Vegas, Wall Street, and Investor Behavior

Posted on Tuesday, March 1st, 2011

If Index Funds Perform Better, Why Are Actively Managed Funds More Popular?


A recent article published by two researchers at Wharton suggest that investors rationally invest in actively managed strategies, knowing that the odds are against them.  It’s been widely known for years that index funds consistently outperform actively managed mutual funds.  Actively managed funds base their investment choices on economic or financial forecasts related to markets and/or securities.  Index funds simply invest in the whole market.

While I agree that investors on the whole are not stupid, which the researcher contends, I don’t think their rationale of investing in active strategies is as well thought out as the researchers claim.  (You can read their analysis here.)

In my thinking, one only needs to travel west from Wall Street to Vegas to discover the thinking of the typical investor pursuing active investment strategies.  Simply replace the dream of pulling the lever on the slot machine, sirens blaring and lights flashing, with an investor checking their account balance daily to see if they picked the next Google or the next Buffett.  But it’s more about the emotion of the moment, not the rational thinking of a well-informed odds-maker.

You may think that’s stupid, or I may think it’s unwise, but clearly investors feel that the likelihood of a lower return is worth the bet of a homerun.  Do most people REALLY think they’re going to win money long-term in Vegas?  I don’t think so.  It may be the thrill of the gamble or simply the entertainment value of a show or the bet itself that drives them.  And for whatever the reasons, it’s worth it to them.

Yes, there are investors who wrongly believe that what they just heard or read somehow escaped the rest of the investment world, but mostly I think it’s fear and greed that drives investors to pursue the holy grail of high returns and no risk from active managers, knowing in the end, just like Vegas, there likely will be a long-term price for their behavior.  And they’re willing to pay it.

Is it wrong?  I don’t know.  As you know, we think there’s a better way.

But for now, whatever happens on Wall Street, stays on Wall Street.

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