We Are Our Own Worst Enemies: The High Cost of Emotional Decision Making
One of my colleagues recently computed the amount of money investors “wasted” on the direct expenses of underperforming mutual funds. The results were staggering, adding up to roughly $500 billion over the last 10 years. I knew it was bad, but I didn’t know it was that bad!
In fact, as we dug deeper, we realized that the actual waste might be double that amount. If you include “hidden” mutual fund expenses, which John Bogle estimated at 0.65% per year (Bogle, 2014), the total amount of unrewarded mutual fund expenses easily jumps over $1 trillion.
Whatever the actual “waste” may be, we know empirically that active management continues to be a net loser for investors. SPIVA’s most recent report (Aye Soe, 2017) shows that over 90% of all US active managers underperformed their benchmark over the last 3-year period and 86% over the last 5-years. The findings of their annual Persistence Study are cause for even greater concern, with the data clearly illustrating that the few managers who happen to outperform are most likely to lag in subsequent periods.
So, if you feel compelled to invest in traditional active management, you have to close your eyes to the data or believe you have perfect forecasting ability. Neither of which is a compelling investment strategy.
With this context, I’ll let you eavesdrop on a typical discussion I have with friends who asked me to look at their investment holdings.
Friend: I hate mutual funds.
Mike: Why is that?
Friend: Because their performance is so bad.
Mike: That is certainly true for actively managed funds. Here is an interesting SPIVA study.
(Mike shares slide with data from SPIVA)
Friend: Yes. That doesn’t surprise me. I didn’t realize it was that bad, but makes sense.
Mike: Even worse, the SPIVA Persistence Study (Mike shares chart) shows that the few that actually win are almost certain to underperform their peers in the future.Friend: So if you buy the most recent 3-year winners, you are likely to lose in the next few years? That is fascinating data. Makes it seem hard to find any good investments.Mike: But there are other options, like fee-efficient index funds and factor-based strategies. So, let’s not throw the baby out with the bathwater.
Friend: Oh. Okay. But before we discuss those, I do like a few of my funds. Like this one. I would like to keep this fund.(He points to an actively managed fund that he currently owns)
Mike: Really? Why?
Friend: Because it has done so well lately and they seem to know what they are doing.
(Mike smacks forehead)
Yikes! All that compelling evidence just thrown out the door to chase hot returns and a hunch! Behavioral finance professionals would say that my friend, a scientist and generally rational guy, fell victim to his behavioral biases. He saw the data. He understood the data. Then, he let his emotions override the evidence. And he is not alone. Conversations like this one play out across the country every day.
The good news is that fund flows are moving in the right direction – away from high-cost, actively managed funds into more efficient ETFs and index funds as the evidence of their performance continues to emerge.
While we may not always think that a passive index is the best option (in most cases, we prefer systematic, factor-based strategies that blend the benefits of passive and active approaches), KPP applauds any movement away from overpriced, underperforming mutual funds towards more systematic, evidence-based or index approaches that serve to protect us from emotions that may destroy value.
