Irrational Investing: An Explanation

Most individual investors invest in actively managed funds. I have long been fascinated by this behavior, because the overwhelming data indicates that active managers do not enhance returns.

A recent study by authors based in Australia may provide some answers. The study sought to answer the question troubling me: Why do investors favor active management to the extent they do? They surveyed plan consultants and chief investment officers of large Australian pension funds. Here's a summary of their conclusions:

Lack of Knowledge

The study concludes that investors and their agents may not be aware of all of the costs of active management. They may be influenced by advertising and place an unjustified reliance on past performance. You would think sophisticated pension funds and their advisors would be aware of this information.

Protection in Down Markets

Investing in actively managed funds was justified by the belief that active management may provide downside protection in down markets. However, as my colleague Larry Swedroe (relying on an independent study) noted, active portfolios are not superior to passive strategies in good or bad markets, but active funds do perform relativelybetter in recessions. This is hardly a justification for active management.

Influence of Advisers

The study found that consultants favor active management because it is consistent with their economic self-interest. One consultant candidly noted: "Recommending passive management was not good for business."

Other Benefits

While the likelihood of outperformance using actively managed funds is slim, there may be other "psychological" benefits for trying to "beat the markets." Curiously, for some, the mere possibility of succeeding in generating superior returns is sufficient incentive to overcome the daunting odds.

Behavioral Factors

There are many reasons unrelated to expected returns that may explain the decision to invest actively. These include confirmation bias, which encourages us to seek facts that confirm our bias; overconfidence in our ability; the thrill of "gambling" and the overwhelming bias toward "favoring activity over passivity."

The authors conclude that "institutional funds over-allocate to active managers" notwithstanding "the relatively weak evidence and theory in support of managers' ability to outperform their benchmarks net of costs... " They suggest the need for more knowledgeable and independent trustees who can act in the best economic interest of their principals.

For individual investors, no complex analysis is required. Your focus should be on receiving the highest expected return for the amount of risk you are taking. The most prudent path to achieving this goal is to invest in a globally diversified portfolio of low-management-fee index funds, in an asset allocation suitable for you.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You'll Ever Read, will be published March 3, 2014.

The views of the author are his alone and may not represent the views of his affiliated firms. 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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