The truth is, individual investors today don’t care as much about exposures as they do outcomes. They’re asking how to build portfolios that will help them achieve their financial goals.
“I Just Wanted Some Granola”
Have you ever stood in a grocery aisle trying to decide which brand of cereal to buy? Rich in fiber. Low in sugar. Organic. Non-GMO. Allergen-free. Shredded. Nutty clusters. Fruity flakes. You get the idea. Choosing from the sheer number of brands and types of cereal available today can make your head spin. Barry Schwartz’s book, The Paradox of Choice: Why More is Less, published in 2004, gave insight into this modern phenomenon.
Feeling overwhelmed by options in the grocery aisle is a near-universal experience, but this paradox of choice also applies to selecting investment products. The dramatic increase in available products, from fewer than 1,000 mutual funds in the mid-1980s when ETFs didn’t even exist to today’s 25,000-plus mutual funds and 2,500 Exchange Traded Funds, makes selecting the right investments a potentially confusing, and possibly paralyzing, endeavor. There’s even a term for it: “decision paralysis.”
Categorizing and ranking investment products
As investment products proliferated, consumers grew more overwhelmed. That’s when navigation of the investment universe became big business. Firms began creating ranking systems — shortcuts if you will — to help consumers better understand the investment products available to them. In doing so, these systems became akin to a “Consumer Reports” for the investment industry. The problem is, instead of creating a shortcut for financial advisors and individuals to choose the most appropriate investment, these services actually created a challenge: how to use a categorization system that’s tilted towards institutions to solve for the investment goals of individuals.
The truth is, individual investors today are no longer likely to ask which small-cap value fund or large-cap growth fund they should buy. They don’t care as much about exposures as they do outcomes. They’re asking how to build portfolios that will help them achieve their financial goals. And because their goals are time-constrained, they may not benefit from focusing on the statistical properties that drive the output of these categorization services.
Individuals differ from institutions
Is the same investment that is “right” for an institution “right” for an individual? The simple answer is: sometimes. Under the right circumstances. Depending on the individual’s situation. As in many things, the true answer is complex.
Individuals and institutions face many different questions, objectives and risks. Two of most notable differences are 1) their investment horizon (time) and 2) their objective (the success equation, i.e., return/risk). Advisors know this all-too-well. Successful financial planning requires a balance of making sure the right product is used at the right time for the right reason. But time horizon challenges can create statistical uncertainty for the individual investor that institutions may not be subject to traditionally.
In fact, an individual’s investment objective and personal timeline can cancel out the statistical “greatness” of one fund and give it to another one that’s “less great” in a categorization scoring system. For example, a highly ranked fund with the best traditional (i.e., institutional) return/volatility characteristics in a given category may severely underperform in a declining market environment. While the high rating may pay off in the long term as the fund outperforms in an up-market, the individual may not want (or be able to withstand) this specific market experience. The risk is that they’ll end up purchasing it anyway, based on a ranking that directs them into exactly what they’re trying to avoid.
The individual (through their financial advisor) is left with questions:
- When will using the shortcut of these ratings systems work?
- Where should caution exist when considering these ratings?
- Where should additional due diligence be done when the shortcut doesn’t provide an advantage?