You Are Smarter Than a 7th Grader

Sometimes, investors ignore evidence contrary to their own beliefs.

I recently came across a study that showed how easy it is to deceive seventh-grade students. Researchers in the Neag School of Education at the University of Connecticut created a website and asked the students to review it. The website discussed a fictitious endangered species, the Pacific Northwest tree octopus. Interviews with the students found that all of them believed the hoax. They also found the website “very credible” and some of them insisted the Pacific Northwest tree octopus really existed, even after they were told of the hoax.

This study has helped me understand why active management is still thriving, despite overwhelming evidence that the majority of actively managed funds underperform their benchmarks in any year, and that they have an even worse track record over the long term.

Investors are every bit as gullible as the seventh-graders in the tree octopus study.

A review of market results for the fourth quarter 2013 illustrates the problem. The number of variables that a broker would have to get right in order to add value to clients is stunning. Did your broker predict that the U.S. stock market would outperform international developed stocks and emerging markets? Or that global real estate would have a negative quarter?

Most advisers recommend that a portion of your portfolio should be allocated to commodities. However, the difference in fourth-quarter returns among the various commodities is stunning. Natural gas topped the performers with a return of 10.99 percent. Wheat had a loss of 12.26 percent. Gold continued its downward spiral with a loss of 9.47 percent. As an asset class, commodities lost 9.52 percent for the year. Over the past three years, it has an annualized loss of 8.11 percent.

U.S. real estate investment trusts (REITS) had a third-consecutive quarter of negative returns. However, longer-term investors have done well, with annualized returns of 16.36 percent over the past five years. With all the negative news about housing, did your broker recommend an investment in REITS five years ago?

U.S. large-cap stocks outperformed other U.S. stocks for the fourth quarter, but small caps outperformed large caps on an annualized basis over the past five years, 20.08 percent to 17.94 percent, respectively.

As you review this data, ask yourself this question: How likely is it that anyone could predict these results consistently and reliably? Yet the premise of active management is that brokers and active fund managers have this ability.

Don’t play guessing games with your investments. Focus on capturing market returns, with a globally diversified portfolio, in an appropriate asset allocation, using low-management-fee index funds.

You are smarter than a seventh grader.

This commentary appeared January 14 on Huffingtonpost.com.

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© 2014, The BAM ALLIANCE

Dan Solin

Dan Solin is a New York Times bestselling author and has published several books on investing, including his “Smartest” series. In addition, he writes financial blogs for The Huffington Post and Advisor Perspectives. Dan is a graduate of Johns Hopkins University and the University of Pennsylvania Law School.

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