Thursday, May 28, 1998

The truth investors don't want to hear on index funds and market soothsayers

By JONATHAN CLEMENTS / The Wall Street Journal

The numbers don't lie. But investors, it seems, don't want to hear the truth.

According to the statistics, most stock-fund managers fail to beat the market, Wall Street strategists often flunk at forecasting and investment newsletters offer mediocre advice.

Yet investors keep buying actively managed funds, they keep listening to strategists and they keep subscribing to investment newsletters.

What's going on here? There are a handful of explanations for this apparently bizarre behavior:

We Think We Can Pick Winners.

According to fund researchers Lipper Analytical Services, 86 percent of diversified U.S. stock funds have lagged behind Standard & Poor's 500-stock index over the past 10 years. That suggests investors would be much better off purchasing index funds, which simply seek to track the performance of the market averages.

Yet we persist in buying actively managed stock funds, because we like to believe that we can overcome the odds and select those 14 percent of funds that beat the market.

"People are overconfident and overly optimistic," says Terrance Odean, a finance professor at the University of California at Davis. "In many respects, this is useful. People who are optimistic tend to be happier, tend to work harder and tend to persevere. The downside is, in financial markets, there's a cost to this overconfidence. People spend too much time and money trying to beat the market."

We Want to Believe There Is Order.

Academics insist that stock-price movements can't be predicted. But the rest of us have a hard time accepting this. We want to find some explanation for all those wild share-price swings. After all, this is how we are saving for our kids' college and our own retirement.

"We believe the gurus because it is hard for us to imagine that the stock market is random," says Meir Statman, a finance professor at Santa Clara University in California. "We look for patterns. Gurus are the ones who come in and explain the pattern."

We Want to Be Told What to Do.

Market strategists haven't exactly covered themselves in glory. Wilshire Associates, of Santa Monica, Calif., calculates that you would have earned an average 280.6 percent over the past 10 years by following the asset-allocation advice of brokerage-house strategists.

By contrast, you could have pocketed 286.1 percent simply by holding a fixed mix of 55 percent stocks, 35 percent bonds and 10 percent cash investments, which is considered a neutral market position.

Moreover, the advantage of this robotic approach is understated, because the 280.6 percent result for the brokerage firms doesn't reflect the investment costs and taxes you would have incurred in following the market strategists' shifting mix of stocks, bonds and cash.

Yet while these and other pundits may offer mediocre advice, this advice probably gives some investors the necessary confidence to get their money out of savings accounts and into better-performing investments.

"For some, it is just what they needed," Mr. Statman says. "It gives them the courage to act. But others are stuck with gurus who are waiting for the Dow to go back to 2000 before they get back into the market."

We Want a Piece of the Action.

Harvard University economics professor Andrew Metrick studied investment newsletters and found that, on average, the performance of their stock picks was very close to that of the market -- before taking into account trading costs.

"After trading costs, on average they would have lagged behind the market," he says. "There doesn't seem to be a lot of evidence that the stock selection of these newsletters is any good."

So why do folks bother to subscribe? "One motivation for reading the newsletters is to get superior returns," notes Mr. Metrick. "But I'm sure there are a lot of other reasons as well."

Indeed, for many, investing is not only a way to make money, but also a hobby. Subscribers enjoy trading on the advice of the newsletters, and they like the thrill of trying to earn market-beating returns, even if the chances of success are slim.

"After all, people also go to Vegas and to the racetrack as well," Mr. Metrick says. "A lot of this is related to gambling. People enjoy trading."

We Want to Have Someone to Blame.

When everything goes wrong, scapegoats come in handy. "People take credit for their successes and they blame their failures on chance and on others," Mr. Odean notes.

"Say you buy a newsletter and things go well," he continues. "You can say, 'I'm a genius and I picked the right newsletter.' If things go badly, you can say, 'The guy who writes the newsletter is an idiot.' It's nice to have somebody to blame so you don't have to blame yourself."