Customer confusion is a phenomenon that has emerged relatively recently and is normally considered in terms of conventional marketing. For instance, if you go into a big box store, you will be confronted with dozens of models of various products, which, to the average person, may look pretty much the same. This can be confusing and problematic for both customers and firms.
The same thing often occurs in the investment market, but the effects are even more substantial and the consequences for consumers may be far more serious than for other goods and services. If you've ever felt overwhelmed by the array of financial products in the market, read on for some tips on how to simplify your portfolio.
A number of studies reveal that while customers may initially be attracted to a wide choice of products, many eventually give up in despair or make the wrong decisions. For instance, Frank Pillar and his colleagues investigated the consequences of mass confusion and the "burden of choice" in the online world (Journal of Computer-Mediated Communication, 2005). I also looked at the confusion phenomenon from a broader marketing perspective in "Choice That Sends Out Wrong Buying Signals" (Daily Telegraph, 2005).
What these studies suggest is that being spoiled for choice has serious implications, not just for the successful marketing of investment products, but on the gains or losses for investors. In the investment sector, the main victims are those that are financially inexperienced and rely on brokers and advisors to recommend products.
Too Many Choices
For instance, investment magazines and the financial sections of many newspapers display a remarkable array of products, categories, sub-categories and statistics. This often confuses consumers.
Take theThe Wall Street Journal Europe, which has a section on international investment funds. In August 2007, the total fund listing for Alliance Bernstein, which is just one organization, contained more than 60 funds: five conservative funds, seven balanced and various permutations of growth funds, value funds and so on. For less experienced investors in particular, choosing which fund or combination of funds will work best for them can be very difficult. (To learn more, read Picking The Right Mutual Fund.)
Too Much Complexity
Some products such as (certain types of) certificates, options and derivatives are notoriously complex and each constitutes its own esoteric world. An article from the highly-regarded Swiss Neue Zuercher Zeitung entitled "Confusion Over Complex Financial Products" (July 2007), makes this exact point. Referring to the collateralized debt obligation (CDO) market, the article points out that because of the high level of complexity, these products are difficult to evaluate and rate.
Furthermore, the markets for all investments are in constant flux. This means that even if you have clarity at one point in time, confusion can arise later as a result of ongoing developments relating to interest rates, market sentiment, economic data and many other factors.
The Dangers of Confusion
With the truly overwhelming selection of assets in the financial markets, many investors find it nearly impossible to make efficient and effective purchasing decisions based on the right criteria. In fact, they are often totally unable to figure out what they really need or even understand what they are being offered. When investing becomes a stressful ordeal, customers' minds tend to shut down in protest. Their wallets either go back into their pockets or their money ends up in the wrong place.
In addition, inexperienced investors are particularly vulnerable to misselling. As a result, cases abound in which people put large sums of money into the hands of a broker, having no idea how their money will be handled. In a worst-case scenario, the money is plugged into products that are totally unsuited to the unwitting investor. (To learn more, please see Is Your Broker Acting In Your Best Interest? and How Risky Is Your Portfolio?)
The growing number of choices in the market can mean that even experienced brokers may not be able to cope with the changing array of funds in the market and, as a result, may limit themselves to a very narrow range. In other words, brokers may sell specific products either because they are genuinely good, or simply because they are familiar. The latter reduces confusion - even for brokers - but can be financially dangerous for their clients. Unscrupulous brokers may also stick to the products that bring in the highest commission. This truly unethical behavior is also facilitated by consumer confusion.
Coping with Confusion
There is a right and a wrong way to cope with confusion about which products belong in your portfolio. The wrong way is to cop out and put everything in cash or in one product or asset class. This leads to a poorly constructed and inadequately diversified portfolio. Conversely, some investors have a hodgepodge of all kinds of assets that do not fit together at all. This is also poor asset allocation and it too can prevent an investor from realizing appropriate returns. (To learn more, see Introduction To Diversification and Asset Allocation Strategies.)
Find A Trustworthy Advisor
Learning enough to make good investments or finding people you can rely on and trust are good ways of working through the customer confusion problem. Some effort is essential in order to avoid falling into the classic investment traps. That is, you need to make sure you either know how to invest well, or you need to know that you are relying on people who merit your trust.
However, given the extraordinary complexity of the investment world, it is necessary to accept some limitations to the above. In this business, even an expert does not know everything. For example, a bond specialist may not be the best person to turn to for guidance on equity investments or foreign products. In order to get the best financial advice, you need to consider where people's expertise lies and where it ends.
Keep It Simple
Even if you have good advisors, don't let your portfolio get too busy. Limit your portfolio to a variety of asset classes and items that both you and your broker understand. For example, the conventional wisdom is that if you have a portfolio of individual stocks, 10-15 stocks is about all that you can cope with without becoming overwhelmed. It simply is not possible to keep tabs too many bits and pieces in a portfolio.
For this reason, despite what they often promise, funds with 40 or more holdings tend to track the market as a whole. That is, individuals or fund managers with overloaded and excessively complex portfolios tend not to manage them actively and effectively. As a result, a market index fund that is designed to move with the market may be more effective - not to mention much less confusing. (To learn more, read Index Investing and The ABCs Of Stock Indexes.)
In the same vein, if you have 30 different funds, it is likely to be very difficult to manage, monitor and control them all effectively. For some investors, a mixed fund that does all this for you might be the best way to avoid confusion. Such funds contain a combination of asset classes such as stocks, bonds and alternative assets and they do all the monitoring and rebalancing. If they do it well, it is probably the simplest and least confusing way to invest for those with limited time or little inclination to manage their own money.
The Bottom Line
If confusion is to be avoided, you need to keep your portfolio simple and sensible, but at the same time, sufficiently diversified. Take the time to find this balance, and avoid becoming overwhelmed by new products. Investing needn't be complicated, and if you avoid confusion, your portfolio will reward you for it.