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Deluding Ourselves

Patrick Geddes

INVESTMENT RESEARCH has overwhelmingly shown that active stock strategies perform poorly over long periods compared to buying index funds and simply collecting the market’s return.

There’s still some debate about whether the best active managers are a smart bet—and whether we can count on them continuing to perform well. But there’s no question that active stock management, on average, has destroyed value for clients.

Yet active strategies remain popular with both individual investors and their wealth managers. Why? A cynical explanation might place the blame solely on the investment industry. After all, it tends to receive much more revenue from active management than index investments.

Indeed, wealth advisors who choose active managers may be trying to dodge a dreaded question from clients: “If you can’t pick managers that’ll beat the market, and instead recommend a stock portfolio that’s entirely indexed, why should I pay you so much in fees?”

While the investment industry may try to avoid the hard truth about active management, the blame for its continued popularity must be shared. In particular, two other groups deserve to be recognized.

First, clients contribute through their own biases, which are well documented in the behavioral finance literature. Investors who hire active wealth managers fall into two traps: the illusion of control and overconfidence.

Behavioral data show that many investors presume they can control outcomes that are, in fact, random. Unfortunately for our portfolios, our brains just aren’t wired for sound probabilistic thinking. Instead, we crave the excitement and satisfaction of trying to outperform the market, much the same way we might crave sweet or fatty foods.

Those survival instincts that encouraged us to eat rich foods might have kept us alive in prehistoric times. But they aren’t well suited to the developed world we inhabit today. Overabundance is now a bigger problem than scarcity. Similarly, we tend to harm our portfolios when we reach for outperformance, even though it feels natural to want to outrun the rest of the pack.

We also harm ourselves when we surrender to an urge to tweak our asset allocation. For example, we may feel compelled to sell in the middle of a bear market. We’re overconfident that we can beat the odds—despite all evidence that, on average, we cannot. As Benjamin Graham wrote in 1949, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”

The second siren song drawing us to active management is financial journalism, be it newspapers, magazines, blogs or podcasts. Media sources, both paid and purportedly free, make money by rewarding our worst habits as consumers.

Exciting stories of successful investors or star managers are far more likely to attract attention than the boring advice to buy and hold index funds no matter what. A recommendation to do nothing—providing you have a good asset allocation with index investments—garners little attention, no matter how solidly studies support this approach.

If nearly all the media coverage highlights the rare successes of active strategies, it’s no wonder that uninformed consumers might presume that beating the market is a lot more likely than the data show.

It’s valid to criticize the industry for recommending active management. As consumers and readers, however, we also need to look in the mirror to assess our own culpability. Unfortunately, we’re hard-wired through evolution to avoid that discipline of introspection. It’s so much more gratifying to blame others for our bad fortune.

Patrick Geddes was the co-founder and CEO of Aperio Group until his retirement in 2021. His book Transparent Investing, available for sale Jan. 25, 2022, helps investors avoid biases in their own behavior, as well as those perpetuated by the frequently self-serving investment industry.

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evan rayers
evan rayers
9 months ago

Great column! Looking forward to the book!

Roboticus Aquarius
Roboticus Aquarius
9 months ago

The thing is, some studies show many or even most active managers beat their indexes… before fees. But after fees, their investors generally do worse than the index. So active managers can claim success while their investors are actually worse off vs investing in an index fund. That, plus there many ways to claim outperformance that rely on framing less than the full story (let me count the ways…).

But also, the reason for an advisor should not be to capture excess market returns; It should be to help keep you on course with respect to a well thought-out plan.

I’m just as subject to it as anyone, so I keep my speculative purchases to about 1% of my portfolio… so yes I own ARKK (and am about break-even), but no I’m not buying more, and yes I will hold for years, and if it goes to zero it’s just further proof I’m doing the right thing with the other 99%

Guest
Guest
9 months ago

Clearly the outperformance of, say, active growth funds over the past 10 years has been primarily attributed to their overweight in FAANG stocks (or some slight variation) vs the index. If any HD readers know of a website where the return of the S&P can be shown after the performance of certain stocks can be deleted from it to show a more realistic S&P return, I’d appreciate seeing that.

Roboticus Aquarius
Roboticus Aquarius
9 months ago
Reply to  Guest

It’s true that S&P gains are even more concentrated than historical norms (though not unprecedented, I believe.) There are always high performing stocks; removing their impact from the index may not tell you as much as you think. About 70% of stocks in the S&P 500 will lose money. 10% will return from 0-10%. The other 20% may make more than 10%. These are long term averages, so it will shift depending on the year, of course. Index fund returns have always depended heavily on the 1-2 percent of stellar performances that outpace all the other stocks by enormous amounts. Market returns have always been heavily skewed, though recent returns do appear to be at the far end of the usual range.

macropundit
macropundit
9 months ago

Correct. AT&T was 13% of the market in 1932. IBM was 9% of the SP500 in the 70s. Half the wealth ever created in the stock market came from the 86 top-performing stocks, around 0.33% of the total. Despite what most people think, a few stocks have always carried the market.

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John Yeigh
John Yeigh
9 months ago

I agree that it has seemed disheartening to hold boring index funds and value stocks in recent years when the media has touted managers that are huge winners with momentum growth-stocks. Most of these companies lose money and have excessive price to sales ratios. I’d contend that mean reversion is underway as the S&P 500 is within 3% of its all time high, yet the bellwether ARKK high-growth ETF is down more than 40%. Our FOMO should be in decline.

macropundit
macropundit
9 months ago
Reply to  John Yeigh

Micheal Mauboussin is awesome on mean reversion. What it is and what it isn’t. Mostly I think it’s used to incite fear, but very few understand it. I don’t claim to know, but as with many things in life knowing what something isn’t is very often the most important thing.

“ROIC … At the extremes, for instance, we can see it is rare for really bad companies to become really good, or for great companies to plunge to the depths, over a decade.”

https://greenbackd.com/2010/04/21/roic-and-reversion-to-the-mean-part-1/

https://greenbackd.com/2010/04/22/roic-and-reversion-to-the-mean-part-2/

https://greenbackd.com/2010/04/27/roic-and-reversion-to-the-mean-part-3/

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