While reading Thomas Homer- Dixon’s fascinating and terrifying book The Upside of Down recently, I came across an assessment of his that struck me as an insightful comment on human nature. He was commenting on the concept of denial.

According to Homer-Dixon, people who succumb to denial go through three psychological phases. The first he calls existential denial, where people simply suggest a problem doesn’t exist. The second phase is called consequential denial, where people admit that there is indeed a problem, but then go on to suggest that it doesn’t much matter – either because the expected impact is nominal or because of the notion that people can easily adjust to account for it. Finally, Homer-Dixon talks of fatalistic denial. This is for people who acknowledge that there is indeed a problem and that serious consequences might ensue. These people might simply give up on trying to solve the problem altogether on the grounds that there’s nothing that can be done about it, anyway.

DOUBLE STANDARDS
My own sense is that some people in the financial services industry are in denial regarding the importance of cost in terms of longterm performance, treating it as a curiosity of little consequence rather than a salient causal indicator of expected long-term relative performance.

It astonishes me that so many people can pay attention to costs when buying houses, cars or any number of consumer goods, yet act as though cost is inconsequential regarding investing. This astonishment pertains to both investment products and the associated advice, by the way.

I’ve met advisors at entrepreneurial firms who fight management types tooth and nail in order to get higher payouts and/or lower costs for phones, printers, copiers, staff, rent and the like. These same people then turn around and tell their clients that cost is “immaterial” when it comes to investing their hard-earned money. If you were looking to hire a lawyer and it came down to two equally qualified and reputable lawyers – one who charges $200 an hour and one who charges $260 an hour – which would you choose? Similarly, if a client had to choose between two equally compelling product and advice combinations and one combination cost 200 bps while the other cost 260 bps, which option would that rational, self-interested client choose? Here’s a hint…

ALL THINGS EQUAL?
The Latins had a phrase to account for the existence of variables – that phrase was ceteris paribus or “all things being equal.” Of course, other variables are not equal, either. However, if they were and if the advice given to a client was identical and the precost return of both sets of products was identical, then the only material difference would be the cost, right?

In the past, I’ve included grids that show the impact of lowered cost at different dollar amounts. Why not try an experiment of your own? Pull out an account statement for one of your favourite clients as well as your financial calculator. Start with the client’s current holdings with you (PV) and assume a suitable age of death (number of years for compounding). Then, for the final variable assume your typical rate of return +/- 60 bps. In other words, use two rates of return in examining the impact of cost.

MATERIAL COSTS
The difference is likely to be a number that most reasonable people would clearly say is “material.” Still, my sense is that most of us are like the ancient Egyptians – we’re living in a state of denial.

John De Goey, CFP, is the vice president of Burgeonvest Bick Securities Limited (BBSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BBSL. You can learn more about John at his Web site: www.johndegoey.com.

Originally published in Advisor's Edge Report