What kind of irrationality causes investors to accept exorbitant prices for active management?
Most “rational” people will prefer more money to less money. Accordingly, they will prefer to gain more monetary value rather than less from what they buy, and they will prefer to pay less for what they buy rather than more. Except when it comes to their investment decisions. Low-cost indexed investment management has gained strength at a great rate in recent years. Yet much-higher-cost active management still claims the majority of investors’ assets. Repeated studies have shown that as much as 97% to 99% of active equity managers underperform passive stock market indexes. Therefore, they provide investors with less monetary value than passive, indexed investment management. On the cost side, the cost for active management can be as much as 40 or more times the cost of passively managed index funds. With fees like that, over an investor’s lifetime the investor can lose as much as a third- to a half of her wealth to fees. How could any rational investor — one who prefers more value in the investment product purchased to less, and lower cost to higher cost — possibly choose active fund management over passive management? Heaton and Pennington use methods developed by Nobel Prize-winning psychologist Daniel Kahneman and his late colleague Amos Tversky to research investor irrationality. Their starting point is to posit that investors suffer from what is called the “conjunction fallacy.” The conjunction fallacy is an apparent failure of logic, represented by the following example: Which of these two possibilities do you think is more likely?
A. Johnny gets an “A” on his final exam.
B. Johnny studies hard and gets an “A” on his final exam.
Most people will answer that B is the more likely. But this is a fallacy, because option A includes the possibility that Johnny didn’t need to study hard to get an “A” and didn’t study hard, while option B doesn’t include that possibility and is therefore less likely. However, people are so used to conjoining “studying hard” with “getting an A” that they don’t see their logical error. To fit this line of inquiry to the investment management area, Heaton and Pennington posed the following question to experimental subjects: ABC Fund invests in common stocks listed on U.S. stock exchanges.
Which is more likely?
1. ABC Fund will earn a good return this year for its investors.
2. ABC Fund will earn a good return this year for its investors, and ABC Fund employs investment analysts who work hard to identify the best stocks for ABC Fund to invest in.
From this, Heaton and Pennington conclude that investors choose active management because they adamantly believe that hard work and a high level of competence must surely be rewarded with good results — even if the evidence shows otherwise. Many active managers, when questioned by clients or prospects about their high fees, will invoke the “brain surgeon” analogy. They will say, “If you need brain surgery would you choose the lowest-cost brain surgeon?” This rejoinder has been proven to work time and time again, because, as Heaton and Pennington would argue, the clients believe that in a just world, “hard-working experts should produce superior outcomes.” Therefore, they should be paid more, even if — bewilderingly and incredibly — the statistics plainly show that they do not produce superior outcomes.