It is not a secret that active management, on the whole, loses to passive management. This rings particularly true when transaction costs and other fees are considered; costs that are typically higher with active managers. And even in that rare instance when the active manager actually beats the market on a consistent basis, it takes more than sixty years of data to state with statistical confidence that the active manager truly possesses the skill to beat the market. This begs the interesting question, if passive management is the proven winner, why is so much global wealth still actively managed? The answer lies in human psychology.
One must first understand what is meant by an active manager and how winners and losers are defined in the market. An active manager is an individual relying on some type of analysis or methodology to select particular securities to buy or sell (stock pickers), to determine appropriate timing of buy and sell orders (market timers), or some combination thereof. The passive manager constructs portfolios which reflect the broader market or various segments within the broader market, and typically does so at a lower cost. 'Winning' or 'losing' is usually determined by comparing a portfolio's returns to the returns of a comparable bench mark portfolio (e.g. an active manager's large-cap portfolio returns compared to the S&P 500 return over that same period).
The field of study concerned with how humans act in the investment world is known as behavioral finance, and this field offers several good theories explaining why money still chases active managers. The first reason is a not-unfamiliar concept known as overconfidence. As humans, we have an innate tendency to overestimate our abilities; to believe that we are better than we actually are at a skill or particular activity. For example, in a 2014 study conducted by State Street Center for Applied Research, a group of investors were asked about their level of financial sophistication, and almost 70% claimed to be advanced. The participants later took a financial literacy exam, and the average score was a paltry 61%. Investment managers are not immune from this overconfidence bias, and this quality leads some to believe that they are smarter than the average investor, or that they can beat the market. Even amateur investors and day traders show this overconfidence bias when they actively trade, believing that they will beat professional investors who have better and more immediate access to pricing information, or that they will perform better than a passive fund.
Another trait influencing how we perceive financial risk is known as optimism bias. This is best described as our tendency to believe that things will work out for the better. We see this with active managers, the skewed belief that the manager's stock picks will outperform the general market. Human cognition leans towards positive-result thinking, and this type of thinking fuels the active manager. Evolutionarily, we are programmed to think optimistically to encourage us to explore new areas, try new ideas or opportunities, and generally advance. Consider a hypothetical world where humans focus on the negative outcomes of every decision; there would be a complete stalling of human development. While optimism bias may very well have its uses, in the world of investing, it can lead to irrational and risky investment decisions.
Hindsight bias and attribution bias describe how we relate to events of the past. With hindsight bias, we tend to remember the positive past events, while downplaying the negative events. Applying this to investing, we are likely to remember more vividly the stock pick that turned out to be a winner, while forgetting all of those stock picks that turned out to be losers. Attribution bias pairs nicely with our hindsight bias, and it is our tendency to attribute positive past events to our own skill while attributing negative events to luck or other forces. These biases would lead one to think that, not only was the active manager's winning stock pick memorable, but it was because of his skill, whereas the active manager's losing picks are less memorable and were caused by some other outside force, or even just bad luck.
A final bias, confirmation bias, provides that we assign more weight to information that supports our already-held conclusions and discount information that is contrarian. A common theme among these biases is the resultant belief that we are better than we actually are at a particular skill, and that our successes are because of that superior skill. Why we think in this manner is answered by our evolutionary history; it is the type of thinking that allowed humans to experiment, expand, and develop. The remarkable jump from caveman to space-explorer occurred in a relatively short period of time, owed in no small part to overconfidence and optimism. Unfortunately, there is very little place for this in the world of investing.
Investing is more cut and dry than our minds would like to believe. Securities can be valued using mathematical formulas and discounted cash flow models, and even the trading of securities is boiled down to computer algorithms. The transaction of securities in competitive markets, in theory, should be completely rational-basis, and without emotional thought. However, people have the impossible task of overcoming their inherent biases, which explains why we still see active managers, stock pickers, and market timers. These individuals think they can beat the market, even against overwhelming odds (and proven statistics) that they are no more likely to do so than if you threw darts at a board to select your portfolio. We cannot predict the future, and in competitive markets, this is the only information that affects securities prices.
For every buyer in the market, there is a seller. When active managers buy or sell to construct a portfolio, the passive manager is on the other side of that transaction. Active managers are overconfident (although they are hardly to blame for this flaw), believing they can profit from unknown future events, whereas passive managers are indiscriminate, capturing the returns of broader market segments. This difference explains why the strategies we employ are 'winners' while those chasing active strategies are the comparative 'losers.' This strategy is not a secret (2015 saw the largest shift of money to passive strategy funds yet), but until investors can overcome innate human psychology, there will always be comparative advantage in the passive strategy approach.
Charles Holder
One must first understand what is meant by an active manager and how winners and losers are defined in the market. An active manager is an individual relying on some type of analysis or methodology to select particular securities to buy or sell (stock pickers), to determine appropriate timing of buy and sell orders (market timers), or some combination thereof. The passive manager constructs portfolios which reflect the broader market or various segments within the broader market, and typically does so at a lower cost. 'Winning' or 'losing' is usually determined by comparing a portfolio's returns to the returns of a comparable bench mark portfolio (e.g. an active manager's large-cap portfolio returns compared to the S&P 500 return over that same period).
The field of study concerned with how humans act in the investment world is known as behavioral finance, and this field offers several good theories explaining why money still chases active managers. The first reason is a not-unfamiliar concept known as overconfidence. As humans, we have an innate tendency to overestimate our abilities; to believe that we are better than we actually are at a skill or particular activity. For example, in a 2014 study conducted by State Street Center for Applied Research, a group of investors were asked about their level of financial sophistication, and almost 70% claimed to be advanced. The participants later took a financial literacy exam, and the average score was a paltry 61%. Investment managers are not immune from this overconfidence bias, and this quality leads some to believe that they are smarter than the average investor, or that they can beat the market. Even amateur investors and day traders show this overconfidence bias when they actively trade, believing that they will beat professional investors who have better and more immediate access to pricing information, or that they will perform better than a passive fund.
Another trait influencing how we perceive financial risk is known as optimism bias. This is best described as our tendency to believe that things will work out for the better. We see this with active managers, the skewed belief that the manager's stock picks will outperform the general market. Human cognition leans towards positive-result thinking, and this type of thinking fuels the active manager. Evolutionarily, we are programmed to think optimistically to encourage us to explore new areas, try new ideas or opportunities, and generally advance. Consider a hypothetical world where humans focus on the negative outcomes of every decision; there would be a complete stalling of human development. While optimism bias may very well have its uses, in the world of investing, it can lead to irrational and risky investment decisions.
Hindsight bias and attribution bias describe how we relate to events of the past. With hindsight bias, we tend to remember the positive past events, while downplaying the negative events. Applying this to investing, we are likely to remember more vividly the stock pick that turned out to be a winner, while forgetting all of those stock picks that turned out to be losers. Attribution bias pairs nicely with our hindsight bias, and it is our tendency to attribute positive past events to our own skill while attributing negative events to luck or other forces. These biases would lead one to think that, not only was the active manager's winning stock pick memorable, but it was because of his skill, whereas the active manager's losing picks are less memorable and were caused by some other outside force, or even just bad luck.
A final bias, confirmation bias, provides that we assign more weight to information that supports our already-held conclusions and discount information that is contrarian. A common theme among these biases is the resultant belief that we are better than we actually are at a particular skill, and that our successes are because of that superior skill. Why we think in this manner is answered by our evolutionary history; it is the type of thinking that allowed humans to experiment, expand, and develop. The remarkable jump from caveman to space-explorer occurred in a relatively short period of time, owed in no small part to overconfidence and optimism. Unfortunately, there is very little place for this in the world of investing.
Investing is more cut and dry than our minds would like to believe. Securities can be valued using mathematical formulas and discounted cash flow models, and even the trading of securities is boiled down to computer algorithms. The transaction of securities in competitive markets, in theory, should be completely rational-basis, and without emotional thought. However, people have the impossible task of overcoming their inherent biases, which explains why we still see active managers, stock pickers, and market timers. These individuals think they can beat the market, even against overwhelming odds (and proven statistics) that they are no more likely to do so than if you threw darts at a board to select your portfolio. We cannot predict the future, and in competitive markets, this is the only information that affects securities prices.
For every buyer in the market, there is a seller. When active managers buy or sell to construct a portfolio, the passive manager is on the other side of that transaction. Active managers are overconfident (although they are hardly to blame for this flaw), believing they can profit from unknown future events, whereas passive managers are indiscriminate, capturing the returns of broader market segments. This difference explains why the strategies we employ are 'winners' while those chasing active strategies are the comparative 'losers.' This strategy is not a secret (2015 saw the largest shift of money to passive strategy funds yet), but until investors can overcome innate human psychology, there will always be comparative advantage in the passive strategy approach.
Charles Holder
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