Why ETFs are a good tool to slaughter some of our biases

Being biased brings with it that we don’t think like we think we think.  We make illogical decisions.

Passive index fund investing via a Regular Savings Plan or Dollar-Cost-Averaging is logically right, right?

But emotionally and in terms of common sense, it often feels wrong.

I do believe it’s worth remembering now and then just how strange it actually is.  I get this feeling particularly when trying to persuade others to the cause during the recent market downturn.

Perhaps it’s also worth feeling just a smidgen of pride at circumventing your human emotions and apparent common sense to make the leap to passive investing.ETF for slaughtering biases

So here are just a few biases that can be slaughtered managed with regular – and thus passive – index investing.

 

Overconfidence:

Many people who invest heavily in stocks tend to heavily exaggerate their own abilities and downplay the role of luck in stock market investment.  Sadly there is a lot of random stuff in the market which we can’t control.  The easiest way of managing this psychological overconfidence tick is to invest regularly and for the long term in index trackers and avoid selling no matter what the circumstances.

Experience really helps with overconfidence.

But maybe not in the manner you thought:  Would you consider those active mutual fund / unit trust managers as being experienced?

Then how could numerous studies confirm that up to 96% of actively managed mutual funds underperformed the U.S. market index after fees and taxes? (according to Ben Carlson)

Thus, by investing in passive index funds (ETFs) with their typically lower annual costs—between 0.08% and about 0.8%—you will beat the vast majority of those experienced and overconfident active fund managers hands down.

What an experience.

 

Framing Bias:

People who frame their portfolios narrowly – which basically means worrying about individual stocks – are more likely to succumb to the disposition/framing effect than people who frame widely – those who view their portfolios as a single entity.

 

Home Bias:

Home is where the risk is.  Familiarity is a poor basis for investment.  Buying stocks headquartered near your house, as if being within driving distance could somehow make companies safer, is too narrow-minded.

A recent study has shown that if you take the long term investment view then avoiding home bias saves you from the worst possible mistakes:

“International diversification might not protect you from terrible days, months, or even years, but over longer horizons (which should be more important to investors) where underlying economic growth matters more to returns than short-lived panics or global coordinated events, it protects you quite well.”

The point is that although there are occasional global crises there are far more localised country or regional specific ones. International diversification is, in the long run, both prudent and necessary – and in an age where acquiring such a spread can be quite easily achieved by buying a few Country-ETFs there’s simply no excuse for ignoring it.

 

Impatience:

There is solid reasoning from the field of behavioural finance to explain why we usually do badly when we frantically look at our portfolios between every email refresh – or even just every week or month.

In short: It’s because we’re monkeys operating supercomputers.  And that fact does not hold true only in the Year of the Monkey.

When we see something happen in our portfolios we want to do something.  And that something is usually for the worst.

Most short-term market movements are simple mean regression in action.  It’s only human mental confusion that attributes these random movements to some kind of underlying purpose.

Volatility leads to upset stomachs, and here is the scientific proof:

Academics ran an experiment where they showed the results of an investment simulation to different groups of subjects.

One group were shown the results of the simulation as if they were checking their portfolio eight times a year.

A second group as if they were checking it once a year.

And a third as if they were only doing so once every five years.

The people who were shown the numbers at lengthier intervals – and so saw less volatility in the results – allocated much more aggressively to equities than those who saw them more frequently.

In other words, those who didn’t see how volatile equities were didn’t really care how volatile equities were.

The takeaway? Patience Attitude

Why do you check your stocks twice a day, but your cholesterol twice a decade?  The former is killing your emotions and the latter is killing you!

So, if you know you should have a big chunk of equities to meet your long-term savings goals (and who doesn’t?) but the thought of a stock market crash makes you run for the nearest 1%-a-year Savings Bonds (and who isn’t tempted to run off and on?), then automate your savings into your personal diversified portfolio, re-balance every year (or maybe even every two years)… and the rest of the time forget you’re an investor at all.

You may well be a better investor for it.

 

My conclusion from all this is that in stock market investment sometimes – nearly always, in fact – simple is best.

It’s logical, after all.

Talking about logical.  I guess Spock would be a passive investor. Kirk would run a hedge fund.

Spock the passive investor and Kirk the hedge-fund manager

 “However beautiful the strategy, you should occasionally look at the results.” – Winston Churchill

One Comment

  1. Great thought provoking post as usual.

    I wonder how many people actually focus on the word “passive” that you have helpfully formatted in bold. ETF is a great tool, and the fund itself is passive, but unfortunately human behavior is illogical and most definitely not passive.

    Ironically, ETFs have made it extremely easy to trade funds. (inverse leveraged ETF? Bitcoin ETF?) DCA and RSP using traditional index ETFs might be a better option for some. I hardly, if ever, call myself a passive investor. Even though my index portfolio rebalancing is based on a fixed criteria, I would still acknowledge it to be an active decision to do so.

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