There’s no shortage of quotes extolling the virtue of hard work. The one I hear a lot is “the harder I work, the luckier I get.”
In most areas of human endeavor, hard work correlates positively with success. In investing, it doesn’t.
And that’s the problem.
Consultants work hard
Consultants to institutional investors work really hard. They generate huge fees based on their purported ability to beat a risk-adjusted benchmark. If their clients weren’t convinced of their expertise, they would simply purchase low management fee index funds and fire the consultants.
Academic studies demonstrate consultants add no value to the pension plans that retain them. After costs, the actively managed funds they recommend don’t beat the returns of comparable index funds.
It’s not because the consultants aren’t working hard enough.
The skill level of your broker
Your broker is also working hard to time the market, pick stocks and select outperforming actively managed mutual funds. It’s unlikely most brokers have the background and expertise of consultants to mega-billion dollar pension plans.
Is it realistic to expect them to succeed where consultants have failed?
The “work ethic” fallacy
Given the evidence on the poor performance of actively managed funds compared to index funds, you would think most investors would invest in index funds. The majority don’t.
This anomaly is confusing. It seems irrational. Could there be another reason for this behavior?
A recent study attempted to solve this anomaly.
It concludes investors are victims of the “conjunction fallacy.” Because hard work generally pays off in most areas of life, they believe the same must be true with investing.
This belief – that the harder you work on your investing, the better your returns will be – simply isn’t true in investing. The authors of the study conclude: But despite clear evidence, 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.
Active fund managers exploit this fallacy by advertising their talent, resources, and hard work, reinforcing the myth that these traits lead to higher expected returns.
The study explains the survival of active management is based on “the work ethic fallacy”.
The authors propose something I’ve been advocating for years. Actively managed funds should be required to issue a warning to investors, like: Many active investment strategies underperform more inexpensive alternatives. Ask your broker for more information.
I have a better idea.
Limit your investments to low management fee index funds. Avoid brokers or advisors who recommend actively managed mutual funds, stock picking or market timing.
With investing, relaxing is a virtue.
Resource of the week
I recommend the study, How Active Management Survives, by J.B. Heaton and Ginger L. Pennington. It’s a quick and valuable read.