The best question investors never ask(Read article summary)
Even when it comes to money matters, many investors are afraid to talk about costs, lest they come off as impolite, or worse, cheap.
There is one question every investor should ask when faced with any financial decision:What will this cost me — all expenses considered? Yet I can’t remember ever being asked that question in 40 years in the financial services industry.
Instead, I hear from clients, “How much does it yield?” Or, “What kind of returns has it produced?” Or, when they’re told I charge by the hour, “What is your hourly rate?”
That last question sounds like it’s about cost, but it’s really about price, which is not the same thing. To understand the difference, consider another question: Who is more expensive — an experienced, effective advisor who charges $300 an hour, or an advisor who charges $150 an hour but may take twice as long or is less competent?
It isn’t surprising that investors don’t ask about total costs when it comes to fees for investment advice or management. Some won’t even bring up the subject to avoid seeming impolite or, worse, cheap. But the whole subject of cost (and price) is loaded with behavioral and framing biases.
We are also vulnerable to pricing manipulation. Gimmicks like 99-cent pricing and “buy one, get one free” convince us we’re getting a good deal when we may just have been conned into paying more or buying more.
The manipulation may not even be deliberate. Our own human nature can lead us to misperceive or miscalculate costs, and the way we pay for goods and services can cause misunderstandings. This is particularly true with investment advice because of the difficulty in comparing commissions (which are transaction-based) to annual asset fees (for ongoing engagements) to hourly rates (which can be both).
Commissions and “markups” are often included in a product’s price (for example, with load mutual funds or municipal bonds). Commissions must be noted in the prospectus, and the salesman is required to disclose costs, but that detail can get lost in the sales pitch. Unsophisticated buyers could assume that they’re not being charged or that the salesman is paid by a third party.
Even sophisticated buyers might think they’re getting a “freebie” if they don’t have to see the bill. Dan Ariely, author of “Predictably Irrational,” asks whether, after eating at a nice restaurant, you feel better if your spouse pays with his or her credit card instead of you paying with yours. People generally do — even when the money is coming out of the same joint account.
Asset management fees on brokerage accounts are charged quarterly and deducted automatically. Clients see only one-quarter of the annual fee on a single section of every third monthly statement. An example of out of sight, out of mind?
Hourly or project fees, on the other hand, are usually paid in a lump sum, and no one likes to write a big check — to an advisor, to the IRS or to anyone else. Ariely calls this “the pain of paying.” So while you may pay less to an hourly advisor, you could feel greater pain.
Painful or not, it’s important to do the math. Cost matters more than just about anything else when it comes to returns. A smart investor calculates all investment costs, including commissions, surrender charges, CDSCs (contingent deferred sales charges), withdrawal penalties, transaction costs, taxes, asset fees and mutual fund expense ratios. While this information is available, it’s not always easy to find. And just because you don’t see a charge, don’t assume you aren’t paying one. Ask the question.
Controlling costs is a critical component of successful investing. The easiest, quickest and surest way to raise your investment return is to eliminate unnecessary expenses.
Learn more about Kent on NerdWallet’s Ask an Advisor.