Anxiety, Personality and the Active vs. Passive Fund Decision

As a psychotherapist well-traveled in the talking cure from both sides of the consultant’s couch, I am no stranger to anxiety. And as a former financial advisor, I am well-versed in how it affects financial choices and in particular the decision to select active or passive funds.

Let’s take your friend Dennis, whose attitude toward investing has been shaped by many different and often conflicting factors. Not a completely naïve investor, he listens to inspirational money-making podcasts and watches the market opening on CNBC while brushing his teeth. Suffice it to say, Dennis knows just enough about investing to get him in trouble and keep him from reaching his financial goals.

Failing to run the table with options and individual stocks, Dennis at least knows enough to seriously consider funds as the sensible way to proceed. But the active vs. passive dilemma has him stumped. A math jock, he can interpret the numbers overwhelmingly in favor of the passive strategy, but he can’t get his head around the seeming illogic that no management is the best management. Why can’t he?

Many reasons, starting with our culture’s caricature of the stock market as a dizzying roller coaster more likely than not to let you off at the bottom. What was the mindset around the dinner table at Dennis’s home? Imagine if his grandparents went bankrupt in the Crash of 1929. Or that his tech-heavy education funds were decimated in the dot.com debacle. From those grim family stories, Dennis’s parents may well have preached a strict investment conservatism.

We’ve now had a glimpse of a possible source of your friend’s reluctance to act on two decisive decades of academic research. Fear of devastating loss had been drilled into him in childhood. Without a portfolio manager, full-service broker or financial advisor at the helm, Dennis’s vacations would be tainted by worry. If the conflict in the Middle East erupted into full-scale war, no one would be there to steer the ship.

But does investment anxiety alone explain Dennis’s quandary? Probably not–we’ve yet to consider how his upbringing molded a personality inclined to overvalue the virtues of going active and perhaps seeking out an investment advisor. Dennis’s father took a back seat to his strong-willed mother, who set the rules that included choosing the college her son could attend. Consequently, Dennis grew up dependent on others and insecure in his decision-making.

Low self-esteem meant that Dennis routinely depended on authorities for advice for problems he might well have solved on his own. Of course, delegating responsibility to people more knowledgeable than you are about certain situations often makes good sense. But Dennis’s boundaries were as permeable as a slice of Swiss cheese. When a boisterous acquaintance boasted how her financial advisor had put her into Nvidia just before its price exploded, it was all you could do to convince Dennis not to impulsively contact her to set up an appointment.

I want to relate a true story about how even a temporary lapse in confidence and vigilance can make folks especially vulnerable to industry propaganda that most investors need to work with a financial advisor. Sally and Dave were two of my clients, who were invested in three broad market index funds—domestic (60%) international (20%) and total bond (20%). In other words, they had an 80% stock/20% bond split, the classic Bogelheads 3 fund “lazy” portfolio. When they planned to move from Sacramento, they asked me to transfer their account to a broker in Los Angeles. Doubtful about their ability to monitor their funds while acclimating to their new surroundings, Sally and Dave hooked up with a traditional commission-based firm.

.In the process of facilitating the change, I was informed that the new brokerage house did not accept (no-commission, low fee) index funds. I was instructed to sell them and send over the proceeds. A few weeks later, Sally called to let me know that the transfer had gone smoothly and they invested the cash into three of the same kind of funds but offered by the broker’s own company. At their first meeting with him, they also purchased an annuity.

Those three “same kind” of funds did indeed cover similar investment territory, but they were actively-managed, had an astronomical fee and carried a front-end commission. Besides, both Sally and Dave could look forward to handsome state pensions and did not need an annuity.

Much academic study has established that our investment decisions are often influenced by cognitive biases. Many people are prone to confirmation bias, the tendency to interpret new information consistent with previously held beliefs. In the investment realm, an investor may devalue an earnings forecast that contradicts his own opinion about the company’s potential.

By the same token, your personality traits can affect your investment choices. Whether or not to go with an advisor or full-service broker or to prefer funds run by a portfolio manager should be based on rational considerations, like limited knowledge about the workings of the stock market. Know thyself. Try to weed out anxieties and personal traits that are vestiges of childhood and may no longer apply to your next investment decision.