Tuesday, August 27, 2013

Why retail investors could care less about rates of return

I often hear from those who serve the retail market that they are rarely asked for their rates of return; this seems a bit odd, as it would make sense for investors to want to inquire into a prospective manager's track record.

An article in this past weekend's WSJ might hold the key to a possible reason: the dislike for mathematics.

Alexandra Wolfe's article, "Edward Frenkel and a Love of Math" explains how most folks avoid anything with numbers. Frenkel, a professor at UC Berkeley, suggests that "you say the word 'math' and people shut down."

When I was working on my second masters (an MBA), I also served as an adjunct professor, and once taught a class on business math. Perhaps because of my approach, I was able to get students, such as those Frenkel references, to find some enjoyment in math. But for most folks it would be difficult to break through the walls they've constructed.

I wonder if most adults could answer the following question: an investor begins with \$10,000 and earns a 4% return; how much money did they make? Do most adults even understand what a percent is? If a financial planner or advisor tells an investor that his/her return was 6.12% versus the benchmark's 5.75%, would this mean much? Would they think it's a good or bad thing?

Further research would definitely be needed to try to uncover the basis for the avoidance of the subject, but I suspect that ignorance might be part of it.

11 comments:

1. I think you are right: all "normal" people hate math - or at least they don't have warm feelings when confronted with it. So, why do we communicate with clients in mathematical terms, such as "total return?" Why not try something practical that they DO understand: MONEY! What's the difference between saying: a) you earned a 4% return on your beginning market value of \$10,000 and b) you started with \$10,000 and you gained \$400 more? Which one is the better communication: the one that is "technically" better, or the one the client understands? We practitioners tend to speak in jargon and financial English (AKA "FEnglish") so your lesson to analysts is well taken: speak in your client's language.

2. Good question ... as opposed to some of your other, more lame, questions.

BECAUSE to say that you earned \$400 doesn't communicate enough. Let's say there is a second investor who started with \$20,000 and he, too, earned \$400 ... did they do equally well? Or, if a third started with \$100,000 and earned \$400? Or, the investor who started with \$1,000 and earned \$400? Percentages bring the starting value (and cash flows) together to compare with the ending value to provide a return that has meaning from a "performance" perspective; the gains/losses are just that: gains and losses. They have some value, no doubt, but not enough. Plus, if the manager is conveying to the client how he/she did (as their manager), it's possible (as you know) that the client LOST money but the manager had a positive return; the loss came from the client's poor cash flow decisions (and again, as you know, investors typically chase returns). 'nough said :-)

3. Au contraire, mon ami: I said "You STARTED with \$10,000 and you now have \$400 more." This is equivalent in all respects to saying "you earned 4%" but it is probably more understandable and relevant in its communication. I believe your deep-seated love for math is showing.

4. It's true that my love of math runs quite deep (how else could you explain my occasional reading of math books!). I think that there is definitely a benefit to let them know how much they earned, too. But to judge performance, returns are better. Do we simply say that Baseball Player A had 200 hits this year and Baseball Player B 250 hits? If we did, we'd say B did a better job; but by reporting their batting average (A's is .310 and B's .298) we have a better sense of their performance. Hits and batting average, like money and returns, both have value; one has to know the perspective. Ah, that word again ... perspective :-)

5. I agree with Dave, nothing in finance could be more malapropos than using a point metric...But using a point metric to measure gains might not be as interesting an example as much as looking at losses is. People for some reason get a little more confused when looking at the rate drop towards 0…Here is an example:

In one week the Dow Jones Industrial Average dropped nearly 2,000 points.(dropped from 10,000 to 8,000) If it keeps falling at this rate, the index will hit zero in one month's time.

So it’s not just the layman investor that doesn't get the difference…the above example is from a widely followed financial online site in 2008.

6. Excellent points ... thanks!

7. From Debi Deyo Rossi:

Interesting column and interesting perspective.

My take is that retail investors care about how much money they have made, not necessarily the rate of return (although, I do believe they care about this). I think that is why the Growth of a Dollar charts are used so often in the retail space. I don’t know if it is the “math” that shuts people down. If someone invests \$10,000 and you tell them they are up 4% for the year that does not sound as exciting as, “Your portfolio made \$400 for the year.” I know there may have been cashflows and other events that may have occurred but I think an investor will be able to visualize \$400 better than 4%. That \$400 can pay for an upgraded cellphone or pay for your kids sports fees or go towards a nice vacation. Actual dollar amounts are easier to “see” and easier to imagine what it can go towards…4% just doesn’t have that same effect.

Well, that’s just my 2 cents…which quite frankly may not seem like much, but it is 100% more than what I was going to give.

8. Dollar amounts are easier to see but if evaluating your past performance holds the key to your future investment decisions then rates of return are necessary.  I think the argument that Dave is making and I agree with, is that the growth of an investment amount can easily lead to logical fallacies.  For example, if you made \$400 in your \$10,000 investment in your first year of investing and the following year you make \$416 and as you mention we don’t factor in flows.  You can boast to your friends that your investment performance is improving year over year since you made more in dollar terms, however, the reality is your rate of return was the same as the year before…

9. Thanks for posting for me, Dave.

10. You're welcome!

11. Interesting point ... thanks!

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