Behavioral Finance and Your Portfolio

30Behavioral Finance Aspects of the Active versus Passive Debate

There seems to be some perverse human characteristic that likes to make easy things difficult.

—Warren Buffett

As many investors know, there is an ongoing debate about the efficacy of active money management compared to simply using passive index investing. Active managers make investment decisions in an effort to outperform their benchmark, while passive managers simply track an index to gain exposure to a market, country, or special segment of a market. Active managers need to have enough skill to consistently outperform the market, but many active managers do not outperform on a consistent basis. This lack of performance, plus the higher cost compared to passive management, has caused a surge of money flow into passive indexing and out of actively managed funds. However, for long-term investors it doesn't just come down to lower costs, as this discussion might suggest. Behavioral finance demonstrates that, although passive funds outperform in the long term, there are challenges of staying invested in long-only index products, especially in times of extreme market volatility. This is the behavioral gap discussed in Chapter 2.

Fundamentally, active management is the pursuit of selecting securities to take advantage of mis-pricings or creating a mix of securities to create an outcome such as lower volatility. On the other hand, passive investing makes the assumption that markets are efficient and securities ...