Why Does Active Investing Flourish?

March 31, 2015  |  

Why Does Active Investing Flourish?

Earlier this month, I had the opportunity to run an educational workshop at the SPA/AAP Pediatric Anesthesiology 2015 Meeting. The workshop was entitled “Evidence-Based Investing and Financial Planning.” We covered the 12 most important insights about evidence-based investing and how those insights can be applied to a rational financial planning process.

Evidence-Based Investing is the alternative to the traditional active form of investing, which depends on forecasting future markets, picking winning stocks and otherwise relying on guesswork and emotions. The workshop was very well received and I was asked some excellent questions. The question that stuck with me most was, “If evidence-based investing is so compelling, why does active investing continue to flourish?”

That’s a great question that deserves a thoughtful answer. I recently attended a conference and heard Professor Kenneth R. French of Dartmouth College speak on this subject. During his presentation he offered the following reasons for the continuing popularity of active investing.

  1. Conflicts of Interest. Quite frankly, the financial press sells more papers and magazines with stories about the active manager who had the most recent investment success. “Breaking news” stories have more sizzle than repeating timeless truisms. Wall Street also has a lot to lose if investors abandon active management. Why? Because active management strategies are much more profitable products to sell.
  2. Overconfidence. According to Professor French, “The number one bias in noisy environments where feedback is weak is overconfidence.” Few investors are qualified to apply statistical analysis to whether an active management strategy can consistently outperform the market. When viewing any outperforming series of numbers, investors often grow overconfident that they are meaningful, even though the results cannot statistically be determined as anything other than random chance.
  3. Persistent superior skill. There are certainly some active managers who have displayed statistically significant superior skill. The problem is they are hard to identify ahead of time – like finding a needle in a haystack. Once their market-beating record is known (i.e., by the time you’re jumping on the bandwagon), everyone else wants to invest with them too, and their ability to continue to outperform tends to disappear. The results: Investors end up buying over-priced shares based on past outperformance and selling them low, after the thrill is gone.

I would add a fourth reason to Professor French’s list. The Advisor Community. It is much harder for a would-be advisor to explain the highly challenging statistical realities of selecting outperforming managers or funds. It is much easier to claim that you have a black box or “expert” process that identifies great managers in advance. Why? The very people selling such products have conditioned investors to believe that they are the secret key to investment success. This is despite the fact that such products are more likely a way to hide excess fees and so-so returns. In contrast, the academic evidence supporting transparent, low-cost, globally diversified investing is clear and compelling.

We have created a website dedicated to explaining the important concepts of Evidence-Based Investing. We hope that it will arm you with the insights that you need to be a discriminating consumer of claims made by the proponents of active management. I would appreciate your feedback.

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About Chas Boinske

Charles P. Boinske, CFA, is a 30 year investment management veteran overseeing the strategic direction and portfolio management process for Independence Advisors, LLC. Have a question for Charles? CLICK HERE TO ASK CHARLES

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