Direct Indexing and the IKEA Effect
- The “IKEA effect” describes a cognitive bias that happens when people put in some form of labor to complete a project or finish a creation.
- Offering personalized experiences that create an emotional attachment is not something the financial services industry has historically done well.
- Direct indexing won’t solve the behavior gap, but it has the potential to create better investor behaviors by allowing investors to play a larger role in the portfolio-building process.
- Given what we know about investor habits, direct indexing has the potential to be the next disruptive force in wealth management.
For General Educational Use Only
The “IKEA effect” describes a cognitive bias that happens when people put in some form of labor to complete a project or finish a creation. It refers to the fact that people tend to place higher values on things they create themselves.
Harvard Business School’s Michael Norton and others coined the term in a 2012 paper and define it as the “increase in valuation of self-made products.” The name itself comes from Swedish furniture retailer IKEA, which sells furniture that often requires physical assembly done by the customer.
Build-A-Bear Workshop is a unique example of this phenomenon. Build-A-Bear is a retail experience where customers walk into a store, buy a standard teddy bear off the shelf, and then have the option to add features (clothing, voice box, etc.) for an additional price. The standard teddy bear retails between $15 and $40, but after add-ons, customers often pay double the retail price, and in some cases, much more.
To the cynic, Build-A-Bear sells expensive teddy bears. But analyzing the business objectively, Build-A-Bear sells a unique experience, offering a personalized teddy bear that has the follow-on effect of creating an emotional bonding experience between the buyer and a loved one.
Business is going well: Build-A-Bear celebrated their 25th anniversary last year with the most profitable year in company history.
The financial industry would be wise to learn from a simple business concept like Build-A-Bear.
Personalization Not a Dominant Feature of Wealth Management
Offering personalized experiences that create an emotional attachment is not something the financial services industry has historically done well.
Direct indexing, one of the latest innovations in wealth management, hopes to bridge that gap.
As background, direct indexing refers to a separately managed account (SMA) that tracks an index, or a blend of indexes while holding the individual stocks that comprise the index. Said differently, mutual funds and exchange-traded funds (ETFs) are wrappers that sit between investors and the stocks they own. Direct indexing removes that wrapper and allows investors to hold the individual stocks that sit inside the index.
Standard indexes (think ETFs or mutual funds) have a single methodology—one set of rules dictating what they own and how they rebalance. In effect, they are “one size fits all.”
Like owning a standard index mutual fund or ETF, direct indexing also invests and rebalances according to a pre-determined methodology. But with direct indexing, the methodology can be personalized based on an investor’s circumstances and preferences and can be easily adjusted as circumstances change.
If an investor:
- Works for a healthcare company and wants to own a broad equity index minus healthcare stocks (to avoid the career risk associated with working in that industry), that can be implemented through direct indexing.
- Owns a large, concentrated stock position (or multiple), you can actively attempt to capture losses from individual stocks within the index, sell a portion of the concentrated stock at different intervals, and use the tax losses to offset gains from the stock sale.
- Wants a portfolio that aligns with their values, whether it's less exposure to fossil fuels or focuses on companies with more women in leadership positions, direct indexing can help facilitate that.
These are only a few examples of practical direct indexing use cases.
Direct Indexing Value Beyond Numbers
Some benefits of direct indexing can be precisely quantified, like capturing tax losses, while others cannot.
The psychological satisfaction investors can achieve from playing an active role in building their own portfolio cannot easily be measured. Nonetheless, it could be a major force in driving better investor outcomes.
Ryan Murphy, Morningstar's Global Head of Behavioral Insights, mentioned the following on the topic:
“Helping investors stay the course is a valuable service from advice providers. Building personalized direct indexing strategies may be a useful way to add to this by driving engagement and at the same time discouraging people from meddling with their allocations, especially during volatile times.”
Among individual investors, the most common pitfall is buying and selling at inopportune times, which in aggregate, causes investors to underperform the indexes they invest in. Morningstar conducts an annual study “Mind the Gap,” which shows across eight asset classes that investor returns have fallen short of the category’s total returns, on average, over the past 10 years.
Peter Lynch is one of the greatest mutual fund managers of all time. His fund, Fidelity Magellan, achieved annual returns of roughly 30% from 1977–1990, but the average investor in his fund only earned roughly 8%. Reason being, investors put most of their dollars into the fund at peaks and took the most money out at troughs.
Direct indexing won’t solve the behavior gap, but it has the potential to create better investor behaviors by allowing investors to play a larger role in the portfolio-building process.
A byproduct of being involved in portfolio building should be a deeper understanding of how the portfolio is invested—an emotional connection of sorts—which could create less uncertainty during periods of market turbulence.
Given what we know about investor habits around buying and selling, this feature alone could go a long way in helping to produce better investor outcomes.
The Bottom Line
Direct indexing has the potential to be the next disruptive force in wealth management.
It’s clear that investors are interested in building portfolios that are unique to them. Whether it’s a focus on tax management, company or sector preferences, factor tilts, or other considerations, direct indexing can play a helpful role.
A customized portfolio experience also creates an additional benefit by increasing an investor’s corresponding attachment to it, which could ultimately translate to less buying and selling at the wrong time.
In effect, it ties the portfolio to the person, and we know people tend to place higher values on things they’re more connected to. And unlike Build-A-Bear, direct indexing doesn't require additional costs for additional customization.
Direct indexing takes the one-size-fits-all approach of ETF and mutual fund investing and turns it on its head, helping financial advisors add compelling value to a passive portfolio and tailor it to a client’s unique needs.
The trends in customization have permeated other industries and created stickier customer relationships—it’s about time deeper customization came to investing.
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