Why Investors Defy the Evidence and Continue to Play the Loser

Why do investors choose to keep playing the loser’s game? Larry Swedroe offers some explanations of his own, then unpacks a study that suggests a form of the conjunction fallacy has a role in active management’s survival.

The opening chapter of my first book, “The Only Guide to a Winning Investment Strategy You’ll Ever Need,” published in 1998, is titled “Why Individual Investors Play the Loser’s Game.” The chapter presents my attempts to explain this anomalous behavior. It begins with a story about Galileo.

I write: “Galileo was an Italian astronomer who lived in the sixteenth and seventeenth centuries. He spent the last eight years of his life under house arrest, ordered by the Church for committing the ‘crime’ of believing in and teaching the doctrines of Copernicus. Galileo’s conflict with the Church arose because he was fighting the accepted church doctrine that the Earth was the center of the universe. Ptolemy, a Greek astronomer, had proposed this theory in the second century. It went unchallenged until 1530, when Copernicus published his major work, “On the Revolutions of the Celestial Spheres,” which stated that the Earth rotated around the Sun rather than the other way around.

“History is filled with people clinging to the infallibility of an idea even when there is an overwhelming body of evidence to suggest that the idea has no basis in reality—particularly when a powerful establishment finds it in its interest to resist change. In Galileo’s case, the establishment was the Church. In the case of the belief in active management, the establishment is comprised of Wall Street, most of the mutual fund industry, and the publications that cover the financial markets. All of them would make far less money if investors were fully aware of the failure of active management.”

“Most investors, investment advisors, and portfolio managers engage in active management of their investment portfolios. They try to select individual stocks they believe will outperform the market. They also try to time their investment decisions by increasing their stock investments when they believe the market will rise and decreasing them when they believe the market will fall. These investors, advisors, and portfolio managers attempt to beat the market through active management strategies despite an overwhelming body of academic evidence that has demonstrated that the vast majority of returns of a diversified portfolio of securities is explained by investment policy (asset allocation). The evidence is that only a very small% of returns is explained by active management.”

Today studies such as Eugene Fama and Ken French’s “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” which was published in the October 2010 issue of The Journal of Finance, have found that only about 2% of actively managed funds are generating statistically significant alpha, less than we would expect to randomly find. What’s more, that’s on a pretax basis. For taxable investors, the odds would be lower, as taxes are typically their largest expense.

The chapter continues by providing what I believed were the most likely explanations for investors ignoring the evidence and continuing to play the loser’s game. The first explanation is what I called the black hole of knowledge. The points I make there are just as applicable today as they were 20 years ago when my first book was published.

Black Hole Of Knowledge

I write: “Most Americans, having taken a biology course in high school, know more about amoebas than they do about investing. Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. This is true unless you go to an undergraduate business school or pursue an MBA in finance. My daughter is a senior in an excellent high school, and she is graduating very close to the top of her class. Having taken a biology course, she can tell you all you would ever need to know about amoebas. She could not, however, tell you the first thing about how financial markets work.”

“Just as nature abhors a vacuum, Wall Street rushes in to fill the void. Investors, lacking the protection of knowledge, are susceptible to all the advertising, hype, and sales pressure that the investment establishment is capable of putting out. The problem with this hype is that, in general, the only people who are actually enriched are part of the investment establishment itself.”

The second explanation I gave for investors continuing to play the loser’s game was related to the faith we have in the Protestant work ethic: Hard work should produce superior results.

I write: “To quote my ex-boss, an otherwise intelligent and rational man: ‘Diligence, hard work, research, and intelligence just have to pay off in superior results. How can no management be better than professional management? The problem with this thought process is that, while these statements are correct generalizations, efforts to beat the market are an exception to the rule. If hard work and diligence always produce superior results, how do you account for the failure of the vast majority of professional money managers (in all likelihood all bright, intelligent, capable, hard-working individuals) to beat the market year in and year out? In the face of all this evidence, they continue to give it the old college try. The lesson: Never confuse efforts with results. As you will see, hard work is unlikely to produce superior results because the markets are [highly, though not perfectly] efficient.”

The chapter also provided several other behavioral explanations, such as overconfidence. For example, I write: “Prof. Richard Thaler and Robert J. Shiller, an economics professor at Yale, noted that ‘individual investors and money managers persist in their belief that they are endowed with more and better information than others and that they can profit by picking stocks. While sobering experiences sometimes help those who delude themselves, the tendency to overconfidence is apparently just one of the limitations of the human mind.’ This insight helps explain why individual investors think they can identify the few active managers who will beat their respective benchmarks.”

I also hypothesized that another explanation for playing the loser’s game in the face of an overwhelming amount of evidence was that many investors feel that, by not selecting an actively managed fund, they give up the chance of being above average, and the vast majority think they can at least do better than that.

Another hypothesis was that individuals like to be able to blame active managers when they underperform, yet be able to take credit for choosing the active managers who happen to outperform the market.

Yet another possible explanation for choosing actively managed funds was that people often feel a sense of loss of control if they invest in passive investment vehicles. Individuals sometimes fail to understand that passive, or evidence-based, investors have total control over the most important determinant of risk and returns—the asset-allocation decision. Once investors turn over their portfolios to an active manager, they actually lose control, as the active manager is now at the helm, making decisions on market timing and asset selection.

Different Kind Of Competition

Another explanation for investors continuing to play the game of active management is that they fail to understand investing is a very different endeavor than other forms of competition, such as sporting events (e.g., tennis) and chess, where relatively small differences in skill can lead to very large differences in outcomes.

For example, I’m a solid 3.5 rank tennis player. If I play against someone just one rank above me (4.0), my odds of winning are very low. However, investing is not a one-on-one competition. Instead, the competition is “the collective wisdom of the market.” The collective wisdom of the crowd is setting prices. That’s a much more difficult opponent. Being smarter than the average investor isn’t a sufficient condition for generating market-beating returns.

Another mistake many investors make is that they fail to comprehend that, in many forms of competition—such as chess, poker or investing—the relative level of skill, not the absolute level, plays the more important role in determining outcomes. What is referred to as the “paradox of skill” means that, even as skill level rises, luck can become more important in determining outcomes if the level of competition is also rising.

On this point, Charles Ellis, one of the most respected people in the investment industry, noted in a 2014 issue of Financial Analysts Journal: “Over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition…. They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”

According to Ellis, the “unsurprising result” is that “the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them—particularly after covering costs and fees.”

Thus, even though the absolute skill level of active managers is increasing, it is getting harder to generate alpha because the level of competition is also increasing. The result is that even if you have Warren Buffett-like skill, the evidence shows it’s more difficult to generate alpha.

Why Active Management Survives

J.B. Heaton and Ginger Pennington contribute to the literature on investor behavior with their June 2018 study, “How Active Management Survives.” Their study, with a sample of more than 1,000 individual investors above the age of 30, confirmed my hypothesis about investors’ belief that hard work must produce superior results was one of the main causes of investors playing the loser’s game.

They noted that while there is much evidence that passive equity strategies dominate active equity management, many investors remain committed to active investing despite its poor relative performance. They explored the behavioral-economic hypothesis that investors fall prey to the “conjunction fallacy,” or what might be called the “work ethic fallacy”—believing good returns are more likely if investment is accompanied by hard work.

The conjunction fallacy is the tendency for individuals to estimate that the likelihood of two events occurring in combination (e.g., Linda being both a nurse and a feminist) is greater than the likelihood of just one of those events occurring on its own (Linda being a nurse or Linda being a feminist). Of course, the two events must be less likely to occur together than either one alone.

Yet many experiments (famously by Daniel Kahneman and Amos Tversky) showed that most people choose the first (Linda is both a nurse and a feminist) because they know most nurses are women. The “representativeness heuristic”—the tendency people have to judge the likelihood of an event by how similar it seems to aspects of the parent population—is often appealed to in explanations of the conjunction fallacy.

Heaton and Pennington note that the belief in active investing is “an especially plausible manifestation of the conjunction fallacy, because in most areas of life hard work leads to greater success than laziness.” Their survey found that “from 30% to over 60% of higher income, over-30 individuals fall prey to the conjunction fallacy in this context.” For example, the first question presented to participants taking their survey was:

ABC Fund invests in common stocks listed on United States stock exchanges. Which is more likely?

(1) ABC Fund will earn a good return this year for its investors.

(2) ABC Fund will earn a good return this year for its investors and ABC Fund employs investment analysts who work hard to identify the best stocks for ABC Fund to invest in.

They write: “This question evoked a strong manifestation of the conjunction fallacy, with 62.8% selecting choice (2). This rate is on par with the magnitude of bias found in past studies using this problem structure.”

They also found that “the magnitude of the conjunction fallacy did not vary as a function of investment knowledge. The biased choice was selected by 62% of the knowledgeable respondents and 63.9% of those without investment knowledge.”

Heaton and Pennington note that such findings “raised significant questions for law and regulatory policy, including whether actively managed equity products should carry warnings, at least for retail investors.”

They went on to note: “The financial industry fights hard against regulation that would expose the high costs and risks of financial products. Given the high financial stakes for retirees and other investors and the evidence that the financial industry does more harm than good for many investors, the case for regulatory intervention—for example, developing programs to debias investors—is strong.”

When Doing Nothing Is Best

The authors explain that, while hard work produces superior results in most areas of life, there are other areas where “doing little or nothing is the dominant strategy.” For example, they write, “meditation—doing nothing but observing one’s thoughts—can be an effective complementary treatment for some psychiatric conditions.”

Heaton and Pennington continue: “Counterintuitively, perhaps, investment in publicly traded common stocks in developed markets is one of the rare areas where passivity is usually the better strategy. Because only a relatively small amount of active management may be needed to keep market prices close to efficient, and active management must, on average, be a zero-sum game, most investors can earn better returns at lower cost by investing in inexpensive passive index funds that do not waste resources—most notably, fees and trading costs—‘picking stocks,’ that is, looking for misvalued securities. Beyond fees and trading costs—and perhaps much more important in explaining underperformance—passive indexing strategies are also difficult for active managers to beat because a small number of securities generates much of the index return and active managers picking subsets of passive indexes have a high probability of missing or underweighting those securities.”

The authors go on to explain: “It may simply be too difficult for a substantial number of investors to believe that superior returns are available by doing nothing but investing in an index fund that costs less than 4 basis points (4/100ths of 1%) rather than fees as high as the ‘2 and 20’ compensation (2% of assets under management and 20% of profits) of a typical hedge fund or even the much smaller but still high fees of actively managed mutual funds. This may be especially true where active equity managers do appear to work hard trying to deliver superior returns, even though they ultimately fail.”

As another explanation for investors’ decision to play the loser’s game, Heaton and Pennington offer the concept of “control-by-proxy” having similar appeal to investors. (This, I would observe, is consistent with my hypothesis about investors desiring a sense of control).

Heaton and Pennington write: “The choice of active management provides investors with the opportunity to feel in control of their fate by promising access to a wide variety of choices, while simultaneously freeing them from the responsibility to navigate complex allocation decisions.”

They cite experiments that demonstrate individuals like to feel in control, even when it is obvious outcomes are determined purely by chance (such as choosing numbers in a lottery instead of having a computer select them).

The authors went on to provide yet another explanation for the conjunction fallacy. They write: “Belief in a ‘just world’ is a second psychological factor that may explain the strong subjective appeal of a causal association between financial success and active investment. The ‘just world hypothesis’ asserts that people have a strong desire to view the world as a fair, predictable place, a place in which a person’s merit and her fate are closely intertwined, and where hard work can be expected to yield just rewards. While a large amount of research on the just world hypothesis focuses on harmful societal effects of this belief (that is, victim blaming), other work examines the influence of just world beliefs on decision-making. Decision makers with a strong belief in the association between hard work and success tend to engage in a range of counter-productive behaviors, spending excessive amounts of time reaching a decision and distorting perceptions of alternatives in a way that unnecessarily complicates choice.”

Heaton and Pennington believe that “the confluence of illusions of control and just world beliefs probably leads investors to accept the idea of a causal link between traders’ work and financial success.”


The conjunction-fallacy explanation for investment with active managers offers a new solution to what is otherwise puzzling behavior. While the evidence indicating passive investment’s superiority is substantial, many investors still cling to more expensive and lower-return active management.

Heaton and Pennington demonstrate that “it may simply be too difficult for a substantial number of investors to believe that superior returns are available by doing nothing but investing in an index fund rather than investing with active managers. This is especially true where active managers advertise that they have ‘specialized investment expertise and extensive infrastructural support, seeking to maximize their investments’ and that they ‘work harder and see farther, empowering the worlds most talented minds with the resources and opportunities they need to achieve extraordinary results.’”

The saddest thing of all is that, despite the Labor Department’s April 2016 promulgation of the so-called “Fiduciary Rule” under the Employee Retirement Income Security Act of 1974 (ERISA), which would have required investment advisors to act as fiduciaries when giving advice on covered retirement plans, the regulation met huge resistance by industry lobbying groups.

The U.S. Chamber of Commerce, the Financial Services Institute and the Securities Industry and Financial Markets Association, among others, sued to have the rule vacated. They won a victory in a recent decision by the U.S. Fifth Circuit Court of Appeals, which held that the part of the rule requiring broker-dealers and insurance agents to act in the best interests of their clients conflicted with the plain text of ERISA. The Labor Department had earlier estimated the rule would save retirement investors from $95 billion to $189 billion over 10 years by reducing conflicts of interest.

That failure should be a call to action for investors. There is no reason whatsoever, in my opinion, to not enforce a fiduciary rule for all investors (not just investors receiving retirement advice). The arguments about the rule causing investors to lose access to advice are fallacies, and easily exposed as such.

This commentary originally appeared July 25 on ETF.com

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