Morningstar Magazine - October/November 2016 - 75

That's definitely a question that remains to be answered. Investments vs. Investors So, we have not settled all the debates, even if the two camps have come closer together on several things. One area that they do seem to have come together on is the attractiveness of low-cost index investing. It makes sense that the rationalist camp has been historically tied to indexing. But when you talk to behavioral researchers, they are also supporters of index investing. Does the panel have any comments on that? Benz: Jack Bogle's cost matters hypothesis. Wendel: It's important to separate out the individual-level research from the market research. At the individual level, behavioralists study why we all struggle to make good investment decisions. We look at, for example, how we struggle with overconfidence. If you ask a room of 100 people, "Who's going to beat the market?", 90% will say, "I will"-which, of course, is statistically impossible, right? So, nobody identifies themselves as being one of the willing losers? They all think they're the willing winners? Benz: Just like we're all above-average drivers. Wendel: Exactly. We are hard-wired for optimism, and we're hard-wired to find the data that supports our view, whether that be for index investing, investing in gold, or investing in stock futures. It doesn't matter. [University of California at Berkeley professor] Terry Odean's work in particular in the late 1990s really just blew a hole in the active individual trading strategies. His work-"Trading Is Hazardous to Your Wealth"-shows that the more individuals touch the market, the more they go in and say, "I've got this hot tip," the worse they do. Now, we see some differences by gender and age. But that line slopes down for everybody. The more you act, the more you get involved, the worse off you are. Now, at the individual level, we can avoid these pitfalls. It starts with making a clear strategy. Sit down with your spouse, your advisor, whomever it might be. Figure out what you're going to do and stick with it. That's why cost matters so much. If you're just sticking with a strategy, you don't want to be paying a lot along the way. And often the best strategy is one where you're not tempted to change course. That's why indexing can be such a great idea. Now, what that means for the market is fundamentally different. Too often we conflate the two. Too often we think, "Well, as individuals, we're subject to optimism, we're subject to loss aversion, we're subject to overconfidence, etc., etc. That means there are market-level anomalies. No such thing. We can't draw a strict link between what makes sense for individuals-setting a plan and sticking with it-and what makes sense as a market. As a market, of course, we've got big problems if everybody is a market-following index investor. As an individual, it is a great idea. Go simple. Go low cost. Keep yourself out of it. Benz: When we look at investor returns- dollar-weighted returns-for index products, they look pretty good relative to actively managed products. Wendel: Yes. And when you look at [Morningstar's director of mutual fund research] Russel Kinnel's annual study on the behavior gap, we see again and again that investors do a lot worse than do their investments. That's largely because of market timing, especially during downturns. But what does that mean for market strategy? It's unclear because they're clearing mechanisms; there's so much else going on. I like that distinction between investments and investors, because I think one thing that people naturally take from behavioral research is that people are not completely rational in the decisions that they make. We observe these anomalies in the market. There seems to be an opportunity for me, as an investor, to take advantage of them. Thus, we see strategic- beta funds that clearly are marketed and presented as for the smart people. Wendel: Ironically, making that link between individual mistakes-it's always other people, of course, who falter in this way-and coming up with a market strategy to outsmart them is exactly an expression of our behavioral biases. That is our overconfidence at work- thinking that other people's human frailties create an opportunity for us to profit from that which no one else has thought of! I can take advantage of that because I'm not like those other people, right? Wendel: That's right. Now, there may be consistent long-term behaviorally derived anomalies. I'm not going to make a claim about that. There may be. There may not. We can come up with arguments about it. But the point is that there is not a necessary link between what happens to individuals and what happens in the market because there are so many other forces that are going on. And our belief that, "Oh, other people are stupid, and therefore, I can make money off of them," sounds a lot like asking a group of people whether they're going to beat the market, and everyone says, "yes." So, Lee, what's the quant response to that? Davidson: If you think about beating the market on a risk-adjusted basis, alpha is a consistent performance stream that occurs the same every single period. Well, that's just the inverse of what fees are, right? And so anytime your fees are higher, your alpha must be lower. Sometimes we forget about that linkage, but they are reciprocals of one another. Benz: Russ Kinnel often talks about one of the big advantages of a low-cost strategy is its persistence-that a fund that charges 20 basis points today is not going to suddenly spike to double that or quintuple that. It's just a very persistent edge. Kaplan: Robo-advisors are putting people into plain-vanilla index funds. What they're doing, from a behavioral perspective, is getting them to not do things that will hurt them, and to do something that, in the long run, is a good idea. That's what global.morningstar.com/Morningstarmagazine 75 http://global.morningstar.com/Morningstarmagazine

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016