Protecting us from ourselves: navigating bias in investments

Alexander Pope famously said that “to err is human, to forgive is divine”. When it comes to investing, not repeating common mistakes is what we should truly aspire to. With this in mind, we explore areas in which investors experience biases, and the investment mistakes this sometimes leads to.

Superiority Bias: Being Better than Average

A statement that typifies superiority bias is: “I am better than average”. Studies have shown that most people (particularly men) rate themselves significantly better than average drivers, which of course can only be true for half, not all. We often similarly rate our abilities when it comes to finding better than average fund managers.

Yet identifying future winners by carefully considering past performance leads to no better result than chance. In the chart below we rank annual active manager performance, colouring each line according to past 3-year performance (green being a past winner, red a past poor performer). If performance was persistent, we’d see greens concentrated at the top and reds mostly at the bottom. The true picture, however, is far more mixed (correlation of past and current performance above each bar).

Despite the evidence, retail fund flow data shows a significant and consistent preference for past winners – clearly indicating investors believe past performance will persist.

Source: Satrix & Morningstar retail funds, December 2003 – December 2022

Confirmation Bias: Passive Investing is Guaranteed to Underperform.

It is not just that identifying winners is hard. Many investors believe that, even if not a top performing manager, their managers are at least able to navigate market turmoil successfully, while “passive investing is guaranteed to underperform”.  Is there evidence to this belief? The Arithmetic of Active Management theory suggests that average active manager performance should be in line with a representative benchmark, before fees, and well below after. The data bears this out too.

A rolling 3-year comparison of local active manager performance over the past 20 years is shown below compared to the FTSE/JSE Capped All Share Index (net of 50bps fee). It shows the median manager underperformed 87% of the time over all 3-year periods, with the index less cost being in the top quartile almost a third of the time.

Source: Satrix, Morningstar, FTSE/JSE & Satrix, January 2003 – December 2022. Performance of retail class active funds excluding fund of funds and index funds. | * Benchmark index less 50bps per annum.

This should not surprise us though. Significantly lower fees and trading costs on indexed strategies make outperformance by (mostly) inconsistent managers over the medium term very unlikely. The cost saving put the odds firmly in indexation’s favour – and even marginally favourable odds make repeated plays achieve a near certain outcome (proof of this is the existence of profitable casinos).

Yet despite the clear evidence, investors continue to be swayed by more recent manager performance (displaying recency bias towards the winners). They are also confronted with a positive reporting bias – where managers are incentivized to attribute outperformance to skill (drawing flows), and underperformance to temporary factors outside of their control (to retain assets). Indexation remains less inclined to draw on these biases, despite long-term successes.

Anchoring Bias

Lastly, Anchoring refers to attaching more value to a widely held belief – even if strong evidence to the contrary exists. One such example is the belief that market complexity requires frequent and active adjustment to succeed. This seems perfectly reasonable at first, but ignores the fact that prevailing market prices are already reflective of all the complexities considered by market participants using increasingly advanced algorithms. All evidence suggests accurate exploitation of mispricing today is extremely difficult.

An example of this is the Satrix Balanced Index Fund, which focuses entirely on longer term asset allocation without short-term tactical adjustments. It is an example of applying masterly inactivity by sticking to strategic objectives. Since its 2013 inception, it outperformed industry peers 94% of the time on a rolling 3-year basis and was in the top quartile more than half the time – all without active intervention.

Local managers have similarly struggled to add value through stock picking in the highly efficient global arena. In fact, since its 2013 inception, the Satrix MSCI World Equity Index Feeder Fund has never underperformed its local active peer group median on a rolling 3-year basis – often performing in line with top quartile managers.

Source: Satrix & Morningstar, January 2013 – December 2022

Adding value above index strategies through active intervention is significantly harder to achieve than our anchored beliefs might suggest. The reality is the experts that provide active differentiation are doing so against other experts. All the evidence points to the average investor standing to benefit greatly from indexation. Unless, of course, your investment manager is indeed better than average.