Yahoo Finanzen How Poor Decision-Making Affects Your Returns
In order to invest successfully, you need to be skilled at decision-making. This is true if you are a do-it-yourself investor or if you rely on recommendations from your financial advisor.
The many decisions you must confront include whether or not to engage in stock picking, market timing and attempts to select an outperforming fund manager who tries to "beat the index." There is, however, an alternative. You could be an "evidence-based investor" and capture the returns of the global marketplace, less the low management fees of index-based funds.
Making these decisions is not easy. We encounter a daily barrage of information masquerading as "news" in the financial media. Self-styled investment "gurus" make all kinds of predictions about interest rates, the direction of the stock market and which stocks are poised to take off or tank.
The real way we make decisions. We may like to think we approach these issues using dispassionate and objective logic. Unfortunately, there's compelling evidence our decisions are often made at lightning speed, based on preconceived biases and beliefs.
According to Daniel Kahneman, a Nobel Prize-winning professor at Princeton University's Woodrow Wilson School and an authority on behavioral finance, most of the time we make decisions on autopilot, using our intuition, according to a 2014 Guardian Liberty Voice article, "Think You're Good at Decision Making? Think again." Kahneman has identified "cognitive biases" that cause us to make speedy, and often illogical, decisions. These biases include:
-- A preference for not thinking about the future, causing us to make short-term decisions that are often not in our best interest
-- A tendency, known as "confirmation bias," to screen for information consistent with our preconceived thinking
-- Overweighting the impact of potential losses, known as "loss aversion," which causes us to hold on to stocks that have earned unrealized losses, rather than selling them and recognizing the loss
These biases, and others, play a major role in preventing us from making rational, intelligent decisions about our investments.
The data on investing in index funds. In a March 2015 white paper, "The case for index fund investing," Vanguard updated its case for index-based investing. The authors of the study found that active managers as a group underperformed their stated benchmarks across the majority of fund categories and time periods considered. For example, 72 percent of U.S. large-cap value equity funds underperformed their benchmarks for the 10-year period that ended Dec. 31, 2014.
Proponents of active management often argue the skill of active managers is most evident in less efficient market sectors, such as mid-cap stocks and small-cap stocks, high-yield bonds and emerging market stocks. However, the study found a significant majority of actively managed funds in these sectors actually underperformed their benchmarks, especially when accounting for funds no longer in existence.
The Vanguard paper also discovered that actively managed funds not only typically underperform their index counterparts, but in many cases, the active fund had higher volatility than the market benchmark. Investors in these funds got the worst of both worlds: underperformance and higher volatility.
Identifying actively managed funds with stellar past performance is no guarantee that this performance will continue. The study analyzed the persistence of top-performing funds over the five years ending in 2009. The authors then calculated the excess returns to those same funds over the following five years, through December 2014. Only 13.5 percent of the top funds in the earlier period remained in the top 20 percent over the subsequent 5-year period.
The study noted that an investor who selected a fund from the top 20 percent of all funds in 2009 had a 33 percent chance of owning a fund that landed in the bottom 20 percent of of all funds -- or of seeing the fund disappear entirely -- in the following 5-year period. In fact, the probability of a top-performing fund in the initial period falling to the lowest quintile in the subsequent time frame exceeded the probability that the fund would remain in the top quintile. Of the 5,375 funds available for investment in 2009, only 147 were able to repeat their outperformance in the subsequent 5-year period.
Another myth perpetuated by proponents of active management is that active managers excel in bear markets, thanks to their ability to accurately time the market and move in and out of stocks as needed. The study found that in four of seven bear markets since January 1973, the average active mutual fund did not outperform the index.
What should you focus on? The white paper noted the research indicating a fund's expense ratio is the most reliable predictor of its future performance. There is also ample evidence that low-cost funds historically have delivered above-average performance. The expense ratio, also known as the "management fee," is readily available and easily discernible for all mutual funds.
Because index strategies generally have lower expense ratios than actively managed funds, they provide investors with a simple-to-implement opportunity to outperform more expensive, actively managed funds. Other benefits of an index strategy include greater control of the risk exposure in your portfolio, broad diversification, style consistency and tax benefits.
Be aware of your decision-making biases. As you contemplate changing to an index-based portfolio, keep in mind that your decision may be adversely affected by behavioral biases such as those Kahneman mentioned. You owe it to yourself and your loved ones to recognize and overcome those biases and make a critical decision based solely on an objective view of the overwhelming academic and historical evidence.
Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."
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