Ilove behavioural finance, but understanding it has made me fatter. I have learned that the emotionally detached, rational part of my brain can only resist temptation for so long, so to save effort I now yield to the call of the doughnut straight away.
By encouraging investors to stop fighting an apparently unwinnable fight, behavioural finance has also been a key driver behind the exponential growth of passive investing.
However, while it is laudable to see individuals using rational logic to make decisions, I suspect it’s overdone.
A bible of behavioural finance – Daniel Kahneman’s excellent Thinking Fast and Slow – explains the behavioural flaw that supposedly dogs all active investors. It is known as ‘base rate neglect’ and describes individuals who forge on with a decision in spite of statistical evidence.
For passive investors, the base rate is the fact that the average investor will match their market less charges. So why pay higher charges for an active manager?
But these criticisms, which are widely-used stalwarts in the case against active investing, have two serious flaws.
The first is the one-year assumption. A raft of studies have highlighted the inability of mutual funds to persistently outperform on an annual basis. The problem is there is no reason to use a year as the defining timeframe for investment performance. A market cycle would be more appropriate, typically 5-7 years. On this basis, there are enough regularly outperforming managers to avoid being written off as statistically insignificant. I am yet to see a passive-sponsored study that covers this.
The second flaw is the ‘30,000ft fallacy’: the problem that base rates can be high-level and imprecise. Take Mr Kahneman’s example of the restaurateur who starts up an Italian restaurant in spite of the fact 60 per cent of new restaurants go bust within two years.
It appears she has made an overconfident decision, but how do we know she was not party to more precise ‘base rates’? Could it be that she has experience? The failure rate for restaurateurs who have already set up a successful venture could be 45 per cent. Or she may know that setting up an Italian restaurant in a town that has none faces a base rate for failure of only 20 per cent. In such circumstances, she would be irrational not to start up her business.
There are lower-level investment base rates that have been proven to work over time, including value or momentum investing, or a small-cap bias. But these successful base rates are swallowed up by the indisputable but clumsy high-level version that shows the average investor underperforming.
In a recent study, Antti Petajisto of the Stern School of Business split out the US mutual fund market into five separate categories using repeatable statistical measures.
Ironically, given Mr Kahneman’s pejorative use of the term, the only category of fund to consistently beat their markets – after all charges and costs – were stockpickers. The average fund in this group beat its market by 1.3 per cent a year over the length of the study. All other types of funds are therefore responsible for dragging down the average.
In light of more precise base rates, the rational decision is now to abandon underperforming trackers to invest in a selection of stockpickers. It will be interesting to see if passive investors are willing to make the change.
Simon Evan-Cook is a senior investment manager on Premier Asset Management’s multi-asset team
