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Could too many financial products be ruining your finances? Part 2

Posted by admin on March 10, 2010 in Investment Information

Today’s post is a continuation on the effect of choice on our personal finances. Yesterday’s post dealt with how the paradox of choice impacts on our finances generally. Today’s post deals with the effect of too much choice on asset allocation and costs.

When an issuer launches new mutual funds or exchange traded funds, this is typically spun as a good thing for the investor. The conventional line of thinking is that more choice allows the investor to customize their portfolio better. However, as with most product launches, the issuer and their shareholders tend to be enriched often at the cost of the investor.

In particular, too much choice tends to wreck havoc on asset allocation and costs in several manners:

1. Drift towards greater equity allocation than desired. Regrettably, many investors buy based on the name of the fund (my initial mutual fund investments were based on this criteria). In good times, they purchase XYZ equity mutual fund or ETF.  In bad times, these same investors purchase a newly issued ABC balanced mutual fund which is supposed to protect their downside risk while giving a little upside. The problem is that ABC balanced fund has equities in it already and, combined with XYZ fund or ETF, pushes the investor into greater risk/reward than they may have intended. A 2001 study confirmed this fact. The more equity based products a retirement plan offered, the greater the participants had money invested in stocks.
2. Investing in higher fee products. If you believe increasing product advertising contributes to the concept of too much choice (after all, how else do you cut through the noise except by, umm, contributing to it…), it also directly impacts on costs paid by an investor. Richard Thaler and Cass Sunstein, in their excellent book Nudge, quoted a 2007 study that ads by the financial industry tended to result in investors investing in higher fee vehicles (how else was the Super Bowl ad paid for?), higher risk (again, more exposure to equities), trendy sectors and home bias., one begins to understand how many investors looked at their portfolio in late 2008 and discovered they were over exposed to their risk tolerance.
3. Too much cash/not invested enough. As cited yesterday, too much choice tends to lead to investors not investing at all.

In summary, what can too much choice do to your asset allocation? You end up in the same position as many investors in late 2008; one wakes up to find out their portfolio has drifted into much greater risk and with higher fees than desired.

What is a poor investor to do?

First and foremost, as mentioned yesterday, always go in with an investment goal and investment plan first. If you do not have one, think long and hard about what you want out of your life and money. Stick to the plan through thick and thin (assuming it is reasonable and realistic) and always put product in a lower priority than the plan.

To state this another way, the question is not “what product will make me a lot of money with little risk?” but “what strategy most aligns with what I want out of life?”

Second, you cannot avoid choice being pushed upon you these days, the point is to filter out as much as possible as quickly as possible. I read many excellent blogs and financial columnists but tend to gloss over any post or column about new product issues. There is no magic bullet solution to life. Why would there be one for your portfolio? If there is a product that fits within my goals and strategy, I will actively seek it out rather than being sold on it.

Third, eliminate the niche products from your radar screen. When experts are asked how to increase employee participation in company sponsored plans, one of the first suggestions is to eliminate the sector or niche products. The holdings are so specialized and sometimes risky that most average investors are better off not even contemplating them. An ETF focusing on a single developing country or sector is not going to make or break most portfolios.

Finally, embracing too much choice, by adding new products to an existing portfolio, is not going to solve the problem. Most under-performing portfolios suffer from overlap, high fee product and trendy products of yesteryear. Running towards more choice is often not the solution. It is tantamount to continuing to dig to get out of a hole (“no, no, dig up stupid!”-Chief Wiggum). The solution to too much choice may be to narrow down your holdings and your choices.