I really don’t understand how active management survives.  The chance of picking an outperforming, actively managed mutual fund is statistically insignificant. When you consider the impact of taxes, and add the inability of outperforming funds to sustain their stellar past performance, the case for active management is even worse.

Yet the majority of individual investors still select actively managed mutual funds, although the trend has shifted markedly towards passive over the past decade.

When I was an advisor, I rarely converted  prospects who told me they “didn’t believe in passive management.”

I now understand why.

A logical explanation

A recent paper, authored by J.B. Heaton and Ginger L. Pennington, provides a logical explanation for the persistence of active management.  They believe the culprit is “conjunction fallacy.”

It’s best illustrated by the mantra, the harder I work, the luckier I get.  In most areas of human endeavor, there’s a positive relationship between diligence and reward.  The authors provide these examples: Time spent with one’s children creates better relationships. Business owners who put more effort into serving customers’ needs usually have stronger businesses. Most students cannot achieve high levels of educational achievement without a correspondingly high level of diligent study. Running a marathon requires months of training. Successful academic research requires many hours of reading, analysis, and writing

Many people can’t overcome the fallacy of believing they must work hard to achieve superior returns.  It …may simply be too difficult for a substantial number of investors to believe that superior returns are available by doing nothing but investing in an index fund rather than investing with active managers.

A different approach

Whether the misplaced belief in active management is based on the conjunction fallacy or something else, here’s the biggest mistake advisors make when confronting this issue:  The attempt to persuade using data.

In her fascinating book, The Influential Mind, What the Brain Reveals about Our Power to Change Others, neuroscientist Tali Sharot explained why marshaling data in support of your point of view is actually counter-productive. When we do so, the other person doesn’t objectively consider the merit of your facts. Instead, they use those facts to support their pre-existing belief or “turn away” and don’t consider them at all.

Here’s a better way.

Don’t try to persuade the prospect that passive trumps active.  Instead, say something like this:

There are benefits to both active and passive management. With active management, there’s a possibility you’ll beat the market and earn higher returns. With passive management, there’s a certainty you will capture the returns of the market (net of low fees), and those returns have historically exceeded the returns of most professional money managers. Is the certainty of knowing you will earn those returns more valuable to you than the possibility of earning even higher returns?

Then engage in a discussion in which you continue to ask non-judgmental questions, like:

What information would you find helpful in resolving this issue in your mind?

You mindset should be one of a consultant trying to figure out what’s genuinely in the best interest of the prospect, and not as an advocate for passive management.

By gently probing with questions (rather than “lecturing” or “educating”), you are far more likely to understand the basis for the concerns expressed by the prospect. You will also increase the likelihood of converting the prospect into a client.

Resource of the week

I highly recommend Tal Sharot’s informative book, The influential Mind:  What the Brain Reveals About Our Power to Change Others.