It’s one of the great mysteries of investing that so many people continue to use actively managed funds. Anyone familiar with rockwealth’s evidence-based investment philosophy will know that only a tiny proportion of active funds beat the index on a properly cost- and risk-adjusted basis over the long term. S&P Dow Jones Indices keeps a regular scorecard on the performance of active fund managers called SPIVA. Morningstar has something similar — the Active/Passive Barometer. What these scorecards tell us, time and again, is that most active managers underperform the market most of the time. Research has also shown that identifying, in advance, those very funds that will beat the market is extremely difficult. For example, a 2018 study showed how recommendations by investment consultants to hire and fire fund managers tend to extract value from the investment process. The researchers analyzed the performance of fund managers recommended by investment consultants between 2006 and 2015. On average, they found, the products recommended by consultants performed no better than other products available to institutional investors. In fact, once fees were factored in, all of the recommended products combined produced returns 0.30% per year lower than a portfolio of all the products available to plan sponsors that weren’t recommended.
Why are active funds still so popular?
Why, then, do people still find actively managed funds so appealing? The fact that the fund industry invests so much money in marketing and advertising certainly plays a part. Passively managed funds, by comparison, are hardly ever advertised, and they tend to receive far less attention in the media. Another factor is overconfidence. Many investors grossly overestimate their ability to identify the best funds to invest in. Other investors like to chase performance, choosing funds that have performed well in the hope that past success will continue into the future. Many investors often don’t fully understand the impact of fees on investment returns. Active funds typically charge higher fees than passive funds, which can significantly eat into returns over time. Another issue is confirmation bias. In other words, investors who have chosen actively managed funds may seek information that justifies their choice and ignore evidence to the contrary.
“The odds are you don’t know what the odds are”
But arguably the main reason why active funds remain so popular is that investors struggle to understand probabilities. As Gary Belsky and Thomas Gilovich explain in their excellent book Why Smart People Make Big Money Mistakes, if you continue to invest actively, “the odds are you don’t know what the odds are.” There are literally thousands of funds to choose from; in fact there are more funds than there are individual securities. At any one time, there are bound to be some funds with strong recent performance, simply by the law of averages. Those recent outperformers are precisely the funds that fund management companies promote and investment journalists like to write about. We rarely read about all those funds that performed so poorly that they were either closed down or merged with another fund. But people’s willingness to make decisions when the odds of success are stacked against them isn’t always down to a lack of mathematical sophistication. Sometimes highly intelligent people make irrational choices. Many investors, for instance, will choose an actively managed fund even though they know, intellectually, that the vast majority of active funds will underperform the market. Behavioural scientists have a theory called prospect theory that helps to explain such behaviour. Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. Among other things it shows how people tend to overweight small probabilities and underweight large probabilities, which means they might overreact to small chances of a very unlikely event happening and underreact to significant chances of more likely events. For example, despite the low probability of winning a jackpot prize, people still buy lottery tickets. Similarly, individuals may irrationally avoid very low-probability risks, like shark attacks, for instance, because they overestimate the likelihood of these unlikely events occurring. Ask yourself these questions So, if you’re still investing in active funds, ask yourself, Why am I still doing it? Is it as the result of a behavioural bias I’m prone to?. If it is, why not engage with a financial planner with a firm, like rockwealth, that understands behavioural biases and sees behavioural coaching as an important part of its value proposition? If, on the other hand, having read this article, you want to learn more about the odds of beating the market as an active investor, and the case for investing passively instead, you’ll find a range of useful videos on our YouTube channel. Whatever you do, don’t carry on using active funds in the hope it will pay off when it almost certainly won’t. In investing, as in life, as Aristotle once put it, the probable is what usually happens.
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