Investment Illusion

Illusion, according to Webster, is a deceptive appearance; an unreal vision presented to the bodily or mental eye; hallucination. Delusion, like illusion, also deals with some misperception, some false impression or belief, but has more of a self-created quality as in to delude one’s self with vain hopes (Webster).

At the Index Fund Educator, we use the term “Investment Illusion” to refer to distortions in investment perception that arise from both of these “distorting” factors, the deceptive appearances (or illusions) created by outside forces and the susceptibility of investors to the deceptive appearances. If we as investors were not susceptible, all the slick investment promotions would have little effect. If the investment industry was not so prone to distort investment reality, we as investors would not need to be so attuned to our own internal susceptibility.

As we explore this phenomenon of investment illusion, a few key understandings will emerge.

1. Investment illusion is a wide-spread phenomenon;

2. Investment illusion is engendered by financial institutions (and related financial media) with a stake in fostering illusions, although the illusions may not always be consciously intended;

3. The marketing mechanisms utilized by financial institutions generally include the following:

a) appeals to our “hopes and dreams”;

b) images of “triumph, success, stability and trustworthiness”;

c) distortions in presentation of performance or “track-record” data;

4. Investor susceptibility results in the “Triumph of Hope Over Experience”.

At Evidence on this web site, you will find an extensive discussion on mutual fund performance data compared to performance data for investment in Index Funds. We found that, on balance, mutual fund managers have substantially failed to equal the performance of Index Funds. Further, we discussed the Fallacy of Persistency, the evidence indicating the failure of so-called superior performers to maintain that performance into the future. In this context, we discussed how investors are Fooled By Randomness, confusing pure “statistical fluke” with investment genius. We also discussed the distortions of performance data by Survivorship Bias and related distortions of performance data that make mutual fund managers appear to have done better than they actually have done when all the data is considered. We explained the simple reason Index Funds perform better than the actively managed mutual funds, the extraordinary Costs hurdle that must be overcome by the managed mutual funds.

Facts are facts. Yet, approximately 90% of individual investors give their precious investment dollars to expensive mutual fund managers in the “vain hope” that such managers will be the exception to the rule and produce superior returns. Why? Why do smart people make poor investment choices?

Industry Illusions – Distortions of Fact

Well, we know that part of the answer is the results of created illusions by financial institutions, distortions of track record. It is not that what is being presented is false in the narrow sense. We know the SEC would not allow that. It is that what is being presented fails to present the track record in the larger context of performance. Mutual Fund prospectuses will state some variant of “Past Performance is No Guarantee of Future Success.” However, they will probably not say the following:

“Yes, this one fund (out of many) happened to do well during the particular time frame represented. However, please be advised that you could be Fooled by Randomness. Further, the academic research on the Fallacy of Persistency indicates quite clearly that it is highly unlikely that this fund will produce superior performance in the future. Most other funds (like this one) have also done well in one period or another. So what? Overall the Evidence is that funds like this fund have clearly underperformed corresponding Index Funds and are likely to do so in the future. In fact, the Costs hurdle that needs to be overcome by our fund (and others like it) is so great, that you would be far wiser investing in one of the Types of Index Funds that most closely mirrors the objective of our mutual fund.”

Now, that would be what we at the Index Fund Educator would call disclosure.

Industry Illusions – Trappings of Success

Another reason smart people make dumb choices relates to what we at the Index Fund Educator call “soft distortions” or “soft illusions”. These distortions are the distortions of competency and trustworthiness borne of image and image-makers. In some ways these are more pernicious distortions than the distortions of track record, which, after all, can be contested with facts. These are distortions borne of the trappings of success, the look of success. These are the big buildings, the well-dressed brokers, the sophisticated look of offices. Our financial institutions are simply INSTITUTIONAL. As such, these financial institutions project competencies and trustworthiness that might not be justified by the facts.

Then, of course, there is the wonderfully crafted images of financial institutions created by the great advertising firms. We see the commercials on television. We see images of people (like ourselves) who have been (the commercials indicate) wise enough to choose the right company to trust. These are very happy people who are living the good life because (the ads suggest or state) they made the right choice years ago. These folks are seen working in nice gardens, or traveling to exotic places, or are surrounded by loving family (particularly grandchildren) or are doing the “good deeds” that their financial success has permitted them to do. Huge advertising dollars are spent in this way. The effect on our collective psyche is powerful. “I definitely want some of that”, we say. “Where do we send the check?”

Yet one final reason smart people make poor investment choices relates to our own human foibles, our susceptibility to distort information in ways that are satisfying, although perhaps incorrect.

In his extraordinary and highly influential book, “Winning the Loser’s Game”, Charles D. Ellis points us towards our own dangerous investment decision-making susceptibilities. He cites the following facts of human nature:

“As people, we are not always rational, and we do not always act in our own best interests. Here’s some of what we actually do:

* We ignore the “base rate” or normal pattern of experiences. (Even though we know the odds are against us, we gamble at casinos.)
* We believe in “hot hands” and winning streaks and believe that recent events matter, even in flipping coins.
* We are impressed by short-term success, as in mutual fund performance.
* We are “confirmation-biased,” looking for and overweighting the significance of data that support our initial impressions.
* We allow ourselves to use an initial idea or fact as a reference point for future decisions even when we know it is “just a number.”
* We distort our perceptions of our decisions-almost always in our favor-so that we believe we are better than we really are at making decisions. And we don’t learn; we stay overconfident.
* We confuse familiarity with knowledge and understanding.
* As investors, we overreact to good news-and to bad news.
* We think we know more relative to others than we really do. (We also think we are “ above average” as car drivers, in evaluating other people, as parents, and as investors. On average, we also believe our children are above average.)”

--Charles D. Ellis, Winning the Loser’s Game, pgs 33-34

Do any of the above illusions seem familiar? If so, you are more enlightened than most. It is, by definition, difficult to see our own foibles and susceptibilities. If we saw them, we wouldn’t be so susceptible. This problem of internal distortion is perhaps the greatest obstacle to investment success. All the Evidence in the world about historical investment performance matters little if we are disposed not to see the evidence. The facts can’t help us if we are disposed to believe otherwise.

Do we at the Index Fund Educator have a solution to this most intractable of obstacles to good decision-making. We do not -- except to point it out as an obstacle. And to remind you, the investor, that the powerful illusion creators discussed above, play into these foibles and susceptibilities.

John C. Bogle in his classic book Common Sense On Mutual Funds warns of this investor susceptibility phenomenon by recounting a quotation from the English lexicographer Samuel Johnson. In “speaking of a man who married for the second time”, Dr. Johnson was known to have said: “It was the triumph of hope over experience.”

Mr. Bogle then goes on to relate this quip from Dr. Johnson to the unfounded optimism of pension fund managers. Mr. Bogle writes as follows:

“I was speaking of a poll of pension managers taken by Institutional Investor. Just 17 percent of these money management professionals, the magazine reported, had outpaced the Standard & Poor’s 500 Index during the previous decade, but fully 95 percent expected to outpace the Index in the coming decade.” (John C. Bogle, Common Sense on Mutual Funds, page 109)

Interestingly, since Mr. Bogle wrote these words in his 1999 edition of his above referenced book, pension managers have taken to investing in index funds in a big way. It is estimated that over 40% of pension funds monies are currently invested in index funds. Individual investors’ percentage commitment to index fund lags this number considerably.

Individual investors obviously persist in pursuing hope over experience. Consider the following studies reported by Larry E. Swedroe, in his book Rational Investing in Irrational Times:

“The June 2001 issue of Smart Money reported that over the past fifteen years the Mensa investment club returned just 2.5%, underperforming the S&P 500 Index by almost 13% per annum. Warren Smith, an investor for thirty-five years, reported that his original investment of $5,300 had turned into $9,300. A similar investment in the S&P 500 Index would have produced almost $300,000. One investor described their strategy as buy low, sell lower.” (RIIIT, pg 6-7)

Mensa is, of course, an organization with membership qualifications related primarily to superior performance of its applicants on intelligence tests.

Also, according to Mr. Swedroe,

“DALBAR, an independent financial services research firm, found that for the fifteen-year period ending in 1998, whereas the S&P 500 returned almost 18% per annum, the average individual investor buying and selling individual stocks and no-load mutual funds (average holding period for the funds was less than three years) earned an average return of just over 7%. The average individual investor in the study earned a cumulative return of 140%. Had he instead simply invested in the S&P 500, his cumulative return would have been 820%”. (RIIIT)

What underlies the sorry performance of investors in these and many other studies? Is it, as Mr. Ellis states (see above) that

“We think we know more relative to others than we really do. (We also think we are “ above average” as car drivers, in evaluating other people, as parents, and as investors. On average, we also believe our children are above average.)”

Is it the simple “triumph of hope over experience” as suggested by Mr. Bogle?

“Why do smart people make poor investment choices” we asked earlier. We must answer: to a large extent, it is the powerful forces of Investment Illusion.

Once The Problem is Clear, The Solution is Available

In this Investment Illusion section of our web site, we at the Index Fund Educator have sought to plumb in some small way the key question: Why do smart people make poor investment choices? We do so in the hope that introducing the idea of investment illusion and its component mechanisms might “jolt’ viewers’ consciousnesses to be more receptive to the investment facts elsewhere discussed on this web site. Perhaps we too succumb to the "triumph of hope over experience” in these efforts. But we try.

We try because we are concerned with inspiring a change in investment behavior of our viewers. Once the fog of investment illusion is lifted the solution is available. Then investors can focus on the aspects of investment that truly matter. Controlling Costs and engaging in a proper asset allocation process. I repeat: controlling Costs and engaging in a proper asset allocation process. And what investment structure lends itself to both of these investment goals....INDEX FUNDS!