray when it comes to choosing investment products:

“The whole cost argument from an investment perspective is counter-intuitive. If you think about your life in other areas, if you are out buying a car, you can buy a Rolls Royce and pay whatever Rolls Royces are going for today, or you can buy an inexpensive Hyundai. You are going to feel a difference in the car. Now whether it is worth it…only you as a buyer can make that decision. But, you are definitely going to feel the difference in quality. In investing, that equation doesn’t hold. And so, when you think about the average investor who is also a consumer, they are used to – the more I pay the higher the quality, the better the results I get. You come to investing and it is just the opposite.⁴ I think that it is really a hard behavior for people to unlearn.”⁵

But to improve as investors, unlearn we must.

1. Victor is the Founder and CIO of Elm Partners, and James is Elm’s CEO. Past returns are not indicative of future performance. This not is not an offer or solicitation to invest.
   
2. This is not true for all track records and all situations, but it is true often enough.
   
3. Of course, in the context of investing, the equation is rarely so clear: “what you get” is, more formally, expected marginal utility in the context of your whole portfolio, and this is not directly observable. Historical net returns may be informative in this regard, but are still an imperfect proxy.
   
4. To wit, McNabb cited a recent Morningstar study which found that, “A fund’s annual fee is the most proven predictor of future fund returns.” http://www.morningstar.co.uk/uk/news/149421/how-fund-fees-are-the-best-predictor-of-returns.aspx
   
5. Watch: https://www.youtube.com/watch?v=SwkjqGd8NC4, starting at 43:16.