Buying a used car is a daunting task, particularly for someone like me. I know where the petrol, water and oil go and I know the brands, but that’s about it. I’m sensible enough to inquire about the profile of previous drivers, check the service history and ask for a test drive. But I only scratch the surface. Luckily, I have a friend who crashes cars for a living, so I take him with me!
The everyday occurrence of buying a used car was the subject of a 1970 paper, “The Market for Lemons: Quality Uncertainty and the Market Mechanism”, by economist and Nobel laureate, George Akerlof. In the paper, Akerlof discusses information symmetry, a phenomenon which occurs when the seller knows more about a product than the buyer. A lemon is American slang for a used car that’s found to be defective only after it’s been bought. It illustrates the problem of “quality uncertainty” very effectively.
The market for investment products is similar to the market for used cars. The quality of the product varies substantially. The seller may gloss over any shortcomings and try to pass off lower-quality products as higher-quality ones. It is also difficult for buyers to look under the bonnet and really understand what’s going on prior to making an investment. The buyer only knows with clarity how comfortable the drive will be once her or she has taken ownership! There is asymmetry of information between seller and buyer and quality is uncertain.
Because many important elements are not easily accessible for inspection and sometimes technically challenging, the buyer of an investment product, like the buyer of a used car, doesn’t know with a great deal of certainty whether a fund is a lemon or not. Thankfully, information asymmetry and uncertainty over quality hasn’t led selectors to believe that all funds are lemons. It does, however, make it more difficult to build conviction in the good ones.
A disciplined fund selection process is therefore required to avoid the lemons. A focus on past performance or the product’s brand won’t do the job! Door’s digital due diligence platform can fulfill the role of the car buyer’s knowledgeable friend and should be part of the toolkit when you review your next fund.