The Ego, The Market, and The Mania

Numbers and Prices can have an interesting impact on our decision-making.

Consider the following scenario that was presented in a study by Princeton’s professor of Behavioral Finance Eldar Shafir:

in three successive years, James, Joseph, and Chris each bought a home that cost $200,000, and each ended up selling their home one year later. During James’s year of homeownership, the country experienced 25% deflation – that is, the average price of all goods and services in the United States fell by 25% – and James sold his house for $154,000, or 23% less than he had paid. During the 12 months that Joseph owned his home, the situation was reversed: the average cost of goods and services actually rose 25%, and Joseph eventually sold his home for $246,000, or 23% more than he paid. As for Chris, the cost of living during her year long stretch of owning a home state pretty much the same, but she ended up selling her house for $196,000, or 2% less than she paid.

So who fared the best in this confusing scenario?

According to Shafir, a majority of the participants in his study – about six in 10 – thought Joseph (who notched a 23% gain during a period when the average price of goods rose 25%) came out on top and James (who posted a 23% loss versus a period when the average prices of goods fell 25%) fared worst. These majority conclusions are interesting, because they’re wrong.

James was actually the only homeowner who made any money. (Most of the respondents did not have understand the impact of inflation)

So what is this number confusion have to do with investment fees. Well, as it turns out, quite a bit.

You see, investment fees can be just as difficult to figure out…

Let’s try another example:

Suppose you had to invest $10,000 in one of two International Mutual Funds specializing in Mid/Large Value Companies, each fund with the following characteristics:
Mutual Fund A
Purchase Cost = $0
Yield = 3.18%

Fund has never had a negative return (13 yrs)

Mutual Fund B
Purchase Cost = $40
Yield = 2.67%

Fund has had negative returns (4 out of 12 yrs)
At first blush, Mutual Fund A really shines, but what if we dig deeper and looked at their return history:
Mutual Fund A
Purchase Cost = $0
Yield = 3.18%

Fund has never had a negative return (13 yrs)

5 YR Return = 22.74%

Mutual Fund B
Purchase Cost = $40
Yield = 2.67%

Fund has had negative returns (4 out of 12 yrs)
5 YR Return = 23.26%
Well, that changes the picture a bit. Fund B actually returned more than Fund A over the last 5 years. But those are just average returns. What if we used the actual returns on a hypothetical $10,000 investment (i.e. the year in/year out return used to make up the averages)?
Mutual Fund A
Purchase Cost = $0
Yield = 3.18%
Fund has never had a negative return (13 yrs)

5 YR Return = 22.74%

$10,000 (invested 2002) = $27,666 (2002-2006)

Mutual Fund B
Purchase Cost = $40
Yield = 2.67%
Fund has had negative returns (4 out of 12 yrs)
5 YR Return = 23.26%

$10,000 (invested 2002) = $27,208 (2002-2006)
Interesting. Now Fund A looks like slightly better fund given its order of actual returns for the last 5 years. Maybe we should compare their performance for the past 1 Year Period:
Mutual Fund A
Purchase Cost = $0
Yield = 3.18%
Fund has never had a negative return (13 yrs)

5 YR Return = 22.74%

$10,000 (invested 2002) = $27,666 (2002-2006)

1 YR Return = 16.18%

Mutual Fund B
Purchase Cost = $40
Yield = 2.67%
Fund has had negative returns (4 out of 12 yrs)
5 YR Return = 23.26%

$10,000 (invested 2002) = $27,208 (2002-2006)
1 YR Return = 27.92%
Fund B provided almost double the return; This certainly only serves to cloud the picture further.

So, here we have very similar funds that have returned very similar amounts over the years. This becomes a very difficult decision indeed.

But, of course, there is a catch…

If you have been reading my past columns, you know that I like to evaluate how numbers and money influence our decision-making – essentially concentrating on how our ego and the media get involved in the process.

Would it help to know that Mutual Fund A was a candidate for Morningstar’s International Manager of the Year and made the Top 100 Funds list produced by Barron’s? Indeed interesting media comments to consider…

But of course, I left out some figures in the scenario above…Would the decision be easier if you knew the following?

Mutual Fund A

Annual Expense Ratio = 1.12%

Commission/Load = 0.00%

Transaction Cost = $0

Ten Year Expense Projection = $1,860 (est. per $10,000 invested)

Mutual Fund B

Annual Expense Ratio = 0.48%
Commission/Load = 0.00%

Transaction Cost = $40

Ten Year Expense Projection = $640 (est. per $10,000 invested)
Over the longer term, the reduction in expenses from Mutual Fund B will help it to produce superior returns. In essence, given the above example, Mutual Fund A must earn an additional 0.64% just to keep pace with Mutual Fund B.

So, even though there was a $40 transaction charge to purchase Fund B, the total expense as represented by cost of ownership is well below that of Fund A.

Expense reduction in investing is one aspect in the process that we can control. However, it is important to make sure that it is done utilizing all available information to arrive at the actual result.

Failure to consider total impact will leave us choosing Joseph over James every time.