Can’t Convince Your Friend To Invest With Index Funds? Logic Might Not Work
May 10, 2017

Can’t Convince Your Friend To Invest With Index Funds? Logic Might Not Work

“Wow,” you say, “Your financial advisor has a really nice car.” Your friend smiles. She knows what’s coming next.

“I guess you help make those massive car payments.” She just smiles again.

She invests in actively managed mutual funds. No matter what you say, she won’t fire her advisor and switch to low-cost index funds. You try all kinds of logic. But logic isn’t working.

You explain that her advisor gets paid commissions or a trailer fee to pick actively managed funds. You say he might get kickbacks from fund companies, like trips to Bermuda or a really nice bonus.

But she still doesn’t budge.

You explain that index funds beat most actively managed funds. You introduce the SPIVA scorecard. It shows that index funds beat more than 82 percent of actively managed funds over a period of ten years or longer. But your friend just shakes her head. “My financial advisor says he can pick winning funds,” she says.

That’s when you show her the SPIVA Persistence Scorecard. It shows that some actively managed funds do beat the market. But the funds that beat the market during one time period rarely keep winning. In March 2014, 631 actively managed mutual funds were among the top 25 percent of performers over the previous three years. Two years later, just 7.33 percent of those funds kept winning.

Your friend just folds her arms. “My advisor says that some fund companies can consistently beat the market.” The American Funds company say they can beat the index. But that’s like Tiger Woods, Pete Sampras or Carl Lewis saying, “I’m still the greatest!” Times change. Legacies mean little. Index funds have beaten the best American Funds over the past 1, 3, 5, 10 and 15 year periods.

Your friend has seen the facts. But she still won’t change her mind. She won’t fire her advisor and build a portfolio of low-cost index funds. This kind of head-in-the-sand thinking might be more common than you think. Psychologists call it the endowment effect.

In 1991, Daniel Kahneman, Richard Thaler and Jack Knetsch published a paper in the Journal of Economic Perspectives. They found that once somebody owned something, they thought it had more value. That might also apply to a financial advisor or an actively managed fund. Obviously, nobody owns a financial advisor. They don’t chain their Wells Fargo guy to a post with the family dog.

Yet, the human mind is strange. Consider the pronoun, my. It might trigger a sense of ownership.

“John Smith is my financial advisor.”

“These are my mutual funds.”

Kahneman, Thaler and Knetsch found that ownership triggers a human-crazy switch. In one of their studies, researchers gave subjects a coffee mug. It cost $3. But once the subjects owned it, they believed it was worth more than twice that amount. When somebody offered to buy their mug for $5, most of them refused, even though they could have bought an additional, similar mug for just $3. In their minds, the mug they owned was now worth more.

William Samuelson and Richard Zeckhauser found something similar. Maria Konnikova described their experiments in her book, The Confidence Game. The researchers had created a role-play environment with 500 financially literate economics students. “You have inherited money,” they were told. “How will you invest it?”

One group was told that a large chunk of that inheritance was already invested with a specific firm. The firm’s prospects weren’t great. They could choose to sell that business and invest in anything they wanted. But the majority of students who were told that they already owned that investment said they wanted to keep it.

In contrast, subjects who were told that they weren’t already invested in that firm said they wouldn’t buy it.

Perhaps the endowment effect isn’t entirely crazy. It might help us to commit to friendships and relationships. But when it comes to investing in actively managed funds, it’s a Neanderthal effect that doesn’t make sense.

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