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Stephen High
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Richard Flohr
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The field of behavioral psychology has determined that most individuals tend to be risk averse -- that is, they tend to more keenly feel the pain of loss than they relish the pleasure of winning. In the realm of investing, there are two main ways to invest -- an active approach that seeks to beat the market via stock-picking or market timing, or a passive approach that instead focuses on capturing dimensions of risk commensurate with expected returns. Academic research indicates that active investing significantly increases the odds of loss. The logical choice, given our risk averse tendencies, is to avoid active investing.
Behavioral finance is a fascinating field, taking what psychologists have learned about human behavior and applying it to investing. One of the most important findings from the field of behavioral finance is that investors are risk averse. They don’t like to lose (even more than they enjoy winning).
Consider the following game in which a coin toss decides a win or a loss. The player is asked to bet $1 and can only play once. How large would the prize have to be? The typical individual requires a jackpot of about $2 to accept the bet. This demonstrates risk aversion because an individual who is risk neutral would only require a $1 jackpot, or an even-money bet.
Now consider the same game with the bet increased to $100, $100,000 or even $1 million. A gambler might be willing to play a game for $1 with a $2 jackpot (2:1 odds in favor of the player). But the same person might require 3:1 favorable odds to bet $100, i.e., a $300 jackpot. To gamble $100,000, the jackpot may need to be as high as $500,000 (5:1 favorable odds). In other words, when the amount at risk is small, we tend to be more willing to take risk (such as the willingness to buy a $1 lottery ticket despite the odds). As the amount at risk increases, so too does the aversion to risk.
With this information in mind, we next consider the academic research, which has found that actively managed mutual funds are highly unlikely to outperform their appropriate benchmark. Active management is the attempt to “beat the market” by trying to pick future winning stocks or guess where the market is headed next.
For example, a study published in the Summer 2000 Journal of Portfolio Management found that, for the 10-year period 1982 to 1991, only about 8 percent of actively managed funds beat their benchmark on an after-tax basis. In addition, while the average out-performance was just 0.9 percent, the average underperformance was 3.1 percent. The risk-adjusted odds against out performance were about 38:1.
The same study found similar results for the 10-year period 1989 to 1998. On an after-tax basis, only 9 percent of the funds outperformed. The average out-performance was just 1.8 percent while the average underperformance was 4.8 percent. The risk-adjusted odds against after-tax out-performance were about 28:1.1.
Academic studies have also concluded that the few actively managed funds that are top performers experience no persistence in performance from one period to the next (beyond what would be randomly expected). This means there is no way for investors to identify ahead of time that small percentage of funds that will beat their benchmarks.
What conclusion should we draw?
Return to the evidence that individuals are risk averse. Faced with the decision on how to invest the majority of their life savings, individuals can choose actively managed funds and face significantly negative odds, as described above, or they can choose passively managed funds, and forego the risk associated with trying to beat the market.
So why do most individual investors still choose to invest in actively managed funds? Perhaps:
- they are unaware of the evidence described here, or
- they are overconfident of their skills.
While recognizing that the vast majority of investors playing the game will lose, they believe that somehow they will win -- even against such great odds. Given the evidence, it seems clear that the rational choice is not to play the game of active investing. Accepting market returns by investing in passively managed funds is the triumph of wisdom and experience over hope.
Copyright © BAM Advisor Services, 2005. Kraft Asset Management, LLC is affiliated with BAM Advisor Services and with KraftCPAs PLLC. This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a registered investment advisor. Robert D. Arnott, Andrew L. Berkin and Jia Ye. How Well Have Taxable Investors Been Served in the 1980s and 1990s? Journal of Portfolio Management, Summer 2000.
