Broker Check
Two Heads are Better Than One

Two Heads are Better Than One

August 30, 2021
Share |

In the 1980s, the New York Yankees gave star outfielder Ricky Henderson a six-figure signing bonus, only to find months later that he had not cashed the check. What gives, wondered the Yankees? "I'm waiting for money market rates to go up before I cash it," Henderson said. Henderson either didn't understand how interest-bearing accounts work (doubtful), or in his mind, he had made a sensible investment decision that was anything but wise.

When we hear of others' investing mistakes, we often get a good chuckle, doubting that we'd ever make such poor decisions ourselves. But we all make our own investment mistakes; it's just harder to see our shortcomings. Blame a psychological behavior that researchers call "blindspot bias," the tendency to see mistakes other people make, but not the mistakes (whether they are the same or different) that we create ourselves. Have you ever said to yourself, "I'm too close to the situation to see it clearly?" That's blindspot bias at work. And it's a danger to your wealth.

When it comes to investing, danger lurks behind every corner. Regularly, it seems, I have to persuade some subset of clients not to make a move that appears sensible or to follow through on a decision they are reluctant to make. Call it "behavioral coaching."

A year ago, the stock market was beginning to find its footing after the significant March Covid/lockdown plunge. You might have found it necessary to rebalance your portfolio by selling some bonds to buy more stocks. A few clients struggled with "taking more risk" at a time when things seemed so uncertain. The result of a failure to act? The Vanguard S&P 500 Fund has gained 31.2% in the last 12 months (the DFA US Large Cap Equity Fund gained 33.1%), compared to just 0.9% for the DFA Five-Year Global Bond Fund. Failing to rebalance? A considerable opportunity cost.  

How about sticking with value stocks? A small number of clients expressed severe doubts about the need to include small-cap and value companies in their portfolios any longer. The 90+ years of historical data and widely accepted theories suggesting that small/value stocks are riskier and have higher expected returns were no longer valid. In their estimation, "this time was different." Bailing out of small/value stocks a year ago would have been a disaster. Compared to the market's 31.2% return, the DFA US Large Value Fund has returned +43.3% in the last 12 months; the DFA US Small Value Fund has gained a whopping 65.6%, more than doubling up the S&P 500. Punting on value? Another huge opportunity cost.

Finally, what if you didn't completely give up on small/value but instead wanted to jump off the winning horse with the greatest likelihood of delivering the small/value premiums (DFA's asset class funds)? Instead, go with the slightly cheaper Vanguard Value and Small Cap Value Index Funds? I advised strongly against this, despite the Vanguard funds performing better in recent years. I knew that Vanguard offers more watered-down exposure to small-cap and value stocks. Their Value Index is less value-oriented, and their Small Value Index Fund is both larger and less value-oriented in price than the associated DFA fund. When value stocks are underperforming, Vanguard's funds typically do better because they hold larger and higher-priced growth stocks. But when value/small-cap stocks are outperforming, as they usually do, Vanguard's large-cap growth bias in their value funds will result in much lower net-of-fee returns.  

Novices only focus on costs, more sophisticated investors know that portfolio construction and management process matter just as much.

So what happened? With value's resurgence, DFA dominance has predictably resumed. Compared to the 43.3% return for the DFA US Large Value Fund, the Vanguard Value Index returned just 35.2% (over 8% less). Compared to the DFA US Small Value Fund's 65.6% return, the Vanguard Small Value Index returned 53.8% (almost 12% less). Making changes to your long-term portfolio based on recent past performance? Yet another painful opportunity cost.

Any of these mistakes would have cost you a serious amount of potential wealth. And these are just examples over the last year. If I were to list off similar situations I've experienced in the previous 10-15 years, it would take a book instead of a blog.

We almost always ignore opportunity costs when measuring the cost of investing, usually because we have a blind spot for them. Everyone can cite a 1% a year advisory fee, and some argue that rate is too high (it's not); how many admit to the mistakes they would make without the advice of a financial advisor that would cost them many multiples of the fee? Not to mention the time spent researching and worrying about the moves? Self-managing your wealth is usually bad for your bottom line and your blood pressure.

What makes a financial advisor immune from blindspot bias, you ask? We're not. It's just that blindspot bias, you'll remember, only applies to our own situation. We see the circumstances of others much more clearly. My mistakes are far more likely to affect my assets, not yours. "Do what I say, not what I do" is an apt phrase for explaining blindspot bias.

If you're honest, you know, left to your own devices, your self-directed financial decisions can be a danger to your wealth.  If you disagree, it could very well be because you're too close to your situation to see it clearly. But there's good news—it's not you, it's how we're all wired. If you work with and trust a financial advisor to help you, the risks drop significantly. As the old saying goes, "Two heads are better than one." 

___________________________________________

Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.