Important question here by Larry Swedroe from last week. If we know that active managers are very bad at trying to beat the market then why do investors keep giving them assets? This is no small topic, but I’ll try to summarize my views here.

Before we begin, we are all “active” investors to some degree. No one, not a single one of us, can implement a truly passive index strategy in the same way that is so often cited by many studies against “active investment management”. We buy and sell periodically, we rebalance, we change allocations, etc. So, let’s all get on the same page and agree that we are all active investors to SOME degree.

Now that we’re all on the same page there the question changes a little bit. If we know that more active managers are not very good at generating high risk adjusted returns or beating the market then why do investors keep buying their funds over a less active and low cost index fund style approach? I have a few thoughts here:

We are all pretty stupid when it comes to money and finance. In fact, the SEC found that “U.S. retail investors lack basic financial literacy”. So, as Larry notes, financial literacy is a huge problem. In fact, if you’re reading this website I’d be willing to bet you’re WAY ahead of the game to begin with. We are extremely biased and emotional animals. Not only will we convince ourselves of things that are totally false in an attempt to make money and protect it, but we react inefficiently at almost every twist and turn in dealing with money. As Laurie Santos shows, we’re about as good with our money as apes are because we’re just not designed mentally or emotionally to handle such a fragile construct. We are told on a daily basis that we must “beat the market”. And we’re told that if we don’t “beat the market” then we’re losers or average. But the funny thing is that the market is the market in the aggregate. And in the aggregate NO ONE beats the market. We confuse real investing with allocation of savings. We are told on a daily basis that we are “investors” on secondary markets who can strike it rich if we just buy the right stocks and bonds. But the reality is that when you buy stocks or bonds on a secondary market you are allocating your savings into what was really someone else’s “investment” and it’s very likely that the easy money has already been made and these real “investors” are cashing out. Real investors build future production, make great products, provide superior services and only sell their majority interest in that production at a much later date (often on a stock exchange via an IPO). The idea of getting rich in the stock market puts the cart before the horse. You shouldn’t look to “get rich” in the stock market. You should look to get rich making investments in yourself and on primary markets where real investment is done. (See here for more). We don’t account for real, real returns properly. In other words, we tend to hear about the nominal return of the stock market or something like that and fail to account for taxes, fees, inflation and other frictions. And in doing so we fail to account for how much a high fee or other frictions can really diminish our returns. (See here for more). We don’t benchmark fund managers appropriately so we end up comparing managers in ways that really make no sense. Most of us will look at nominal returns and declare a fund to be worthless or a good buy. Not only are we datamining and falling victim to recency bias, but we’re not looking at risk adjusted returns. And so we see ridiculous headlines about how “hedge funds underperformed” even though the comparison is likely an apples to oranges comparison of underlying fund styles. (See here for more).

All of this leads us to buy into a dream of a road to riches in the stock market that often turns out to be a nightmare. Don’t get me wrong. We’re all active managers of our own accounts and there are ways we can manage our assets efficiently so that we reduce frictions, taxes, fees and optimize returns to meet our personal financial goals. And there are actually active money managers out there who charge very reasonable fees and provide strategies and services that are very useful for clients in numerous ways. Unfortunately, most “active” fund managers are closet indexers or doing something that adds very little real value to a portfolio while charging 1%, 2% or even more. But when you consider how poorly most of us understand these topics, well, it’s pretty enticing to fall for the idea that a smart guy working on Wall Street can help you “get rich” in the market….