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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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