One of the biggest issues facing clients and investment managers today is the agency costs involved in the relationship. The standard business model for investment management (revenue based on assets under management) while wonderfully scalable, misaligns incentives between the client and the asset manager. The business model rewards the investment manager for growing the assets under management more than investment performance.[1] There are ways to solve this issue, but it would require changing the business model and some managers are doing it successfully. Of course if you have the time and skill, an individual can solve this issue by managing her portfolio on her own. On the surface this seems like a simple was to remove principal/agent problem, but agency costs are present in more than just relationships.
Successful investment management takes a tremendous amount of time, skill, and luck. Few investors are able to beat the market consistently over the long-term. That is part of the reason why passive index investing has become so popular and will continue to accumulate assets.
If an individual is going to manager her own portfolio, it will most likely need to be her full-time job. That means that her income is based on the performance of the portfolio. This can create some strange dynamics. First, the tax code incentivizes long-term investing so trading in and out of stock profitably is difficult and costly. The investor will be forced to the hold more dividend and higher yielding stocks (agency cost) as a source for paying for living expenses.
This will also affect portfolio construction by possibly forcing the individual to construct the portfolio in a way that has high yield stocks as the largest portion of the portfolio, regardless of potential investment outcome (agency cost).
Because the individual is managing her own money, unless she is a dyed in the wool stoic, any losses will be felt much more emotionally than if a manager were managing the portfolio (agency cost).
The individual will also be more subject to prospect theory than a third party manager. The manger’s incentive structure allows for her to be more emotionally removed from short-term stock movements.
While people with the time and skill might feel more
comfortable managing their own portfolio, it’s important to understand that
while the money will be in your control, there are many things that are not.
Emotions, luck, and life needs will all play a role in an investment decisions.
[1] I understand that AUM will only grow if investment performance is good, but at a certain level, the level of AUM gives potential clients that the manager knows what she is doing and will have more confidence in the manager as long as performance is ok. Also, managers don’t usually think about the capacity of the investment strategy and would happily manage more money if it seems sacrificing some investment performance. That is not the fault of the manager, it’s just the way the incentive structure is designed.
The views expressed are my own. They have not been reviewed or approved by my employer. Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. Please read my disclosure page.
