A Hidden Bias Is Killing Your Returns

A Hidden Bias Is Killing Your Returns
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Until recently, it was frustrating trying to convince you to become an evidence-based investor. Part of the problem was persuading you that brokers and self-appointed stock market gurus are emperors with no clothes. There’s no credible evidence anyone has the expertise to reliably and consistently pick outperforming stocks, tell you when to get in and out of the market or pick the next “hot” mutual fund manager.

Yet an entire industry is built on this false premise, supported by much of the financial media which derives massive revenues from perpetuating these myths.

How times have changed.

The tide has shifted

According to Morningstar, in April, 2017, investors put $17.1 billion in U.S. stock passive funds and pulled $16.8 billion from actively managed funds. This pattern of outflows from actively managed funds started over a decade ago. For the ten years ending March, 2016, actively managed U.S. stock funds have experienced net outflows of almost $890 billion.

Investors have figured out that the low odds of an actively managed fund outperforming a comparable index fund are low, primarily due to high costs. The odds of a portfolio of actively managed funds outperforming a comparable portfolio of passive funds is infinitesimal.

Most investors ignore the evidence

There’s overwhelming data that “...few funds sustain outperformance over time and that some funds with excess returns over their benchmark can become underperformers over time.” Few who study the peer-reviewed evidence would disagree with the conclusion of William D. Nordhause, a Yale economics professor, that “most investors will be better off using index funds as the cornerstones of their portfolios.”

Why then, do a majority of individual investors ignore the data and continue to invest in actively managed mutual funds? According to Dr. Mark Perry, a professor of economics at the University of Michigan, as of 2014, only 30% of investors owned at least one index fund and only a minority made passive funds the core part of their portfolios.

Are these investors engaged in cognitive dissonance? Are they irrational? Why do they cling to what some journalists describe as “the triumph of hype and hope and marketing over wisdom and experience”?

The answer may lie in understanding a hidden bias.

The endowment effect

According to Investopedia, the “endowment effect” describes the tendency of people to place a higher value on things they own compared to a similar item they don’t own.

How does the endowment effect apply to investors? You’ll frequently hear investors talk about “my broker”, “my stocks” and “my mutual funds.” These investors believe they have an ownership interest in their broker and their investments. This perception may cause them to over value what they own and fail to do an objective analysis of alternatives (like index funds). An article in Morningstar correctly notes “the cognitive tendency to ‘love what you own’ applies to the shares, bonds and funds in your portfolio.”

You can overcome the endowment effect, but first you need to recognize it as a sub-conscious bias.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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