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Why You Overpay for Financial Advice

By Morgan Housel - Jan 16, 2015 at 12:04PM

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Context is key.

I bought a new car this weekend. I'm usually frugal, a bargain hunter. But here's the truth: I caved on the price.

I ended up paying $750 more than I was trying to bargain the dealer down to. I still think I got a decent deal, but my wife commented how easily and quickly I gave up on $750. Normally I'll jump through hoops to save $2 here, $5 there. But at the dealership I let $750 go without much fight.

Why?

To me, it was easy. The car costs tens of thousands of dollars. Who cares about $750 at that point? It felt trivial in the grand scheme of things.

But that is stupid logic, and I know it. A dollar is a dollar. Why does saving a buck on a cup of coffee feel big, but letting $750 on a car go feel like no big deal? It makes no sense.

But it's more common than you might think.

Half of homebuyers who need a loan don't shop for a lender, according to the Consumer Financial Protection Bureau. They take the first mortgage offer they come across.

Homebuyers probably shop around to get the best deal on dishwashers for their new home. That might save them a hundred bucks. But when it comes to the mortgage on that new home, the attitude is, "Eh, sure, 4.5%, whatever." That might cost them a hundred bucks per month for 30 years.

Part of this is because shopping for a car is intimidating, as is getting a mortgage. People just want the transaction to be over.

But it's also because of something called "mental accounting."

University of Chicago economist Richard Thaler once did a study asking participants:

Imagine that you are about to purchase a jacket for $125 and a calculator for $15. The calculator salesman informs you that the calculator you wish to buy is on sale for $10 at the other branch of the store, located 20 minutes' drive away. Would you make a trip to the other store?

In this case, 68% of people said they would.

Then they were asked the same question, but with the scenario flipped. Would they be willing to drive 20 minutes to save $5 on a $125 jacket?

Just 29% said they would.

Even though they'd save the same $5 for the same amount of effort, one scenario felt worth it, the other didn't.

That's because people put both transactions into separate mental accounts, and value the savings subjectively.

Five bucks is one-third the price of the calculator. That feels good! But it's just 4% of the jacket's cost. Who cares about 4%? It rounds to zero.

One area I think this flaw is especially dangerous in is financial fees.

Fees on things like mutual funds and financial advisors are typically done as a percentage of assets. Maybe you pay 0.9% for your mutual fund, or 1% a year to your financial advisor.

Those numbers sound so small. One percent? Half a percent? Big deal. They're such small numbers -- and a small percentage of your assets -- that I've found people dismiss them as irrelevant.

But they can be huge. One percent of a million-dollar portfolio is $10,000 per year, every year, for as long as you're invested. One percent may sound like nothing, but $10,000 likely does. It could easily be one of your biggest annual expenses. 

That's the problem when we think about money in percentage terms. When we contextualize spending next to big-ticket items -- like a car, or your investment portfolio -- you start making decisions that seem OK for that purchase but in any other area of your life would seem wasteful and profligate.

Which is why I paid too much for my car, and most of us pay too much for financial advice.

Check back every Tuesday and Friday for Morgan Housel's columns. 


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Contact Morgan Housel at mhousel@fool.com. The Motley Fool has a disclosure policy.

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