Three dollar raffle tickets

It seems a number of readers have recently either taken my points out of context or missed the point altogether. Lately, I’ve been writing about cost and why it is important to keep expenses down. People have written back and talked about the importance of planning, the randomness of returns for actively managed products and the overall quality of advice they give.

I’m sure all of those points are valid but it seems some have missed the overall issue here.

The point that needs to be repeated is while short-term returns are unknowable and unpredictable, in the long run, the large majority of actively managed options lag their benchmark. The few that do outperform cannot be reliably identified in advance and those little factoids ought to play a role in the advice that is given.

Let’s play a game of logic…

Suppose there’s a bazaar being run for your daughter’s grade school and a separate bazaar for your son’s high school. Both schools are selling raffle tickets to raise money. In both cases, only 1,000 tickets are being printed (i.e. the odds of winning are identical) and in both schools, the prizes are also identical- $500 for first; $200 for second and $100 for third. The only difference is that one school is selling tickets at $2 a ticket and the other school is selling tickets at $3 a ticket.

If you wanted to maximize your personal outcome, which ticket would you buy? The answer should be obvious.

The flip side is if you’re the parent and you’re trying to maximize the revenue for your beloved child’s education, you’d want to get more people to buy $3 raffle tickets. Of course, you’re hardly an unbiased participant in this scenario.

“The odds of winning are identical and the prize money is exactly the same too. It makes absolutely no difference which ticket you buy,” you say to potential buyers.

That last bit is where the logic falls apart and the “friendly advice” crosses the line toward a self-interested sales pitch. The ultimate benefits, both as to probability and degree, are indeed identical. The only difference between the two options is the cost of participating in the first place.

Similarly, before cost, the average actively managed mutual fund investor and the average index investor achieve identical returns with identical probability of success. However, the index investor pays less for the product that gains access to the market so after cost, the average product that costs less does better than the average product that costs more. It cannot be otherwise.

In the immortal words of John Bogle, “You get what you don’t pay for”. Pretty much every study under the sun illustrates this point. Managing money is not a cost-free exercise and the most reliable determinant of long-term performance is cost.

That’s the thing with the advice people give regarding financial products. Cost is a material consideration in investing, yet a good number of advisors pretend that it is not.

The phrase “the client comes first,” means the client needs to know about important things affecting their choices. Things you’d want to know if the shoe was on the other foot. They should be allowed to make a decision based on what they feel is important not based on partial information that is filtered through their advisor’s own value system.

There’s nothing wrong with advisors who advocate based on their own beliefs. In fact, most of us wouldn’t want it any other way. Imagine (we might need to go back 50 years on this) though if a physician deliberately withheld telling a patient cigarettes are harmful to one’s health because he decided the studies that demonstrated this fact needn’t be disclosed. How does that square with the Hippocratic Oath?

Similarly, there are many who believe advisors have some kind of fiduciary responsibility regarding client welfare. How is that served when material facts are willfully or negligently concealed?

John De Goey, CFP, is the vice president of Burgeonvest Bick Securities Limited (BBSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BBSL. You can learn more about John at his Web site: www.johndegoey.com.