Behavioral Finance And Indexing

June 12, 2008



Francis Kinniry, principal and senior member, Vanguard's Investment Strategy Group

JoI: What does behavioral finance tell us about investing and indexing?

Francis Kinniry, Vanguard (Kinniry): Behavioral finance has several implications for index investing. At one end of the spectrum, investors in broad market index funds may be more patient, cautious, deliberate and cost-conscious in their decision making, and thus tend to be more immune to the negative behavioral aspects of investing, such as overconfidence, which can manifest itself in return chasing, market timing, wholesale portfolio changes, etc. These investors don't ''follow the herd''—they own the market, invest for the long term, adhere to a buy-and-hold strategy and tend to understand the math and probabilities behind investing. Specifically, these investors understand that commitment to a strategic index asset allocation provides the highest probability for success.

At the other end of the spectrum, investors who follow or participate in a more tactical or aggressive market rotation approach or who actively engage in very narrow indexes may be more risk-tolerant, impatient and overconfident in their investing skills.

JoI: What are the biggest mistakes investors make from a behavioral standpoint?

Kinniry: By far, the biggest mistake investors make is extrapolating recent returns as an indication of future returns. As a result, they fall into the trap of overbuying the current outperforming asset class and underowning the current underperforming asset class. (This statement does not qualify as an endorsement to underweight the winning strategy or overweight the losing strategy as others in the investment community may suggest.)

Another big mistake is investor overconfidence, or believing that you have unique information about future market changes or other advantages that no one else has. Since that is highly unlikely, it could be the reason why professional active managers on average have tended to not outperform indexes over time.

JoI: Is behavioral finance being used to justify poor investment decisions and a lack of education?

Kinniry: It's easy to use the concept of behavioral finance or lack of education to explain investors' decisions. However, we have seen very sophisticated, educated investment professionals fall into some of these situations over time. After all, much, if not most, of the money that trades daily in the markets is under the control of institutional and professional money managers. We must remember that investing is not a science. It is an art that takes on many forms. It is constantly changing; the future attributes that determine outcomes are highly eclectic, dynamic and extremely uncertain. This environment makes predicting or forecasting the future a great challenge.

For the nonprofessional investor, the investment decision process runs counter to most other buying decisions we may make. For example, the concept of ''you get what you pay for'' would suggest that like a good meal, quality and costs are correlated. But, obviously, this is not the case with investing. Similarly, when shopping, we might utilize services that rate the best-performing and highest-rated products. But again, this process does not work nearly as well for investment products. In fact, when comparing funds, index funds are typically rated as average, while the current winning sectors are rated high, and out-of-favor funds rated low. So, some of the concepts of behavioral finance—ill-advised decisions made on the basis of poor information, lack of understanding or the impulsiveness of trying to beat the market—also apply to individual investors.

In the end, behavioral finance is about evaluating the investing habits of people, and people—whether professionals or nonprofessionals—are capable of making rational and irrational decisions.

JoI: If indexing is proven to provide the best odds for long-term success, why don't more investors index?

Kinniry: As in many other areas in life, we often overestimate our capabilities (i.e., we are all better-than-average drivers and our kids all have higher-than-average IQs). It is no different when it comes to investing. In many respects, our ego tricks us and limits our ability to consider that we may be average or even below average when compared with the competitive and large playing field of investment professionals. As a result, we tend to ignore proven strategies such as indexing and think that we can do a better job following other strategies.

JoI: Can active managers use behavioral insights to outperform the market?

Kinniry: Some managers will outperform the market, whether they use behavioral research, technical research, fundamental research, quantitative research or a combination thereof. However, the challenge facing active managers is being able to outperform the market by having information that is superior to that of all other market participants and by having very low trading friction. These are not impossible hurdles, but high hurdles. Perhaps the best chance for active management to be successful over the long run is to utilize the best of passive management: low costs, low relative friction along with their active management techniques and a talented yet humble team of sophisticated investment professionals.

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