Benjamin Felix July 16, 2018 Behavioural Finance The Four Stages of an Index Investor Investing in index funds is obvious once you subscribe to the idea, but getting there is not always easy. The majority of Canadians still invest their money in actively managed mutual funds. From what I have seen, the acceptance of index investing typically follows four stages: Ignorance Denial Acceptance Peace Ignorance I don’t have a statistic to back this up, but I would guess that a majority of Canadians do not know what an index fund is. Owning actively managed mutual funds or a handful of stocks probably seems like a perfectly sensible investment if there is no reason to believe otherwise. It was only in 2017 that Canadian investors started getting a clear statement showing both their performance and their fees. Prior to that, it would have been a challenge for many people to get a feel for how they were doing. Even now I doubt that most people open their year-end statement to view these numbers. In this state of ignorance, there is no consideration given to index funds. There may be uneasiness around the feeling of being sold products by so-called financial advisors, but without a known alternative many investors will stay the course. Denial The message of index funds is powerful. At some point, through some mechanism, investors will likely hear it. It may come from the media, a friend, or a family member. In any case, the investor will eventually do some digging. The problem with digging is that there is no single source of obviously reliable information on the best way to invest. This is true of the internet, and it is especially true of most financial advisors. There are enough articles online discrediting index investing as risky or foolish to cast doubt on the approach. A conversation with the financial advisor who has been selling high-fee products to earn commissions will be even more confusing – they will have well-scripted rebuttals against index funds. To the investor with limited knowledge and trust in their advisor, this conversation could be enough to keep them on the course of active funds or stock picking. They will find ways to justify their actively managed investments. They will be in denial of index funds. A small handful of investors will never accept index investing as the most sensible approach. Only a tiny fraction of actively managed mutual funds outperform the index over the long-term. Nonetheless, there will be some investors who own those outperforming funds while they outperform. The confirmation bias in these cases is likely far too strong to overcome. A combination of the advice to buy active funds or pick stocks and actually seeing outperformance makes indexing seem foolish. A taste of market-beating performance will be hard to overcome, potentially leading to years of performance chasing. Statistically, even these investors will likely be knocked down by a consistent poor performance at some point. There is no good evidence that the best performing active managers continue to outperform. Acceptance Unfortunately, it often takes a slap in the face to realize that trying to beat the market is a fool’s game. The slap could take many forms – it might be a substantial loss in a concentrated stock portfolio, an extended period of active fund underperformance, or an overly-generous year-end commission statement. Whatever form it takes, the result is an acceptance that passively owning the market using index funds is the most sensible approach to investing. Following this realization, investors will seek access to index funds. They may take a DIY approach, following the teachings of the Canadian Couch Potato; they may find a suitable online robo advisor; or they may engage a wealth management firm that uses index funds to invest their clients’ money. Peace Index investing is peaceful. There is no reason to worry about the stocks that you own or how your fund manager is doing. There will always be active funds that outperform; an index investor knows that it is next to impossible to find those funds before they outperform. When investments stop being the focus, other, arguably more important, financial decisions come to the forefront. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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