Controlling What’s Controllable

Active (Investment) Management is the practice of trying to beat the market by attempting to identify “great” stocks or mutual funds, or by attempting to time exactly when to get in to, or out of, the market. It is the antithesis of Passive Management, which is a buy-and-hold strategy that uses low-cost index funds to simply match the returns of various asset classes. Compared to Passive Management techniques, Active Management is riskier and almost invariably produces lower long-term returns. If you study the objective research, you can come to no other conclusion. As Charles Ellis so eloquently stated, Active Management is a Loser’s Game.

Yet, despite all the evidence, and despite all the harm being done to the typical investor’s portfolio, there is still more money invested using active techniques than there is using low-cost index funds. The question is: “Why?” Why do so many investors pursue the failed practice of active investment management? Certainly, many are simply uninformed or misinformed: There is a powerfully profitable alliance between Wall Street and the popular press which continues to disseminate mountains of misleading investment pornography. But even informed investors – investors who have read the research – often ignore the facts, pursuing active strategies when they know they are likely to make less money than they would if they had invested in simple low cost index funds. But, again, the question is: “Why?”

For some, whether they admit it or not, investing is a form of gambling. Gambling and the tendency to assume unnecessary risks for highly unlikely rewards appears to be a basic human trait. Winning (even if it is by luck) fuels the ego and many investors appear to be happier with an underperforming portfolio that has an occasional “home run” than they are with a portfolio that earns relatively consistent returns but offers little potential for abnormally high gains.

For others, it’s a matter of “belief perseverance” – the tendency for people to hold on to their beliefs even in the presence of contradictory evidence. Not only are people reluctant to search for evidence that contradicts their beliefs, they will most often treat any evidence they do find with excessive skepticism. To some, it must seem impossible that something as seemingly simple (and boring) as indexing could reign supreme over something as complex (and intellectually stimulating) as active management.

Of course, there are many other behavioral issues which cause investors to favor the complex over the simple, and to actively manage their portfolios when the best course of action is to index. Examples are plentiful. There’s self-attribution bias – the tendency for investors to attribute their successes to their own skills (rather than luck) and to attribute their failures to factors beyond their control. There’s overconfidence – the tendency for investors to believe they have keener investment insights than everyone else.

There’s hindsight bias – the tendency for investors to see historical peaks and troughs as obvious and meaningful (when they weren’t and aren’t). And there’s familiarity bias – the tendency to invest in what we know, thus giving ourselves a false sense of control (this is a particular problem for Michiganders who seem to love to put their portfolios at unnecessary risk by owning shares of either Ford or GM). Investors are also prone to extrapolation – the tendency to perceive historical “patterns” as trends when, in fact, they are nothing but random noise.

All of these behavioral issues serve to cloud the reasoning of otherwise prudent investors and steer them away from the benefits of indexing.

But I think, perhaps, the most powerful behavioral issue that perpetuates the active management myth (other than, perhaps, the popular press) is our unrelenting desire to feel in control – even when facing uncontrollable random events (such as the performance of the stock market). Humans are not very good at statistically understanding the world around them. Our brains are programmed to see trends where none exist, to draw conclusions based on incomplete data, and to dismiss the consequences of certain risky behaviors. To most, randomness does not look random (thus the popularity of statistically meaningless “5 Star” rating systems).

So, when someone comes along offering a way to “control” one of the most uncertain aspects of investors’ lives (i.e., stock market performance), active investors gain a great deal of comfort – even when that comfort is a very risky illusion.

In their search for control, and whether they realize it or not, investors who use active techniques actually add more uncertainty to their portfolios; because with active management comes the additional (and almost guaranteed) risk of underperforming the markets. And this underperformance risk can be devastating – especially if it happens to coincide, for example, with an investor’s planned retirement date. A single year of underperformance can easily wipe out a decade of market-beating gains.

Thankfully, trying to control portfolio performance via active management is not a necessary ingredient for investing success. What is necessary, however, is recognizing (and acting upon) what we can control.

If we define success in investing as being able to use our portfolios to meet our most important financial goals, then investors have control over just two variables: the amount of market risk they expose themselves to, and their cash flows (the amount of money they spend, and the amount of money they save). Assuming a diversified portfolio, risk is controlled via asset allocation. The asset allocation decision, in turn, is determined largely by the cash flow variables – planned levels of spending and planned levels of savings.

All else being equal, the more you plan to spend (or the less you plan to save), the more risk you will need to take to meet your financial goals.
So, while investors cannot control the timing of market returns, or whether or not their portfolios will beat the market, they can control the overall level of market risk that they need to subject themselves to: Not by looking for stock-picking or market-timing gurus but, rather, by simply changing their spending and/or savings habits.

Again, the less you spend (or the more you save), the less risk you will need to take to meet your goals. Conversely, if you plan to spend a lot during retirement and are unwilling to maximize your savings, you will probably have to take more risk in your portfolio to try to earn the returns that will be necessary to support your lifestyle.

In other words, closely examining your spending and savings habits (and adjusting your portfolio’s allocation accordingly) can do far more to help ensure you’ll meet your financial goals than trying to identify the next market “guru”, or waiting for the next “perfect time” to reinvest your money. The former – controlling what you can control (i.e., how much you save, how much you spend and your overall allocation) – has an almost 100% chance of succeeding. The latter – trying to control what you can’t (i.e., the timing of portfolio returns via active management) – has an almost 100% chance of failing. $$ Michael L. Gay, MBA, CFP®