It’s a question I’ve spent the last few years trying to answer. Why, in the face of overwhelming evidence that they would be better off with a low-cost, passively managed, buy-and-hold portfolio, do the majority of investors choose to invest actively?
There are probably several factors — not least, the vast sums spent by the fund industry on PR and advertising, and a host of in-built behavioural biases, such as overconfidence. But new research suggests that we may be overlooking the importance of social factors and, in particular, the way that different investment philosophies spread and evolve.
The study, Social Transmission Bias and Active Investing, by Bing Han from Toronto University and David Hirshleifer at the University of California at Irvine, is well worth reading in full. But here, for now, is a potted version:
- As Robert Shiller once said, “investing in speculative assets is a social activity. Investors spend a substantial part of their leisure time discussing investments.. or gossiping about others’ successes or failures in investing”.
- Ideas are transmitted in both face-to-face conversations and on social networks, as well as via blogs and the news media.
The authors describe the way in which investment choices spread as a form of contagion, passing from person to person. Of course it’s possible for passive as well as active strategies to spread, but the evidence shows that social interaction is more likely to trigger the excessive and aggressive trading associated with active investing.
For example, studies have show that members of investment clubs tend to select individual stocks based on reasons that are easily exchanged with others; choose small, high-beta, growth stocks; turn their portfolios over frequently; and, as a consequence, underperform the market.
So why should social interaction boost active rather than passive? Han and Hirshleifer found that conversations about investing tend to reinforce the perception (or rather misconception) that active leads to better outcomes. That is largely because investors often exaggerate how well they have done:
- When discussing their investment experiences with other people, we naturally prefer to recount our victories rather than our defeats — a behaviour known as self-enhancing transmission bias, or SET.
- There is also evidence of internal self-enhancing thought processes; in other words, we like to think of ourselves as being better investors than we really are. To quote the study, “it is a small step from thinking in a self-enhancing way to talking that way”.
Of course, communication is a two-way process, and the researchers looked at both sides of the conversation, which they refer to as senders and recipients. Both, they found, are affected by bias. In particular:
- When someone tells us about a successful investment experience they’ve had, we tend to discount the possibility that what they’re saying is not entirely accurate.
- We are especially prone to be impressed by an extremely successful outcome; for example, hearing of someone winning the lottery, or making a fortune on a penny stock.
The final reason that Han and Hirshleifer suggest for why social interaction promotes active investing — and for me the most important — is, simply, that active is more engaging than passive as a topic of conversation. As a result, active is talked about more than passive, which in turn favours the spread of active investing strategies.
In conclusion, say the authors, the more successful active investors are, even if only fleetingly, the more likely they are to talk about it; and the more they talk about, the more likely people are to pay attention and, ultimately, “be converted”.
Put another way, active investors are, quite literally, talking each other into investment behaviour that, over the long term, will produce lower returns than simply buying and holding index funds. Next time your best mate starts bragging about the killing he’s made on such and such a stock, close your ears or politely change the subject.
Read the paper here: