Discover more from Overcoming Bias
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.