In the Portfolio Ideas column dated December 24, 2018, we had discuss why it is difficult to choose active funds. Readers responded that they prefer active funds despite the risk of picking a fund that could eventually underperform its benchmark index or peers. We believe that they are behavioural reasons behind such a response. In this article, we discuss why you may be behaviourally motivated to choosing an active fund.

Affective forecasting?

Positive alpha — the excess return that a fund generates over its appropriate benchmark — causes happiness. You invest in active funds in anticipation of this happiness. There is a trade-off, of course. The fund you buy could underperform the index or generate negative alpha, or it could underperform its peers; either is a cause for pain.

You could buy an active fund because you believe that the present value of happiness is more than the present value of pain. But you may be suffering from estimation error. The craving for positive alpha is human. Your compelling desire to buy active funds may be because you do not trade to capture short-term gains. If you do, you are likely to generate alpha from your trading portfolio. Then, your goal-based portfolio could have index funds. So, not having a trading portfolio, combined with the craving for alpha, could drive you to underestimate the pain you may feel in the future if the fund underperforms its peers or benchmark.

Alternatively, you could be overestimating your future happiness when the fund outperforms. This refers to affective forecasting — we tend to overestimate our feelings in the future. It includes the emotional satisfaction if the fund generates positive alpha. After all, picking an active fund requires skill. And the positive alpha is a testimony to your fund-picking skills.

The problem arises a couple of years after you have invested in the active fund. What if the fund generates one percentage-point alpha in the first year of your investment and less in the next year?

Your brain is unlikely to get excited with the positive alpha. So, a lower alpha compared with the previous year could leave you unsatisfied.

That is not all. Happiness is relative. Your fund has to generate alpha and beat its peers. Otherwise, it may leave you craving for more. All of this could well prompt you to switch to another active fund. And then the emotional process starts all over again.

Reference dependence

One way to break this compelling urge to invest in active funds is to change your reference point. What if you do not chase returns and instead pursue goals? Picture how your investments can help you meet, say, your child’s college education. Is earning positive alpha likely to generate more happiness or failing to meet your child’s college education more painful?

It is likely that the feeling of loss- aversion kicks in with the shift in reference point. That is, you are more likely to state that failing to achieve a goal will be more painful than the happiness of achieving positive alpha.

Also, remember that we are better at everyday tasks and not so good with decisions that involve large amounts and require in-depth analysis.

That is why buying groceries is easier than investing in active funds or real estate.

The above discussion does not mean that you should not invest in active funds. After understanding your behavioural biases for choosing active funds and the associated risks, you could invest in such funds if you really want to. You can have an index fund to meet life goals along with a trading portfolio to capture alpha.

The writer is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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