How Wall Street Uses Complexity to Exploit You
The real reason investing feels so complicated and how to simplify your finances
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Investing is both important and simple.
Do you agree with both parts of that statement?
If you’re like most people, you would probably agree that investing is important, but few people believe that investing is simple.
This is by design.
The financial services industry has an economic incentive to convince you that investing is too complicated for you to handle on your own.
If investing is both important and simple, it’s something you can do yourself. But, if you believe investing is important but too complicated for you to handle, you’ll fork over your money to have an expert handle it for you.
The more complex investing gets, the more profits the middlemen can extract.
You get what you don’t pay for
If you don’t understand how the stock market works, it’s a simple task for financial advisors to pitch you an overly complex investment fund. If you don’t know what to look for, it’s easy to assume that complexity is important to outperform.
The advisor will likely trot out a bunch of statistics about how well the fund has done in the past and reassure you that they aren’t going to give you some boring old index fund. The message is clear: “if you invest with me, you’ll outperform.”
It doesn’t matter all that much if you don’t know what the hell is inside your portfolio; they’ll handle those types of details for you.
Except it matters a lot that you understand what your investing in.
A 2017 paper titled “Use of Leverage, Short Sales, and Options by Mutual Funds” found that investment funds that use risky, complex tactics like leverage (debt) and trading options lead to bad outcomes for investors.1
What bad outcomes, you ask? To quote the researchers:
“Lower performance, higher idiosyncratic risk, more negative skewness, greater kurtosis, and higher fees.”
Here’s a simplified definition of these technical terms.
Lower performance = lower investment returns
Higher idiosyncratic risk = risk investors aren’t compensated for taking
More negative skewness= risks of rare but massive losses
Greater kurtosis = more extreme outcomes
And by paying higher fees, you get to pay more for the privilege of lower returns, more risk, and volatile outcomes.
Often, advisors will use complexity to justify their higher fees. We’ve been told, “you get what you pay for” so many times throughout our life that many of us have come to view the terms “expensive” and “quality” as interchangeable. While that might be true when you’re buying a pair of winter boots, it couldn’t be further from the truth when it comes to investment products.
Research from Morningstar has shown that investment fees are the best predictor of the performance of an investment fund.2 The lower the investment fees, the higher the expected returns.
When it comes to investing, you get what you don’t pay for. Saving on investment fees means you get to keep more of your money.
Investing can be simple and profitable
You don’t need to mess around with complex investments that overcharge and underdeliver.
You can be a successful investor with a simple portfolio of low-cost index funds. If you can stay invested for the long run and ignore the temptation of trying to time the market, you’ll outperform most of these high-fee complex investment products.
If you want to build a simple, low-cost, passive investment portfolio using index funds, grab a copy of my new book, “The Rational Investor,” here. Paid subscribers to Making of a Millionaire can read the book for free here.
When to pay for investment advice
I don’t want to give you the impression that paying for financial or investment advice is inherently bad.
Even if you read every page of The Rational Investor and fully understood why a portfolio of low-cost index funds is the way to go, that does not mean you necessarily want to manage that portfolio yourself.
Maybe you’re too busy, aren’t interested, or lack the confidence to manage your portfolio all by yourself.
There’s nothing wrong with hiring a financial advisor. Just make sure you hire a fiduciary financial advisor. This is an advisor who has a legal obligation to recommend investments that are in your best interest.
You might think, don’t all advisors have that legal requirement?
Nope.
With non-fiduciary advisors, you can easily imagine situations where what’s best for them and you aren’t the same thing. Non-fiduciary advisors only have to recommend investments that are “suitable” for you. They could argue that a high-fee, complex fund is “suitable” for you, even if it’s not optimal.
If you work with a fiduciary, you can feel confident that they are giving you advice that they believe to be in your best interest. Remember, a fiduciary can still be wrong about what they believe to be in your best interest.
You also need to ask advisors what their investment philosophy is.
If they believe high-cost, active investment funds are the best way to invest, you may think twice about working with that advisor.
The perfect advisor for you puts your interest above their own and uses research and data to make recommendations.
Investing is important; if you let it be, it can be simple too.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
Calluzzo, P., Moneta, F., & Topaloglu, S. (2017). Use of Leverage, Short Sales, and Options by Mutual Funds. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.2938146
Kinnel, R. (n.d.). How Fund Fees are the Best Predictor of Returns. Morningstar UK. https://www.morningstar.co.uk/uk/news/149421/how-fund-fees-are-the-best-predictor-of-returns.aspx
Hi Ben. This article was so well written and highly aligned with the focus and approach of my own writings. Can you please reach out to me at beachman2115@gmail.com? I wanted to check in with you about something specific. Thanks