The Business of Investing - Part 4/6: A Cancer Called "Scale"

I'm a big fan of the industrial revolution, really I am.  The picture many of us have of dirty textile mills and unsanitary, Victorian-era slaughter houses looks apalling when juxtaposed with today's workplace standards.  But if you compare, say, the hardships and health risks of American frontier life, or the life of an 18th century English farm peasant to Chuck Dickens' neighborhood, the latter looks a lot better. 

Certain types of goods and services lend themselves well to mass production.  How many of us could really afford our own cutsom car?  Does it matter to you that your Cherios are identical to mine?  And would it really make sense to pay for your own unique amusement park ride?

In the examples mentioned above, the only way in which certain goods and services could ever be affordable is if essentially the same experience is shared by many people.  Sometimes uniqueness matters, sometimes it doesn't.

Scale Doesn't Always Work 

Let me begin with a rhetorical question: is investment management properly a professional service or a means of product distribution?

In contrast to the Cherios example above, some services require unique solutions because the needs they seek to satisfy are also unique.  Medicine offers a great example.  I went in to see my doctor a few weeks ago because I've been having trouble sleeping for about the last 4 years.  Before the doc prescribed a treatment, he asked me loads of questions about my sleep "hygiene."  "Do you read in bed? (Always.) Then stop; Do you ever have an adult beverage in the evening? (Often times on Friday nights.) Knock that off, too; If you snore, do you stop breathing when doing so? (Um, Doc, how would I know?) Ask your wife and get back to me."

At the end of this interrogation, did I get a prescription to Lunesta or Ambien?  Nope.  I got a four staged solution, geared toward me specifically.  First, I had to control the environment better; I've now quit reading in bed...ouch.  Next, given the impact sleeplessness has on my energy level, Doc recommended I take Melatonin - an over the counter hormone whose natural production in humans begins to decline in middle age.  If that stuff doesn't work, then we might try an anti-depressant: not because I'm depressed but because it has a secondary approved indication for sleeplessness.  Finally, and depending on my wife's snore report, if I do stop breathing when I snore, Doc may put me in a sleep study. 

If my age, weight, medical history, symptoms, or responses to treatment were any different, Doc may have recommended an entirely different treatment plan.

Imagine another scenario where I go to see my Doctor:

"Good afternoon, Steve.  I understand you're having trouble sleeping, is that right?"

"Yes, it started about -"

"Well, I'm going to recommend that we put you on Amoxicillin, Lipitor, and, by the way, you still need to lose 15 pounds.  Your co-pay is $25."

"But, Doc, wait!  What's that stuff have to do with my sleeplessness?!"

"Well, many people get bacterial infections, thus the Amoxicillin.  And lots of guys your age have high colesterol and should lose some weight.  You ask really fantastic questions.  Thanks for coming in, and have a great weekend!"

The Model Portfolio

OK, so that last example was hyperbolic. Any doctor pulling that kind of thing would lose his license.  Yet investors tolerate that same sort of thing from their investment advisors all the time, and the primary vehicle is what's known as "the model portfolio."

Most investment firms - of all sizes - use model portfolios.  A model portfolio just means that the investments within the portfolio are standardized and applied across many investors' accounts.  Let's say you and I each made an appointment with a particular financial advisor, who uses models.  Assuming you and I answer the same few investment questionnaire queries similarly, you and I would be placed into the same model portfolio.  If the model calls for a 10% allocation to XYZ fund, your investment might be $10,000 and mine $5,000, assuming our total account values were $100,000 and $50,000, respectively.

Oh, sure, there could be a little differentiation if our "risk profiles" were different, and the way the advisor would handle that would be by adjusting the primary asset allocation - the mix between stocks and bonds.  If my questionnaire reveals that I'm less risk tolerant than you are, I might be placed in a 75/25 (75% stocks, 25% bonds) model while you might be in an 80/20 model.

Here's the advisor's recipe:

1. Ask a few questions about "risk" tolerance.
2. Select model portfolio indicated by the risk profile.
3. Push the giant green "INVEST" button.
4. Sneak out for the 2:30 tee time.  

And here's what I'm getting at: the model portfolio has become so commonplace that investors don't stop to ask important questions, questions that could well render the model portfolio approach thoroughly inadequate.  Questions like:

• How can I ensure that I have $10,000 available for my daughter's semester in Europe in two years?
• I need $75,000 in income from the portfolio when I retire.  Will the model be able to meet that need with interest rates as low as they are?
• I work for IBM - I don't want any more information technology exposure than I already have.  Can we scale back on tech investments in the model?

Model portfolios aren't designed to meet unique needs - they're designed for scale.  The problem is that the entire purpose of investing is to ensure that unique financial needs are satisfied by financial assets.  Does it make sense that those unique needs could be satisfied with mass-marketed, generalized solutions?

Time to be Painfully Blunt

Investment firms and most of their advisors don't really give a rodent's gluteus about your unique financial needs.

Period.

How do I know this?  Well, for starters, they don't hire investors, they hire "relationship managers" whose sole function is to treat you so well - make you feel so "tucked in" - that you keep your money with their firm through thick and thin.  They hire "asset gatherers" whose function is to distribute model portfolios and financial products to as many people as can be glad-handed, cajoled, or guilted into signing up with their firms.  They hire "financial planners" who run colorful graphs which actually tell you nothing useful, but probably will make you feel as though the advisor really understands your needs.  (By the way, I'm not down on financial planning per se - heck, I spent two and a half years as a planner.  I'm going to address financial planning in a future post.) 

And why do they hire these non-investors to invest your money?  Why wouldn't they hire actual investors to satisfy the needs of their clients?  Why wouldn't they insist that unique investment needs are satisfied with uniquely selected investments?

I'm glad you asked:

1. You don't demand it.  You don't want to deal with the people who know how to invest because, frankly, they're not nearly as fun as the relationship managers.  Investors are geeks.  They tend to drone on about things like cash flow and finding security mispricings.  Relationship managers golf well.  Relationship managers send you birthday cards.  Relationship managers make you feel like you're on their team and that makes you feel successful. 
2. Good investors require years of education and training.  Investors are, in a word, expensive.  Relationship managers, on the other hand, need to pass a barely relevant FINRA exam like the "Series 6" or "Series 7."  All that's really needed to run a successful investment firm are a bunch of ambitious, personable people who want to make a lot of money without having to study too much. So, hire a few investors to construct model portfolios, then send out an army of asset gatherers to jam customers into the sausage maker.  That's a really profitable model because it offers...

Scale.  You're OK with it, and it's way more profitable for the firms that employ it.  So, it remains as the dominant investment management service paradigm.

Puke.


A Bizarre Market Reality


Curiously, some firms do actually employ investors to work with each client to construct unique portfolios geared to satisfy unique financial needs.  And guess what?  95% of the time, it's less expensive than the traditional fee-on-fee approach the non-investors are forced to use.

This discrepancy shouldn't exist in an efficient market.  Investors should recognize the grossness of mass marketed model portfolios and investment products they're sold and should - in theory - fire incompetent glad-handers and hire investors.

But so often, they don't.

This comes back to a point I made in the first post in this series: markets don't function well when participants are either un-willing or uneducated.  That's what I'm on about: education.

Scale-induced incompetency is the cancer that plagues our business.  But, like a deep tumor, it's hard to tell that it's there.  The symptoms of its presence, though, tend to manifest in two distinct ways that are more easily discerned.  The next post will cover the two broad categories of symptoms: price and value.  In the post following that one, I'll conclude the series with my specific recommendations to extract maximum value from an investment management relationship.