Services marketing is a well-established field that can provide investors with some useful insights into the investment sector as a whole. Some interesting issues emerge if you look beyond the specific investments themselves and consider what the nature of the services imply. This connection is seldom made in investment literature, or even in marketing literature, but the two fields complement one another extremely well.
The very nature of services - which make up a large portion of what the investment industry provides - can create some awkward problems for investors. In this article, we'll look at some of these problems and provide you with some ideas to solve them.
Services are intangible. The old adage "what you see is what you get" doesn't really apply to investments. All you see up front are brochures, internet sites and other written material, generally containing boastful statements about past performance. You may hear some subjective recommendations and praise, but much of this can be attributed to "spin', to make an investment sound and look good. The actual attributes of the investment itself are more difficult to determine.
In the same vein, you don't actually own a service. Investments give you rights to assets, rather than ownership of the assets themselves. Unlike an automobile, for instance, you cannot get into a bond fund and take it for a test drive. For this reason (amongst others), the investment market is not an easy one to evaluate. Some investments, like government bonds, are not even backed by any physical manifestation at all and are just loans based on trust and credibility. A common stock generally has some kind of business behind it (which might be a service anyway), but investors still do not buy a tangible item.
Investors pay the investment industry for many intangible benefits. Although many of these benefits undoubtedly have value, it is difficult for investors to measure the value - not to mention an appropriate cost - for investment services.
Adding to the above, informational asymmetry, that is, an imbalance between what is known by the buyer and seller, constitutes a classic services industry dilemma. Particularly in the investment market, there are frequent and often very substantial informational asymmetries and conflicts of interest between the buyer and seller in a transaction. The seller is the one who is generally prepared and well informed, but the buyer may not be.
This informational asymmetry can create an unfair situation in which the buyer/investor has to rely on and trust the seller of an often rather unclear and/or complex service. This issue of reliance is crucial, given that most investors, even experienced ones, must rely to some degree on their brokers, banks or on the fund providers themselves.
Informational asymmetry in investment service transactions can put investors at a disadvantage, particularly when they do not entirely understand the benefits and drawbacks of the services they receive. As such, investors can end up buying into products or services that are not appropriate for them, or paying too much for products and services that will not provide adequate benefit for the cost incurred.
Service heterogeneity describes a situation in which services tend to be extremely varied and are delivered by many different people. This problem applies to the financial industry on a grand scale. The number of different stocks, funds, certificates, bonds, options, derivatives and so on is truly unlimited. And there are lots of managers, analysts, intermediaries, agents and brokers involved - all the way to the proverbial bank. This wide variety of choice makes it hard to choose properly. (To learn about these building blocks of finance, see our Investing 101 tutorial.)
The standard services industry problem is exacerbated for investors, because the variability and complexity have important implications. When you buy a new TV or even a car, variability is unlikely to seriously impact your entire future, but this can happen with an investment. The right investment may provide you with stable returns of 7% for years, whereas the wrong one could leave you with half your initial investment in a matter of weeks or months.
Service heterogeneity in the financial services industry makes it difficult for investors to successfully compare different investments to each other. The variability and complexity of many investment products makes it hard for an investor to determine whether an investment will benefit his or her portfolio and, more specifically, whether it will be of more benefit than another, similar investment.
Difficulties In Evaluation
All the above problems lead to difficulties in evaluation. A services analogy can make the point clearer. Suppose you go to a café or restaurant one day and have great service, but the next day that same service from that same restaurant may be awful. Correspondingly, your friend may swear by the restaurant you are going to as the best in the city, but you may have a horrible experience with it. This happens in the financial world too. A friend may recommended a particular fund that has genuinely served him well for years, but if you buy the same fund now, the timing may be wrong, or it may not be what you need or want at the moment in terms of risk and investment style.
In the services industry, theoreticians talk of the inseparability of production and consumption. That is, the service unfolds as you are consuming it. In this case, the quality of the investment and the nature of the market evolve as time goes on.
Services can often only be assessed for a specific period - after the service has been delivered, and in some instances, not even then. After all, how many investors thought their brokers were just wonderful until the dotcom bust? They had performed superbly on the surface, but in reality, the market had simply been booming and when that was over, many seemingly great investments rocketed downwards with the rest of the market. (To learn more about market bubbles, check out The Greatest Market Crashes and Why Housing Market Bubbles Pop.)
The difficulties involved in evaluation have some specific implications for investors. A fund or stock that was a super "service" in the past, may prove to be a dreadful "disservice" in the future - possibly just when you buy in! Likewise, managers may change for the better or worse, and so can the economy and general environmental conditions. Services are intrinsically quite difficult to understand and grasp. While this may not matter so much with a household repair service, it really does matter when your total retirement fund is on the line.
Solutions to the Services Dilemma
Education and consistently accurate, reliable and honest information are indispensable, but there is the same need for partnerships and cooperative strategies. In the same way that consultants might advise a manufacturing company on the use of certain maintenance services, investors also need third parties with whom they can work.
Independent advisors, who work on an hourly or flat rate rather than on a commission may be a good bet in terms of getting reliable, objective information. Likewise, rating agencies that have nothing whatsoever to do with the investments they cover can be invaluable. (To read more about commission, see Paying Your Investment Advisor - Fees Or Commissions?)
Regular control and monitoring can also do a lot to ensure that your broker and other suppliers are keeping an eye on things and modifying your portfolio in the appropriate way. This means neither too little nor too much. The latter, which typically implies trading, simply generates costs which eat up returns. It is important to be flexible in your approach, and to achieve an appropriate level of risk, which, given the nature of services as explained above, is quite tricky to achieve. (To find out what duties you can do to keep your advisor aligned with your goals, see Are You A Good Client?)
Diversification is a must. Given all the fundamental and awkward issues discussed above, most investors are best served by holding investments in several different asset classes, and funds served by different managers. No individual asset class will provide a good service all the time. (To read more about diversification, see Introduction To Diversification and The Importance Of Diversification.)
The services industry - of which the investment industry is a subset - is often harder for buyers to deal with than the markets. The typical characteristics of services, such as intangibility and heterogeneity, lead inevitably to choice, evaluation and monitoring problems. After all, services deliver an experience, and, in the context of investment, this can greatly vary from profitable to traumatic - and even disastrous.
These problems cannot be overcome completely, but they can be minimized by a few simple actions: learning about the market and products yourself (or at least learning who you can trust and rely on); finding the right advisors and sources of information; and evaluating, monitoring and controlling your portfolio regularly. With a proper diversification strategy in hand and these actions in place, you should be able to overcome the services dilemma and enjoy great dinners at superb restaurants.