We Can’t Go On Like This
Why the financial industry is failing.
Here’s an uncomfortable truth: Retirees and future retirees are careening towards a financial crisis and the only way out is through higher returns that are unlikely to materialize.
Research by asset manager Natixis has found that 63% of investors have no financial plan and 51% don’t have the financial goals on which a plan might be based. These numbers are worse for individuals who aren’t investing at all. Even more concerning is a 2011 study that found that while “households aged 60 years and older control more than half of the wealth in the United States,” those households showed a consistent linear decline in financial literacy with no commensurate decline in their confidence making important financial decisions.
Declines in competence without commensurate declines in confidence at best increase the probability of making mistakes and at worst the probability of being taken advantage of. It’s perhaps in recognition of that fact that financial misconduct is most prevalent in counties with wealthy elderly populations.
Collectively, this means that about $45 trillion in this country is either un-managed or mismanaged, which is a pretty sobering thought.
Another sobering thought
Even leaving that massive problem aside, we’re still in dire straits. That’s because even the people with plans are likely to come up short in the future. Without Social Security or defined benefit plans (neither of which seem long for this world), it’s only earnings on savings that will help individuals meet future financial goals. But we’re seemingly blind to what those earnings will be.
For example, recent work by Research Affiliates demonstrates that the probability of conventional asset allocation plans achieving their underlying expectations is not only low, but in some cases rounds to zero. The industry, in other words, is failing to design for and deliver the higher returns customers need…which is why I wish I sold tacos.
I sit in our local taqueria and envy the simplicity of it all. When people come in, they know how hungry they are and they know whether they like it hot, medium, or mild. They’re also willing to pay for extra guacamole and know a good taco when they see it.
Ah, to sell tacos. Or to work in any industry where the price one pays for a good or service agrees with the consensus estimate of its value.
In the financial industry, it’s the opposite. For one, the customers are delusional. They don’t know what they want or need and have no idea what it should cost. Further, while a taco hawker can guarantee deliciousness, no financial industry professional can legally or in good faith guarantee anything. Financial outcomes are too variable, the stock market too volatile.
For two, the relationship between price and value in investing is opposite what it is everywhere else. Generally speaking, as one pays more to invest, the quality of the return stream that results goes down. This is because cost is such a powerful frictional force when it comes to compounding capital. It’s a tautology, but the less you lose, the more you keep.
What’s more, forces are conspiring to drive pricing in this space to zero. Not only does the current industry leader (Vanguard) operate as a not-for-profit, but rising competition funded by irrational venture capital means proprietors are willing to acquire customers at prices that may never prove profitable. This is troubling because if you agree that the industry needs to earn better returns for customers, there is little incentive to figure out how to do so.
Your reaction here may be crocodile tears. After all, practitioners in this space have charged too much for too little for too long and there is no shortage of too-rich fund managers. But that doesn’t change our future of financial insufficiency and its social, political, and economic consequences. Market-cap weighted index returns aren’t going to get the job done at scale.
But is there a better way?
When Josh Brown opined on this topic, he correctly noted that market-cap weighted indices — indeed all benchmarks — are not end-all-be-all standards. Their construction methodologies are flawed and can be improved upon, theoretically resulting in better performance. The problem is that it takes a lot of time and work to discover outperformance — work that does not come cheap. To date, most of those improvements either have not been significant enough to overcome the current standard’s cost advantage or — in the case of something like Renaissance’s Medallion Fund — lose their significance at scale and so cannot solve for mass market returns.
Earning returns, though, is hard, while driving down costs is comparatively easy. And while I applaud all of the work that has gone in to making this the cheapest time in history to invest, I do wonder if the industry’s relentless recent focus on cost reduction means that we’re missing — or will miss — some slightly more expensive ways to think about earning better returns.
Maybe not — the track record for the underperformance of active management runs deep — but I like to think that just as one can charge more for a universally regarded better taco, investors will one day be able to pay a little bit more for a better investing product.