Investing In Index Funds: A Tangible Reward of Overcoming Bias

On this blog Nick Bostrom once asked “What practical things does debiassing enable us to do?”  Well, investors who overcome overconfidence bias and invest in index funds earn much higher average returns than investors who think they can beat the market by investing in actively managed mutual funds.

Mutual funds buy stocks.  When you invest in a mutual fund you are essentially paying someone else to pick stocks for you.  For the purposes of this essay let’s consider mutual funds that buy stocks only in the S&P 500.  The S&P 500 consists of the 500 largest publicly traded U.S. stocks.

Actively managed mutual funds invest in stocks that they think will do well.  In contrast, index funds buy all stocks in proportion to each stock’s relative total value.  (Most of my savings are in S&P 500 index funds.)  Index funds, therefore, always turn in an average performance while actively managed funds try to beat the market average.

Actively managed mutual funds have higher fees than index funds because actively managed funds must pay people to research stocks.  Also, because they tend to engage in more trades, actively managed mutual funds are not as tax efficient as index funds. 
Consequently, it’s only worth investing in an actively managed fund if you think the fund will significantly beat the market average.

There is strong theoretical and empirical support for the theory that most actively managed mutual funds won’t beat the market average.  As reported in index fund pioneer John Bogle’s The Little Book of Common Sense Investing, after paying taxes and fees, someone who put $10,000 in an index fund in 1980 had $149,000 in 2005.  In contrast, someone who put this same $10,000 in an average actively managed mutual fund in 1980 had only $61,700 in 2005. 

Each year some actively managed mutual funds do outperform the market.  Funds that do well one year are not, however, more likely than average to do well the next.

Despite the clear advantages of investing in index funds, Americans put more money in actively managed mutual funds than they do in index funds.  Part of the reason is because of overconfidence bias on the part of investors who irrationally think they can pick actively managed mutual funds that are more likely than average to beat the market.

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  • http://amnap.blogspot.com Matthew C

    I’ve read somewhere (maybe a link on MR) that a properly-designed market basket fund does even better — the standard index funds are biased towards market cap, which means that they automatically buy more when a stock is overly expensive and less when it is a good deal.

  • Doug S.

    Here’s a crazy idea: “Socially Irresponsible Investing.”

    http://www.youtube.com/watch?v=6Ivx_1u_2HY

    If people don’t want to invest in companies that produce, say, tobacco or weapons for moral reasons, then, by definition, their stocks are undervalued relative to where they should be in a “rational” market. Remember: Evil will always triumph, because good is dumb!

    Oddly enough, there really is a fund that does something like this:
    http://www.vicefund.com/index.html

  • http://stockmarketbeat.com Trent

    Funds that do well one year are not, however, more likely than average to do well the next.

    As Harlow and Brown note, the question is not whether the average actively managed fund can outperform but whether those that will outperform can be identified in advance. Their research suggests the odds of doing so can be as high as 60%.

    Kosowski et al have also found that there are more successful active managers than would be explained by random variation, supporting the notion that such managers have skill.

  • http://stockmarketbeat.com Trent

    Matthew-

    The “fundamental indices” you describe, I consider strategies as opposed to indices. The advantage of a market-weight index is that there is no need to rebalance the portfolio whenever the price changes. The weightings of a fundamental index are constantly changing so it is impossible to truly track performance of the benchmark.

    Not that there is anything wrong with the strategy, I just think the term index is as much a marketing ploy as anything else.

  • Biomed Tim

    Another aspect of tangible reward–which doesn’t get talked about often here–is in medical application. Many of us possess a myriad of strange biases toward science and technology; I can’t tell you how many times I’ve gotten into an argument with someone over the expression “natural is better.” (whatever that means)

    Overcoming biases can help one pick the most beneficial medical treatment in times of need. (and avoid hack treatments)

  • paul

    I don’t think its overconfidence. I think its more for the entertainment value. If it was really overconfidence people would have a much bigger allocation to active strategies in their portfolios than they really do. “professional” investors behave the same way. They really take very little active risk. They say they believe but they act like they don’t.

  • Eric Falkenstein

    Ross Miller has a neat paper where he measures the active portfolio manager by his deviation from a benchmark like the S&P500. Thus one’s position in IBM is the amount by which it differs from the S&P weights. As these differences are much less than the absolute position weights, and reflect the active part of the adviser’s skill, he then figures the actual expense ratio by dollar is more like 5%! You pay a lot for a quasi index fund with a couple of anecdotes. Puts the hedge funds 2% of assets and 20% of profits in perspective.

    see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926

  • Hollywood_Freaks

    However, the market needs these researchers in order to keep it efficient. While the index fund does not bear the cost of researching, they certainly are receiving the benefit. This could turn out to be a problem if the amount invested in index funds becomes significantly larger than those invested in managed funds.

  • Floccina

    First I am a big fan of “A Random Walk Down Wall Street” and thus I am a cost minimizer, but isn’t it true that if a higher and higher percentage of the money invested in stocks goes into index funds, won’t the market for stocks at some point loose its mind and the managed money start to win. After all stock investing is all about dividends and future dividends (stock buy backs and liquidation being equal to dividends) they are the only real return on stocks so that it is possible to be right apart from what the market does.

    I have an E*Trade account and I AM buying one stock at a time building up to 60 + stocks buying in approximate $5,000 chunks which I hold for 10s of years/indefinitely will I not end up with even lower costs ($5.00/trade = 5/5000 = 10 basis points over 10 years = less than 2 basis points expense) than index finds?

  • Floccina

    BTW Matthew C I have in the past shorted MCel and Bldp based on my belief that many MCel and Bldp investors seem to support those companies for charity reasons rather than value reasons. Also MCel and Bldp are what they call suckers bets very very long shots that cpuld pay out very big but if I use puts I limit the damage if the stock home runs but I win in most cases.

  • Patri Friedman

    There is a pretty good book which talks about how to overcome bias in financial decisions, it is a bit dated, but it was one of the first things I read about overcoming bias:

    http://www.amazon.com/Smart-Money-Decisions-change-better/dp/0471296112

  • zzz

    isn’t it true that if a higher and higher percentage of the money invested in stocks goes into index funds, won’t the market for stocks at some point loose its mind and the managed money start to win.

    Yes. The real point of the random walk hypothesis is that returns to speculative activity are competed down to the lowest wages of superintendence that the market will bear. This means that speculation is a very bad deal for casual traders.

  • http://www.atheist.net Torben

    Henry Blodget of Slate.com points out how the past performance of mutual funds says next to nothing about their future performance. Check figs. 5.2-5.4

  • Jason Bourne

    investors who overcome overconfidence bias and invest in index funds earn much higher average returns than investors who think they can beat the market by investing in actively managed mutual funds.

    You are really stretching the evidence to make this claim. Most active fund managers fail to beat their relevant benchmarks, but this says precisely nothing about the returns I see on my statement. My behavior has far more to do with it than which funds I’m investing in. Overconfidence might be a small part of it, but there is a veritable stew of biases which affect investor decision-making.

    That’s why there’s, like, a whole academic field devoted to the topic.

  • gh

    Read the prospectus & online for the fee adjusted return vs the benchmark. The YTD is always less, but look at the 5 yr,10 yr,etc..

    Mutual funds are great just pick ones that outperform the index in the long run and don’t be a squirrelly shorter. For avoiding taxes put your funds in a tax sheltered account. People say MOST funds =fail but that is the whole purpose..pick one that outperforms. I mean look at CWGIX/Dodge and Cox.

    If you are going to be that simplistic then most new businesses fail..so investing in new business won’t make you $?

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