Why do people invest in active funds?

By: Julio Cacho, PhD

Because of many factors including that it is tough to disentangle luck from skill, and overconfidence.

We all like to win big, especially when it comes to stock market investments. We aim to outperform the stock market for larger gains! Many people pick actively managed funds over a broad-based index to achieve these huge gains. People expect an expert manager to easily achieve larger financial gains. However, The Economist article linked below shows a clear trend that active fund managers almost always lose against the index over three to ten consecutive years. Yet people still want to use an active fund manager when the odds are clearly against them…..WHY do people think this way? 

One reason people believe they can select a winning fund manager is because it is hard to decipher luck from skill. It’s human nature to be more confident in our abilities even if it’s unwarranted. However, the laws of probability suggest that it’s almost impossible to pick a consistently successful active fund. The Economist article links to a fascinating coin-flip thought experiment where financial professionals conclude it takes a long time to figure out a fair stock price from an overvalued stock price. Active fund managers will often pick the “hot” stocks to beat the market, when often the “hot” stocks are overvalued, and the result is a loss in long term gains.

Oftentimes the “hot” stocks are overvalued because success in investing is built on past data. People think they can find the right active manager by looking at the past fund success. But relying on past data for future success is not a good strategy! A previous great investment strategy will be discovered, and stocks will become overvalued when more people invest in them. Instead of active funds that rely on these overvalued stocks, investors should use a broad-based index, like the S&P 500, and allow for time-based returns that offer a greater return on investment.

It’s difficult to pick a winning active fund manager for future success when relying on its past performance. Instead, choose to invest in a broad-based index fund and the odds will long be in your favor.    

Read this article to see why the odds are not great for picking active fund managers!