Financial Status

At a finance conference last year, I learned this: Instead of saving money directly for their own retirement, many workers have their employers save for them. Those employers hire in-house specialists to pick which specialty consulting firms to hire. These consulting firms advise employers on which investment firms to use. And those investment firms pick actual productive enterprises in which to invest. All three of these intermediaries, i.e., employer, consultant, and investor, take a cut for their active management.

Even employees who invest for themselves tend to pick at least one high fee intermediary: an active-management investment firm. Few take the low cost option of just directly investing in a low-overhead index fund, as recommended by academics for a half-century.

I’ve given talks at many active-management investment firms over the years. They pay speakers very well. I’ve noticed that (like management consults) they tend to hire very visibly impressive people. They also give big investors a lot of personal quality time, to create personal relationships. Their top people seem better at making investors like them than at picking investments. One math-focused firm said it didn’t want more investors because investors all demand more face time and influence over investment choices.

Since 1880 the fraction of US GDP paid for financial intermediation has gone from 2% to 8%. And:

The unit cost [relative to asset income] of financial intermediation appears to be as high today as it was around 1900. This is puzzling. Advances in information technology (IT) should lower the physical transaction costs of buying, pooling and holding financial assets. Trading costs have indeed decreased, but trading volumes have increased even more, and active fund management is expensive. … Investors spend 0.67% of asset value trying (in vain on average, by definition) to beat the market. … While mutual funds fees have dropped, high fee alternative asset managers have gained market share. The end result is that asset management unit costs have remained roughly constant. The comparison with retail and wholesale trade is instructive. In these sectors … larger IT investment coincides with lower prices and lower (nominal) GDP shares. In finance, however, exactly the opposite happens. … A potential explanation is oligopolistic competition but … the historical evidence does not seem to support the naive market power explanation, however. (more)

Our standard academic story on finance is that it buys risk-reduction, and perhaps also that we are overconfident in finance judgements. But it isn’t clear we’ve had much net risk reduction, especially to explain a four times spending increase. (In fact, some argue plausibly that those who take more risk don’t actually get higher returns.) On overconfidence, why would it induce such indirection, and why would its effects increase by such a huge factor over time?

Finance seems to me to be another area, like medicine, schools, and many others, where our usual standard stories just don’t work very well at explaining the details. In such cases most economists just gullibly plow ahead trying to force-fit the standard story onto available data, instead of considering substantially different hypotheses. Me, I try to collect as many pieces of related puzzling data as I can, and then ask what simple but different stories might account at once for many of those puzzles.

To me an obvious explanation to consider here is that we like to buy special connections to prestigious advisors. We look good when bonded to others who look good, and we treat investor relations as especially important bonds. We seem to get blamed less for failures via prestigious associates, and yet are credited for most of our success via them. Finally, we just seem to directly like prestigious associations, even when others don’t know of them. And we may also gain from associating with others who share our advisors.

To explain the change in finance over time, I’ll try my usual go-to explanation for long-term changes in the last few centuries: increasing wealth. In particular, social bonds as a luxury that we buy more of when richer. This can explain the big increases we’ve seen in leisure, product variety, medicine, and schooling.

So as we get rich, we spend larger fractions of our time socializing, we pay more for products with identities that can tie us to particular others, we spend more to assure associates that we care their health, and we spend more to visibly connect with prestigious associates. Some of those prestigious associates are at the schools we attend, the places we live, and via the products we buy. Others come via our financial intermediaries.

This hypothesis suggests an ironic reversal: While we usually play up how much we care about associates, and play down our monetary motives, in finance we pretend to make finance choices purely to get money, while in fact we lose money to gain prestigious associates.

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  • Kevin Erdmann

    I think you’re right. I did a post regarding the effect of reputation on fund expenses and performance here:

    The only thing I would argue with here is that reputation is actually becoming less important over time because of the commoditization of fund management which has been brought about by firms like Vanguard and by the technological advancements that you mention. Low expense index funds have become a much larger portion of assets.
    I think the larger costs have come about partly because additional needs for financial management that come from our compressed working lives and extended retirement have led to this extra layer of intermediaries, so that we tend to pay some fees to a planner to manage our risk profiles, even if they are using index funds to do it. To a certain extent, I think this is reasonable, although information asymmetries are a difficult problem here.
    But, I think much of the increase in total aggregate expenditures is from compliance due to growing regulatory oversight, which is a reaction to those information asymmetries. I think if you reviewed the work of any financial advisory office, you would find that the majority of what gets measured as their “value added” in aggregate accounting measures is regulatory compliance.

    • The article I cite says that on average the fee% of assets intermediated has NOT changed much over the decades.

      • Kevin Erdmann

        Skimming the article, I don’t see any mention of compliance, which I think anyone in the personal financial management area would say are responsible for much of the lack of a decline in proportional costs. Low cost funds are increasing in usage. I agree that reputation explains the use of high status/high fee funds, but this is becoming less important, not more. And, it is only natural that as trading costs decline, some of the savings will be mitigated by additional trading. And, as the costs of managing assets decline, alternative asset classes that have had limited investor access in the past will become more available, at a higher management cost than the traditional asset classes that they are displacing. This includes both non-corporate asset classes and the growing importance of emerging market assets.

  • This model seems to fit the anecdotal evidence I have from the few Berkshire-Hathaway investors I know. They seem to derive some pleasure from association with Warren Buffett — even a pseudo-familiarity.

    • brendan_r

      Oh, that’s for sure!

      But how do you distinguish efforts to, a) identify w/ a guy because he’s cool, from b) trying to profit from a guy because he’s a stud.

      Eliezer has profited from Richard Feynman’s ideas and therefore justifiably feels good identifying w/ him.

      Fact is, Buffett’s made people a lot of money. And the advice he dishes to would-be investors is excellent (if rather obvious and too general to be useful to most people; he hands you a framework).

      In every field there are people dishing useful advice to attentive learners who profit from their advice and admire them. That’s how I feel about Robin.

      But it doesn’t distinguish finance from other fields.

      And if it’s ubiquitous in finance then who is the #2 after Buffett? The median investor couldn’t name more than a handful of stud investors.

  • Andy Stein

    What about an alternative, simple hypothesis that people just don’t believe the decades of research on index funds and think they’re smarter at picking financial managers then they actually are? Sort of along the lines that something like 90% of people think they’re above average drivers. What evidence leads you to favor your model over his one?

    • That is called “overconfidence” which I did mention.

      • Andy Stein

        I guess I just see overconfidence and prestige/appearance as two pretty different explanations for why people give so much money to financial managers and I wasn’t sure how one would distinguish which is more important.

      • silent cal

        “On overconfidence, why would it induce such indirection, and why would its effects increase by such a huge factor over time?”

      • IMASBA

        It’s in the piece: retirement saving now works. differently from the way it used to (especially in America). Savings accounts and large pension funds have decreased in significance.


    There’s little to no status increase in it for the ultimate clients. I’m with Andy Stein (below): overconfidence is the major factor here. Clients are overconfident that the “right” middlemen can help yield greater returns and the middlemen think they’re better than other middlemen at “reading” the market. This is irrational but not strange: we’re constantly bombarded with the notion that the successful are consistently superior. Those same academics who (correctly) warn that you can’t beat the stock market do worship the likes of Warren Buffet, or Steve Jobs for that matter (the chaotic dynamics of marketing are no more beatable than an efficient stock market). We all suffer from domain dependence.

    P.S. You have to run to stand still on the stock market: even an index funds needs overhead but I completely agree when Robin’s implying that at least 75% of global investing overhead is dead weight.

  • Status seeking by business association has been channeled into finance because of the increasing dominance of the banks, but that doesn’t mean that, as we’ve gotten richer, we spend more resources on status. Business has always had an association-seeking dimension, apart from pecuniary interest. For example, in 19th century Britain, a commoner would prefer to enter into any kind of association with an aristocrat than with a commoner. [This conduct seems more associated with “decadence,” whatever that means, rather than with absolute level of wealth.]

  • Tom

    Most people don’t have a firm enough grasp of the market to trust themselves with investing their money. It’s reassuring to think that your money is in the hands of an expert, whereas investing on your own can lead to heart palpitations every time your portfolio takes a hit.

    The best analogy I can come up with is technology. There’s a subset of the population that can troubleshoot a computer and are willing to use Google to find a solution, while a much larger subset throw up their hands and call tech support if the problem requires anything more complicated than a restart (and many will call before they do a restart). They’re unwilling to go beyond their area of expertise and hand their problems over to a (presumed) expert to solve.

    • Is it reassuring to see your employer pick a consultant who picks an investor who picks an investment, all of whom take a cut? Really see that whole chain as “experts”?

      • Tom

        Personally? No. I suspect that the average employer is in much the same boat as the employee: they want to hand over the problem to someone else. Someone who has credentials and seems to know what they’re talking about.

  • Lord

    Many do rely on trust, even if misplaced, because it is about personal relationships to them. They often believe in conspiracies and corruption and the feel their only chance is to have someone on their side, even if they turn out not to be. Also remember though most individual investors are even worse at investing, so even this expensive support may be worth it.

  • annonn

    Isn’t it true that since 1880 the percentage of people who invest in stocks has grown tremendously? These are the people who are least confident about investment and wouldn’t believe you about index investing especially if you cited a bunch of esoteric academic studies. Perhaps hand-holding (even if the non-efficient sort) is the only way to assuage the fears of these investors. For many people, investing in stocks at 3%, 5%, or even 7% more than Vanguard is worth it if the alternative is that they choose much, much less.

    There is also the phenomenon that unqualified but otherwise smart people can be terrible investors because they are convinced they can beat the market. A high level Fidelity advisor told me that his doctor clients are unusually prone to falling for nice-sounding scams and don’t listen to moderating advice. The share of all these types of new investors would raise the demand for finance.

    • Lord

      I think this is the case, especially as many deferred plans don’t even offer index funds as a choice.

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  • aretae

    The Eric Falkenstein line that Envy rather than Greed explains things might be relevant here.

  • Silent Cal

    “Financial Intermediation” sounds like a broad category. Did investment management drive the increase in cost of “Financial Intermediation”?

    • The category also includes insurance and home loans.

      • Silent Cal

        …and did investment management drive the increase?

        Looking at the BEA data (, it looks like the “Finance and Insurance” group is being used as “financial intermediation”. “Funds, trusts, and other financial vehicles” and “Securities, commodity contracts, and investments” combined make up about 22% of that total. This is too small a share for these to have accounted for 4x GDP share growth.

        The other two categories, both large, are “Federal Reserve banks, credit intermediation, and related activities” and “Insurance carriers and related activities”–I can’t pretend to tell you what exactly those include, but I don’t think investment management falls into either.

        None of this indicts the signalling explanation of managed funds’ popularity, but that’s not the driver of the growth of finance.

  • brendan_r

    Snakeoil will always be for sale. The puzzle is why it’s purchased. In particular, why it’s purchased by the ultimate payor – the investor – not the agent (the employer) who doesn’t have much incentive to care.

    There is no way around it: delusional overconfidence mixed w/ ignorance is a massive part of the story.

    OB’ers don’t know regular people. They don’t know the non card-counters who think they can beat blackjack; the folks w/ lucky lotto ticket vendors. You probably do know engineers who think they can trade energy stocks profitably, but you underestimate its prevalence. Seeking to affiliate w/ impressive people can’t explain any of this. Seeking to BE impressive, yes.

    The space for delusion in finance is gigantic. Everyone’s either hit a homerun personally or knows someone who supposedly has. Analyzing performance and strategy plausibility is HARD. And people aren’t much interested in doing it anyway. They’d rather delude themselves than own up to their bad choices.

    I know so many folks in the 95th percentile of finance experience who are nonetheless not close to a realistic view of how things work.

    You know who is not deluded? People who are good at poker. For three reasons (none of which is that they’re not status conscious), a) incompetence costs money more rapidly and certainly in poker than stocks (delusion is cleansed more slowly in investing because you have to be truly reckless hurt yourself badly; and stupidity can pay well for long stretches), b) they understand the importance of rake/fees, c) they understand what efficiency is.

    • But overconfidence and ignorance was there in 1880. So why do we spend 4x as much on finance today?

      • What about that a much higher percentage of folks work for firms than in 1880?

      • brendan_r

        But the really high cost stuff isn’t offered through firms. You can’t access a hedge fund through your 401K. And they make it difficult for people to trade their own stocks. People are mostly steered towards moderately priced mutual funds.

      • Is the trend driven by the high-cost or low-cost investments? I can’t tell whether Robin’s first paragraph is an example or an encapsulation.

      • brendan_r

        I don’t know.

        Look, no doubt people are willing to pay for prestige in finance. But bank premises (at least before deposit insurance) are prettied up for different (overlapping) reasons than jewelers are: comfort/safety/trust vs. sexy status.

        Trust and comfort is big in finance.

        Securities law is expensive but comforting; that’s changed. And so is easy fast access to info: I’d feel uneasy if online brokerages went away.

        Maybe greater comfort has unleashed dormant overconfidence.

      • richard silliker

        See first paragraph of this post.

      • If the first paragraph describes the source of the trend toward financial nannyism (I can’t fathom why anyone would think of this as over-confidence), then it’s essentially just another way firms swindle employees.

        Numerous pressures are applied within firms to induce employees to let employers control their money.

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  • I would think a more likely explanation for this phenomena is that a lot of people are simply not making rational market decisions. They think these fancy highly-paid financial advisers must be good for something, because otherwise why would they exist? And so they patronize them because that’s the thing you do, and they spend a lot of time selling you on the benefits.

    • Why do they exist?

      • What do you mean? They exist because they’re profitable. This is capitalism, remember? There’s no requirement that a business produce any positive social value, they just have to have a legal way to accumulate money.

      • IMASBA

        Exactly. Sure, it’s a chickien and egg thing with these businesses being profitable only because people think they must be worth it since they are so profitable, but that’s true of countless others types of business in our world.

      • The problem is to explain why they’re profitable. There are innumerable scams one could imagine: why is this particular one successful.

      • I mean I’m not a scam artist and economics are complicated, so I’m not exactly sure how to answer that question. Why is any particular business model, whether it has social value or not, more successful than any other? Apparently in our current economic system, money management can produce a lot of profits by putting a lot of effort into convincing people that you can help them invest their money. So a lot of people get into that industry and get rich. There’s no particular deeper explanation, that’s just how it worked out.