Readers of my books often ask: "Given that the evidence against active management and for indexing (or passive investing) is so overwhelming, why do the majority of investors keep playing a loser's game?" I offer three explanations for this phenomenon.
Lack of Public Education Unless one obtains an MBA in finance, it's likely that they haven't taken a single course in capital markets theory. Without the knowledge, how can they know whether an active or a passive strategy is the right strategy? The result is that they get their "knowledge" about investing from the very people -- Wall Street and the financial media -- who don't have their interests at heart. Wall Street needs investors to trade a lot and to pay the high fees imposed by actively managed funds. The media needs investors to "tune in." The result is that most investors are unaware of the historical evidence.
Lack of Private Education However, people also seem unwilling to invest the time and effort to overcome the failings of the education system. Instead of reading books like mine, John Bogle's or William Bernstein's, they would rather watch CNBC.
Unwilling to Admit Mistakes As we saw yesterday, most people are simply unwilling to admit when they make a mistake. It could be for a host of reasons, but the bottom line remains the same: People keep making mistakes because they refuse to admit their errors so they can correct the behavior.
Of course, investors fall into this trap on a frequent basis. Investors, relying on the past performance of active managers (and rankings like Morningstar's ratings), hire managers, eventually firing most of them and repeat the process. They do so without ever asking: "What am I doing differently in the selection process so I don't repeat the mistake I made last time?" In a triumph of self-justification, they end up doing what Einstein said was the definition of insanity -- doing the same thing over again and expecting a different outcome.
Carol Tavris and Elliot Aronson, authors of the book Mistakes Were Made (but Not by Me), note that "None of us can live without making blunders. But we do have the ability to say: 'This is not working out here. This is not making sense.' To err is human, but humans then have a choice between covering up or fessing up. The choice is crucial to what we do next. We are forever being told that we should learn from our mistakes, but how can we learn unless we first admit we made any?"
Political scientist Philip Tetlock demonstrated in his outstanding book, Expert Political Judgment, that even professional economic forecasters don't make accurate forecasts with any persistence. Yet, despite the overwhelming body of evidence that there are no good forecasters, investors pay lots of attention to economic and market forecasts, often acting on them, altering even well-thought-out plans.
Tavris and Aronson explain: "When experts are wrong, the centerpiece of their professional identity is threatened. Therefore...the more self-confident and famous they are, the less likely they will be to admit mistakes." Instead, what they do is justify their forecasts by "coming up with explanations of why they would have been right if only -- if only that improbable calamity had not intervened; if only the timing of events had been different; if only blah blah blah." They (and we) do this to preserve our belief that we are smart.
This doesn't mean that we're doomed to keep justifying our mistakes and, therefore, repeat them. Even smart people make mistakes. What differentiates their behavior from that of fools is that they are capable of admitting their errors. They alter their behavior so that they don't repeat the mistakes.
This is a call for action. If you have been using active strategies and have failed to outperform appropriate risk-adjusted benchmarks, or the fund managers you've hired have failed to do so, or if your advisor using active strategies has failed to do so, ask yourself:
- What will I do differently to ensure a different outcome? If I can't identify anything, then why do I think the outcome will be different?
- Why do I think I will succeed where others (institutional investors) with far greater resources and other advantages (such as lower costs and/or no taxes to pay) have failed with such great persistence? What advantages do I have?
If you don't know, my suggestion is to take your portfolio to a fiduciary advisor, one that uses passive strategies, and ask them to analyze your portfolio and show you how it has performed relative to appropriate benchmarks. It might just turn out to be the best "investment" you have ever made.
A fitting end is the following paraphrasing of a 2,500-year-old quotation from Chinese philosopher Lao Tzu:
- A great investor is like a great man
- When he makes a mistake, he realizes it
- Having realized it, he admits it
- Having admitted it, he corrects it.
- He considers those who point out his faults as his most benevolent teachers
Book Review: Mistakes Were Made (but Not by Me) What Rising Correlations Mean for Market Returns Can You Find the Future Winners? Why Getting Too Conservative As You Age Can Hurt Your Retirement Quest for Alpha: 10 Rules for Being a Successful Investor
Three ways I can help you become a wiser investor: