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Why People Believe
The Impossible

The idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it and full of other people who believe them. Why do people believe they can do the impossible? And why do other people believe them? —Daniel H. Kahneman, 2002 Nobel laureate in economics.

Why People Believe<br />The Impossible

Role of the Media

 

Despite 50 years of empirical evidence that passively managed index funds are less expensive, safer, and better performing why do millions of investors continue to invest in actively managed funds? Why do they mistakenly believe their advisors to be among the select few who can predict the future?
 
Experts agree the best explanation is the illusion of skill fostered by a powerful professional culture of newspaper, television, and radio pundits. Who, too often, present themselves as being able to forecast future market movement and undermine the truism that the future is unpredictable by the ease with which they explain the past.
 
Other people simply have great confidence in their ability, real or imagined, to pick stocks, sectors, and markets—to make intelligent guesses. These investors fail to grasp that in game of investing there must be a loser to counterbalance every winner. The costs of investing already put every active investor at a disadvantage. Then they have to compete against each other. None of this deters the active investor armed with confidence and a willing advisor.
 
It’s likely that many investors are simply unaware of the differences between active and passive investing. Advertising makes active investing look easy and profitable, and make investors believe it’s simple to beat the market. Yet beating the odds is impossible in the long-run. Nearly three-quarters of active funds annually fail to outperform passive funds on a pre-tax basis. After taxes, the record of actively managed funds is even more dismal. Sales charges on active funds lock in immediate losses, and forever diminish the compounding power of an investment. To beat passively managed funds, active fund managers would have to outperform the market by 1% to 2% annually, year after year, before expenses. A manager who could do this is extremely rare, and would be statistically impossible to select in advance.
 

Misleading Media

 

Today approximately 85% of mutual fund investors reportedly have their money invested in actively managed funds. Given the proven long-term performance and expense advantages of index funds, why does active investing remain so popular? The short answer is that people don’t know what they don’t know—and the multi-billion dollar investment industry is not about to enlighten them. In contrast to the individual investor, more than 50% of Public Pension assets use passive strategies to manage their portfolios according to one study by Greenwich Associates.
 
The financial services industry would have a great deal to lose if passive and indexing strategies were well understood by the average investor. Stockbrokers and mutual fund brokers wouldn’t earn commissions if millions of investors turned to index funds. Fund advisors wouldn’t be able to reap the huge gains from portfolio management fees. Morningstar’s touted five-star rating system (a record of past performance) would be meaningless if investors stopped using their track records as a guide.
 
The investment media, including magazines like Fortune, Forbes and Barrons, along with hundreds of expensive investment newsletters, would hold little appeal if investors decided to match the market rather than try to beat it. Likewise, TV and radio talk-shows on money and investing would lose millions in advertising revenue if investors stopped following their advice. Clearly the financial media has powerful incentives to guide investors to active management strategies.
 
Index investing is often derided by money managers as a strategy that delivers mediocre results. Given the choice, who wouldn’t prefer to beat the indexes rather than match them? The overarching message of the financial services industry is that this can be done provided the investor has the right advice, strategy, stock picks, or timing. Newspapers and magazines support this idea with frequently updated lists of funds with 3, 5 and 10-year records of market-beating performance. Performance-chasing investors see winners, but don’t understand that for every winner there must be a loser.
 
By encouraging investors to chase returns, the investment media fuels short-term thinking and frequent changes in investment strategy. This is extremely costly to investors, but very profitable for the advisors, brokers, fund houses and investment gurus who live on commissions and fund expenses. Short-term thinking also enhances media revenues. Who would turn to Fortune’s stock picks for 2010 when the calendar has turned to 2011?
 
In short, the financial media consistently supports the idea that active investing is the best way to invest. Any investor who watches the financial talk shows on television, or listens to the radio, or browses the money magazines would find it difficult to miss this message. Yet it is well known that the active management process generally fails to match the returns from passive and index investing.