MANY OF THE WORLD’S religions view humility as an admirable trait to which we should all aspire. It’s frequently associated with poverty, as practiced by devout orders like Buddhist monks and the Sisters of Mercy. But when it comes to investing, humility can—ironically—make you significantly wealthier.
As documented by the behavioral finance research, overconfidence can lead to worse investment returns when investors presume, without justification, that they’re skilled at, say, picking market-beating stocks. The research on indexing versus active stock fund management overwhelmingly shows that, for long holding periods, actively managed funds perform worse than index funds, on average. That doesn’t mean active management never succeeds, but the odds are heavily stacked against those who try.
The superior return history of indexing can strike folks as counterintuitive. It seems as though investors are just settling for average. But research shows that investors who choose low-cost indexing can end up with fund results that outpace 80% or 90% of active managers.
In addition to feeling counterintuitive, indexing flies in the face of our inherent belief in our own abilities. In opting for index funds, it can feel like we’re surrendering to the poverty of a religious order by not aiming to outperform. But in fact, it does just the opposite, making investors on average wealthier than if they’d pursued active strategies. Want to avoid the negative financial consequences of overconfidence? Let humility be your antidote.
Though I like Warren Buffett think most people should be investing in index funds, I wouldn’t call doing that humility. An accurate assessment of reality as it related to you isn’t humility, it’s wisdom, and that assessment varies by person. I always thought the “hey just invest in index funds and you’ll be fine” crowd was way overconfident about the assumptions inherent in that. I like to ask: You’ll be fine? Really? You know that? What are your assumptions about inflation?
Though I think most people should, I’ve never invested in mutual funds. My returns aren’t average. It’s not hubris. It’s just the recognition that sometimes people can recognize outliers for various reasons, and do. That’s it. Nothing more than the strategy Peter Lynch outlined for some individual investors. But that was before the full uptake of MPT (modern portfolio theory) into the grad schools. Yet there are reasons to be skeptical of its applicability to known reality. Reasons to think the financial advisory complex is overconfident in the tenets of MPT, which was intended to address institutional investing rather than individual to begin with.
So there you go. One man’s humility is another man’s hubris. All depends on your perspective.
Yes, even the great William H. Miller III of Legg Mason was probably the most celebrated active manager of his time. The Legg Mason Capital Management Value Trust’s after-fee return beat the S&P 500 index for 15 consecutive years from 1991 through 2005. And, then it didn’t; thus, trying to find the hottest mutual fund or ETF winning managers is a monumental task. I shoot for singles and doubles and live to fight another day. FOMO is the psychological problem with chasing the market (stocks or the hottest managers). It will get you in trouble. Investing is a marathon not a sprint (think Buffett and BRK.B). Invest wisely folks and there is nothing wrong with protecting your A$$!
And when you write ” results that outpace 80% or 90% of active managers.”, that means ALL managers, not specific ones. The ‘winners’ each year change each year, so you have to pick the right manager year after year to beat the average. Think you can do that?
Very appropriate article for the “HumbleDollar” site!