Active investing strategies for stocks just do not work. They don’t. End. Fin. There is no debate. Research demonstrates this fact time and time again. Passive investing strategies for stocks beat active investing strategies. Doesn’t matter who is doing the active investing. Passive wins.
That should be the end of this post. We should all just invest passively in low cost, broadly diversified index funds.
But it’s not the end. Why? Because despite the research and the science behind why passive beats active, active investing in the stock market is just super attractive. So, people keep trying it. Over and over.
So, maybe the key to embracing a passive investing strategy is to simply lay out and understand all of the reasons that active investing in stocks seems so attractive. So that we can be on the look outa and avoid falling into these wealth-draining and financial freedom delaying traps.
The reasons that active stock investing is so darn attractive even though it doesn’t work
Will our attempt to debunk and remove the “cool” factor from active investing work? I don’t know. But I sure I hope so. So let’s try it!
1. The psychological reason
The psychological reason that active investing is so attractive here is the same reason that people still gamble.
I mean, gambling really doesn’t work. And never has. Yet people get addicted to it. Even recently, I put $100 into an online sports book just to see what the fuss was all about and I felt the addictive powers. Until I lost my $100. The problem is that most people don’t stop there.
Why?
Well, our brains and ego feel big losses more than they feel small wins. However, when we gamble or invest actively, we often aren’t looking at a big one-time loss. It’s death by a thousand cuts. We keep gambling $20 or investing $100 actively. It seems like a small price to pay for some of the HUGE payouts that we see. (And yes, this analogy works for serial lottery ticket buyers as well.) So, we overlook the price of these strategies because they are small in the short term but stack up and can potentially become huge in the long term.
In the converse, investing passively takes the same amount of financial input. You contribute the same amount as you would to an active investment, but this time it is invested in an index fund. However, the short term payoff is really small and modest at best. Because broad index funds don’t grow by 200% over a single year (they also don’t fall by 300% the following year). So, to our brains, we are paying the same price for a smaller (short term) reward.
The problem here is that the long term reward for passive investing is so much better! Here, the small wins stack up to create huge wins. Too bad our primitive brains are wired to think more about the short term…
So, end of the story, don’t be a Neanderthal. Invest for the long term using passive index funds.
2. The bias reason
Biases in our lives are very real and responsible for a lot of our good and bad behaviors. For example, the certainty bias causes a lot of bad financial decisions! However, when it comes to stock market investing, the retrospective bias can really hurt us.
Let me start with an example…
Imagine two investors 30 years ago. Investor #1 invests all of their money in Apple. Investor #2 invests all of their money in Enron. Groan….I know, I know! I live in the future too!
It seems so easy to judge Investor #2 in this example because we have the benefit of knowing how things turned out. But if you go back 30 years, you can find “experts” saying that both Apple and Enron stock are no-brainer, blue chip, must-own stocks. In fact, both of these investors made bad decisions – as in their decision-making was flawed. One just got lucky and the other didn’t.
That’s the retrospective bias.
In terms of applying this to why active stock investing is so attractive, it’s because we remember big wins in the stock market. Our brains like the story of a big win better. Plus, big wins get a lot more media attention.
So, we start to think that we are missing out. That these big wins from active investing are the result of great decision-making. That we could do it too. Because that’s what our retrospective bias tells us. And so, the sheen on active investing glows a bit brighter despite the reality.
3. The conflict of interest reason
This is a big one.
Active investing seems so much better and sexier than passive investing because there is a whole industry dependent on active investing for their living. Doctors trust professionals. Because we want our patients to trust us. However, financial advisors have a conflict of interest. It’s just the way it is.
And again, I’m not saying not to use a financial advisor. But you need to understand where the conflict of interest is and how it impacts your investing. (And always ask a potential financial advisor these 7 questions before you work with them!)
If your financial advisor gets paid via commission or per trade, it is in their best interest that you invest actively. That way they make more money. So they sell the idea of active investing. They talk about why it is better (even though research shows it isn’t). They show manipulated numbers before taxes and fees that purportedly demonstrate a higher return. So, obviously it starts to look more and more attractive.
My recommendation – trust the data. Stick with passive investing.
4. The statistical reason
Whenever a researcher is working with a small sample size, there is a big risk of mistaking a chance relationship for a statistically meaningful one.
And again, this happens to seasoned PhDs. So it’s no surprise that we are susceptible to similar mistakes when taking mental notes on investing strategies and their outcomes.
We already spoke about about our bias and how we tend to notice wins more. Well, that gets compounded by the fact that we see a very small sample size of the overall investing pool. And these small numbers tend to skew us into thinking that beating the market with active investing in stocks is much more likely than it actually is.
The same thing happens in gambling. Where we believe in the existence of a hot hand. Whether that be when playing cards or watching a basketball player “get hot.” It actually honest exists. It’s just due to a small sample size.
Take the basketball player for instance
We watch a game and Player #1 goes 6/8 behind the 3-point line. The next game he is 3/4. And then 5/6. So, the next game, we bet he will shoot >60% from behind the arc. Seems like a sure-thing. And a very attractive bet!
The problem? He is actually just a 33% shooter from 3-point distance in his career.
We watched a small sample size and believe that he will continue to exceed his average. However, over the long term,. what actually happens is that he regresses to the mean. Meaning he is much more likely to shoot closer to 33% or lower in his next game.
In fact, whether you are a basketball player or the manager of an active mutual fund, to meet your average or homeostatic value, you need to be above it half the time AND below it half the time. So, just because a stock seems like you are on a hot streak, you’re not. Regression to the mean is the rule. Think of this as the Linsanity rule…
We’ve seen this happen with tons of “hot” fund managers. Only to come crashing down. Because no one, repeat no one, can guess those random fluctuations.
5. The chemical reason
Passive investing is boring. Active investing in stocks feels exciting. And our brains are to blame.
Most of the time in life, the more we do and tinker and practice and study and work, the better outcome we achieve. Work hard tracking food in the savannah and you get to eat. Study hard and you get into medical school. And on and on. So, our brains developed a reward system for this kind of thing. Dopamine. Take an action like this. Boom…hit of dopamine. You feel good as a reward.
The problem however is that with investing in the stock market, the more you do (actively trading, trying to time the market), the worse your outcome. And this is because of higher fees and taxes.
And even though we may know that, our brains just don’t understand it. Or don’t want to understand it. Because dopamine. And so we keep trying it. Similar to how dopamine can cause problems with our spending habits…
My recommendation? Rise above. Get your dopamine hits somewhere else where they are actually productive for you. De-couple investing as an exciting thing in your brain. Good investing is boring. Embrace it.
At the end of the day…
I still get tempted by active investing strategies from time to time. Even though I know and write about all of the reasons that passive investing is better, despite being more boring.
And the reason why is simple. I can understand that passive investing is boring. But when the next tempting and attractive active investment comes along, all of these forces play on me to entice me.
And I need to fight against them all over again.
Or do I?
I’m not that smart. Enough temptations and I’ll fall for something. Even a bad investment. So, I build systems to protect myself. Systems like:
- Creating and referring back to my written financial plan so I remember I just need to do what’s in the plan (and not more!) to reach my financial goals.
- Automating my investments so money comes out of my paycheck/check account and into my investments without me doing anything.
- Having a financial accountability partner (my wife).
- Getting my active investing kicks from real estate investing where active work actually means better returns
What do you think? Why is active investing in stocks so darn attractive? How can we fight against this? Let me know in the comments below!
Jordan, very accurate analysis. However, maybe there is one important addition reason missing. Namely, that if you want to achieve portfolio growth both through dividends and stock appreciation, active investing and stock picking can work, *if done properly*. What do I mean? Assume you manage your own portfolio. You know that no stock has ever a simple linear growth trajectory: rather, day to day, month to month, it looks more like a seesaw, with highs and lows that are sometimes „explainable“, sometimes random. With this in mind, you can take the small and manageable risk of picking stocks when they hit a relative low, and bet that they will rise above your buying price (which they will do most of the time), at which point you sell them for a profit, which you can reinvest along the same lines. This strategy can generate faster growth than passive investing, provided you make enough every time to exceed transaction costs and taxes. It does of course carry the risk of wrong decisions, but as long as relatively small amounts (say max. 10-20k at a time) are being traded, these will rarely be disastrous. And it requires a lot of effort and the willingness to engage in (almost) daily trading. So only for the enthusiastic but cool-minded and calm-handed individual investor with plenty of time on their hands.
Thanks for sharing Richie!
I do get what you are saying but think that to be successful long term this strategy requires a pretty clear crystal ball. You’re right that with small amounts of your portfolio, active investing like this will not be fatal but data still supports the core of your investments in a passive strategy in my opinion.