This article shows why index funds are behaviorally optimal. Specifically, it discusses how index funds moderate certain biases that investors suffer from. This and the cheap beta exposure offered by index funds make them an important part of the core portfolio.
Loss and regret biases
Psychology plays an important role in the investment process - during portfolio construction and at the time of rebalancing.
Consider this. Suppose an investor buys an active fund benchmarked to the Nifty Index. If the fund outperforms the index by 5 percentage points on a risk-adjusted basis, the investor would be happy with her choice. The investor would be, however, unhappy if the fund underperforms the index by 5 percentage points.
The fact is that the investor`s unhappiness from the five percentage point underperformance is likely to be more than her happiness from five percentage point outperformance. This is because the pain due to losses is more than the pleasure from gains. Exposure to index funds moderates this bias. How?
The pain of loss or pleasure of gain is typically relative. The investor will no doubt feel the pain if her portfolio losses 10 per cent in value.
But her pain will be even more if her portfolio underperforms the market by 5 percentage points. In other words, performance relative to the market benchmark is important. And index funds moderate this pain by mirroring the market return.
Loss and regret biases
Psychology plays an important role in the investment process - during portfolio construction and at the time of rebalancing.
Consider this. Suppose an investor buys an active fund benchmarked to the Nifty Index. If the fund outperforms the index by 5 percentage points on a risk-adjusted basis, the investor would be happy with her choice. The investor would be, however, unhappy if the fund underperforms the index by 5 percentage points.
The fact is that the investor`s unhappiness from the five percentage point underperformance is likely to be more than her happiness from five percentage point outperformance. This is because the pain due to losses is more than the pleasure from gains. Exposure to index funds moderates this bias. How?
The pain of loss or pleasure of gain is typically relative. The investor will no doubt feel the pain if her portfolio losses 10 per cent in value.
But her pain will be even more if her portfolio underperforms the market by 5 percentage points. In other words, performance relative to the market benchmark is important. And index funds moderate this pain by mirroring the market return.
This is not all. The feeling of regret of investing in equity is lower during market downturns if the investor has exposure to index funds than to active funds. The reason is that choosing an active fund requires an active decision by the investor. And with active decision comes the responsibility of choice. A bad choice leads to higher regret.
Risk psychology
Exposure to index funds also impacts risk psychology. Investors often tell us that active funds are better, as the market has managers with superior skills. We agree. What we wish to reiterate is that such superior managers are not easy to find.
The reason is that fund performance cannot be an indicator for a manager`s skill, as outperformance can be due to good luck and underperformance can be due to bad luck. And the problem is that good or back luck can persist for a longer time than investors can be solvent!
Suppose investors choose an active fund purely on past performance. The superior past performance could prompt the investor to undervalue the risks associated with the investment. This is because the fund manager`s past performance prompts the investor to make unrealistic expectations. But the fund could underperform the next year even if the fund manager possesses superior skills. And underperformance, in turn, leads to regret.
Investors` perception of risk is not so skewed when it comes to market expectations. That is, investors realize that markets cannot continually climb up. This translates into more realistic expectations from the market than from the active managers.
In other words, investors do expect asset prices to reverse direction, but do not expect outperforming managers to turn underperformers. And since index funds merely tail the market, the returns expectations from passive funds will be more measured. Realistic risk perception also helps in effective asset allocation.
ConclusionOur objective was to show why passive exposure is optimal. Readers may also recall from our earlier discussion that index funds also offer cheap market exposure, making it an important part of equity core portfolio. We wish to emphasize that an optimal portfolio should contain both active and passive exposure to the market. Index funds are important. So is alpha return.
Risk psychology
Exposure to index funds also impacts risk psychology. Investors often tell us that active funds are better, as the market has managers with superior skills. We agree. What we wish to reiterate is that such superior managers are not easy to find.
The reason is that fund performance cannot be an indicator for a manager`s skill, as outperformance can be due to good luck and underperformance can be due to bad luck. And the problem is that good or back luck can persist for a longer time than investors can be solvent!
Suppose investors choose an active fund purely on past performance. The superior past performance could prompt the investor to undervalue the risks associated with the investment. This is because the fund manager`s past performance prompts the investor to make unrealistic expectations. But the fund could underperform the next year even if the fund manager possesses superior skills. And underperformance, in turn, leads to regret.
Investors` perception of risk is not so skewed when it comes to market expectations. That is, investors realize that markets cannot continually climb up. This translates into more realistic expectations from the market than from the active managers.
In other words, investors do expect asset prices to reverse direction, but do not expect outperforming managers to turn underperformers. And since index funds merely tail the market, the returns expectations from passive funds will be more measured. Realistic risk perception also helps in effective asset allocation.
ConclusionOur objective was to show why passive exposure is optimal. Readers may also recall from our earlier discussion that index funds also offer cheap market exposure, making it an important part of equity core portfolio. We wish to emphasize that an optimal portfolio should contain both active and passive exposure to the market. Index funds are important. So is alpha return.
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