Jonathan Clements

LOGIC AND DATA MAKE it abundantly clear that we’re highly unlikely to beat the market averages—and that indexing is the best strategy for the vast majority of investors. Yet half of U.S. stock fund assets remain actively managed and, for money that isn’t in mutual funds, the percentage is likely far higher.

That brings me to today’s contention: Maybe we should spend less time making the case for indexing. Instead, perhaps we should focus on the more obvious conundrum: If beating the market is a game that we’re extraordinarily unlikely to win, why do so many folks keep trying?

Follow the money. Market-beating efforts may backfire for most investors, but they remain a huge moneymaker for Wall Street. What else can explain the hysteria and silly arguments constantly emanating from investment “professionals”? These folks have all but given up claiming that active management is a reliable route to superior returns, which it most certainly isn’t.

Instead, they want us to believe there’s an index-fund bubble and that indexing is worse than Marxism, so we’ll pay up for active management and fatten their coffers. Let’s face it: It’s a strange contention—that it’s somehow our patriotic duty to actively manage our portfolios, even though we’re likely sacrificing our investment performance.

Unnecessary confusion. Wall Street’s arguments may be fatuous, but they help to make muddy waters even murkier. Wall Street has long sought to cloak the simple business of managing money in language that befuddles everyday Americans.

Consider a simple example. When financial experts discuss how to divide money between stocks and bonds, they’ll talk about “your asset allocation between equities and fixed income.” That may sound a whole lot cleverer and more mysterious, but it’s just disguising a straightforward notion with words sure to scare off the uninitiated.

Hidden costs. Some investment expenses are clearly disclosed, including a fund’s annual expenses, the brokerage commission you’ll pay to buy or sell a stock (often zero these days) and what percent of assets is charged by your fee-only financial planner.

But other costs are tough to figure out. Examples: how much you lose to the bid-ask spread every time you trade a stock, what’s the markup or markdown when you buy or sell a bond, and how much your funds are incurring in total trading costs. If investors were fully aware of these costs, it would be even clearer what a bargain indexing is.

Overconfidence. There are, of course, investors who realize how much active management costs and how unlikely they are to win the beat-the-market game, and yet they insist on playing. Why? In a word: overconfidence. Just as many folks believe they’re better-than-average drivers and smarter than most, they also believe they can outpace the market, even as most others fail.

Experience should deflate this overconfidence, but for many investors it never does—because they have no idea how their portfolio is really performing. And even if they do, they don’t compare their portfolio to an appropriate benchmark and don’t factor in the amount of risk they’re taking. To be fair, figuring all this out can be a tricky. Financial firms could help, but (surprise, surprise) they don’t: It seems Wall Street doesn’t want to provide investors with anything more than rudimentary performance information.

Reading tea leaves. Investors’ overconfidence is also fueled by a host of behavioral mistakes. We often imagine we see patterns in today’s share price movements and believe those patterns foretell what’s to come. Looking back, what occurred in the markets seems obvious—and we may even feel we predicted what happened, a mental mistake known as hindsight bias.

But perhaps the most insidious behavioral error is availability bias. Every year, most stocks underperform the stock market averages, because the averages are skewed higher by a minority of stocks with huge gains. Yet it’s those big winners that stick in our minds, and they make beating the market seem easy. What if we try our hand at finding the next hot stocks? The odds suggest we’ll end up picking duds instead—and our results will lag behind the market averages.

Tax locked. The stampede into index funds began in earnest some 15 years ago. Today, some folks would no doubt like to join the stampede but haven’t—because they’re reluctant to dump the individual stocks and actively managed funds they already own.

What explains this reluctance? Even if their current holdings have been market laggards, these investors may be loath to sell, because unloading their current positions would trigger large capital-gains tax bills. Obviously, this isn’t an issue with investments held in a retirement account. But it’s a real dilemma with a taxable account—and hanging on to those old active bets and avoiding taxes is, alas, often the right decision.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Count the CashSignal Failure and Cash Back. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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