You could say that when more restaurants pop up in a city, the easier it is, at some point, to find reasonably priced restaurants that offer good food and service – good on an absolute basis. The amount of competition does not reduce the chances that a new restaurant will deliver great food (on an absolute basis); quite the opposite. And that’s because in order to be competitive, you need a certain minimum level of quality.
Similarly, the more investment professionals there are around who offer funds etc. with different styles and strategies, the easier it becomes to find one that possesses decent investment know-how, one that does not collapse and lose all client money, etc.
Quality and Excellence
However, the more competition in a city, the more difficult it will be for a restaurant to be great on a relative basis. It will be very hard to excel (relative to the others). The average restaurant is already very good. And in the meantime, you may have great food that can be delivered to your home, in many cases much better and much cheaper than in a nice and trendy restaurant. Of course, the restaurant needs to pay salaries, rent, interior designers, etc. It is not just about food in rich societies – when people go to a restaurant, they generally also want the “experience”. The “nice and trendy” in “nice and trendy restaurants” has a value (for some).
The more competition in the investment industry, meaning the more banks, investment managers, advisors, etc. offering investment products, tailor-made strategies, etc., the lower the probability that they will excel. And the harder it becomes to beat the take-away services of asset management: low-cost, passive investment products and strategies (equivalent to the market average). If there were just a handful of investment managers investing in listed equities, competing with retail investors, they would have decent chances to beat the market. According to EFAMA, the European asset management industry association, there are over 4’500 asset management companies in Europe. Less than the number of restaurants, but enough to suggest that it is indeed crowded out there.
As reminded by Warren Buffett in his 2016 letter, and elegantly formulated by Nobel Prize William Sharpe in 1991, the market is the average. Let’s say you have passive investors on one side (those who go for decent takeaway or are decent cooks) and active investors on the other side (those who try to be better than the average). It doesn’t matter how highly talented the professionals investing actively are – they will have to perform on average roughly as the market – actually market minus costs.
Individual preferences
One may say “I still prefer to pay more for a dinner at a restaurant than having cheaper, better food at home”. Fair enough. I think there is a limit though – at some point this does not make you happier, it likely just makes you more addicted to going out. Some will say “What are you talking about?!?! That’s how our economic system is supposed to work!”. But by the way, when you see so many people sit at the restaurant watching their mobile phones instead of their partners or friends, doesn’t it say something about diminishing returns from going out? You decide.
Anyways, similarly, one may be happy to pay high fees for investment products, customised advice, tailor-made solutions, all accompanied by a cup of coffee to be enjoyed on a designer leather-chair… the problem is that the market average remains the market average. The market (average) does not care about the coffee, the cup, the chair … or the leather (be it real or eco-leather). Assume the world is made almost entirely of boring passive investors, except for two advisors allocating 1’000 francs (or euros) for their clients. For each 1’000 francs or euros or whatever that gets allocated to an outperforming asset (single stock, stock sector, fund, …) there is another 1’000 that underperforms (you have to assume at some point someone will trade again of course). Unfortunately, that’s how it has to be. The stock market is not a zero-sum game, but alpha (the outperformance, the ability to add value relative to the average) is. Alpha is actually a negative-sum-game, since there are always costs involved.
Just like with dining out – is there a point where it just does not make sense to spend money on a negative-sum game?
Choosing consciously
Savers and investors should be aware of the arithmetic law of passive vs. active investing – that the market average has to remain the market average. Expensive solutions (and with expensive I mean including explicit and implicit, direct and indirect costs) may feel good (sense of security, positive feeling of being taken care of, feeling special, expectations of great performance – and let’s not forget selective memory) but over years, decades – a lifetime – these costs erode returns to an often-unimaginable extent.
And people too often forget to compare results with an appropriate benchmark. How does someone perform relative to the average that could (with no hindsight) have been obtained at a very low cost with a passive approach?
Just like everyone is free to dine out every day, everyone is free to spend how much money he desires in fees and commissions, even when there is an overall negative expected value. Who knows, maybe he will do better than average, thanks to skill, luck, or a bit of both. But are we always sufficiently aware of the arithmetic law highlighted by Buffett and Sharpe? Do we ignore benchmarks or keep them sufficiently well in mind?
Photo from Unsplash by Delightin Dee