When he was once asked if there was ever a case for using actively managed funds, the Nobel Prize-winning economist Eugene Fama fired a question back: “Why do we pay people to do something they cannot do?”
So, what did he mean by that? Well, the market return is there for the taking: you simply need to buy a low-cost index fund. Yes, you’ll pay a modest ongoing fee for the fund, and there’s likely to be a small tracking error (which may work to your advantage or may not). But, if you simply stay invested, you will be guaranteed to receive the average market return. And, because of the money you save in fees and charges, after costs you will outperform the vast majority of investors.
The only logic for using an active fund over an index fund is that you think you will beat the market. Indeed you might, but the odds are very heavily stacked against you. The evidence tells us that only a very small number of active funds — somewhere around 1% of them — outperform in the long run on a cost and risk-adjusted basis.
The odds of picking a winner, in advance, are therefore in the region of 100-1. And the more active funds you have in your portfolio, the less likely it is, overall, that you will outperform. Say, for instance, you invest in six active funds. The chances that every fund will outperform its benchmark index are about the same as picking all six winning lottery numbers.
It’s not exactly Mission Impossible, more like Mission Highly Improbable. As Professor Fama would say, paying an active fund manager to try to beat the market is paying them to do something they almost certainly cannot do. So why do so many people still use active managers?
One explanation is that we don’t understand probabilities, and for many people that may be true. But it also has something to with how the human brain works.
In his book Experiencing the Impossible: The Science of Magic, Gustav Kuhn, a psychology professor from Goldsmiths, University of London, and a keen magician himself, details a study in which people were shown video clips of magic tricks.
After one particularly amazing trick, researchers gave the group a choice: would they prefer to discover how the trick was performed or watch another trick. The result? 60% opted to watch another trick, while only 40% wanted to know how the trick was done.
There is, in fact, a growing interest in magic among psychologists and neuroscientists. What the research shows, is that, manipulating the mind, and getting it to believe the impossible, is frighteningly easy.
It isn’t because we are stupid that we don’t see something that is happening literally right in front of us, says Professor Kuhn; it’s because the brain is brilliant at economising.
“It's purely about efficiency,” he says. “We have to filter out information to save energy, otherwise we would get overwhelmed. Rather than just processing all the information, the brain selects the stuff that’s really important. So, we can be looking at something right in front of our eyes, but the information doesn’t go any further and reach our conscious experience.”
Psychologists call this inattentional blindness. And it’s not just magicians who are clever at exploiting us. Think, for example, of distraction thieves or con artists. It also happens in business — especially in marketing and advertising.
In a few moments, we’re going to invite you to watch a video presented by the magician Robert Strong. It illustrates how the fund management industry uses the same techniques as magicians — misdirection, sleight of hand and the powers of suggestion — to exploit our cognitive biases and persuade us to buy its products.
“The investment industry,” Strong explains, “counts on your brain to make assumptions and come to magical conclusions.”
So, for example, we are hardwired, as human beings, to think that the past predicts the future. “That gets your brain producing a drug called dopamine, he says. “You are literally getting high from imagined wealth.”
That’s right — dopamine, the same drug we crave when we can’t stop checking our mobile phones, when we keep putting money in a slot machine, or crave a giant slab of chocolate cake.
On one level, we know it doesn’t do us any good. But we do it anyway.
Enjoy the video, but, most of all, learn from it. Become a conscious consumer. And stop believing in magic.