Are investors being fooled by the work ethic fallacy?

While most active funds underperform, investors persist in belief hard work pays

Trying to beat the stock market by buying expensive funds is a bit like smoking: most people should know it's bad for them, so why do they persist? Could it be because investors think active fund managers are hard-working folk and that the stock market will reward them for their efforts? That's the premise of a clever new study, How Active Management Survives, which argues there's no point looking for rational explanations for what is a "fundamentally irrational choice". Active fund managers might baulk at that description but there's no denying the vast majority of active fund managers underperform simple passive funds that track market indices. The authors – psychology professor Ginger Bennington and JB Heaton, a legal consultant specialising in finance – note that this habitual underperformance is explained by two simple facts.

First, active funds are more expensive than index funds. A manager might beat the market before fees, but it’s difficult to earn above-average returns after costs are deducted.

People's instinct might be to assume that strong investment performance is more likely if the fund manager works hard

Second, a very small minority of super-stocks – companies like Amazon and Apple, which have earned mammoth returns over the last few decades – are responsible for the bulk of stock market returns. This leaves active fund managers in a catch-22 position. If their portfolio contains hundreds of stocks, it will too closely resemble the index it seeks to beat; if it takes a concentrated approach and contains a relatively small number of stocks, it's unlikely to be holding the handful of winners that drive indices higher.

Work ethic fallacy

There has been a big shift towards index funds over the last decade, but most people still invest in active funds, despite the fact their odds of success are inevitably low. So why do it?


It is “difficult to explain”, the authors say, why active funds “continue to attract and retain investors”. Some academics have tried to “force” a rational explanation on to this “irrational choice”, but Heaton and Bennington hypothesised that a psychological explanation is more likely. In most areas of life – in business, in sports, in schools, and so on – hard work generally delivers better results than laziness.

Investing is different, one of the "rare areas where passivity is usually the better strategy", but people's instinct might be to assume that strong investment performance is more likely if the fund manager works hard – the "work ethic fallacy of asset management", as they call it. Specifically, they tested whether investors may be misled by the conjunction fallacy, a thinking bias popularised by behavioural finance expert and Nobel laureate Daniel Kahneman where people mistakenly believe there is a greater likelihood of two events occurring in combination than just one of those events occurring on its own.

For example, Kahneman asked people which statement is more likely: 1. that a man has had one or more heart attacks or 2. that a man has had one or more heart attacks and is aged over 55. By definition, there must be more men who have had heart attacks than there are men over 55 who have had heart attacks, but people often choose the second option because the age-related information makes it “feel” more likely to people.

This cognitive bias, the researchers note, has been found to affect medical judgments, sports outcomes and financial risk-taking.

Simple question

In the new study, they asked 1,001 adults – all aged 30 or more and from households with an annual income of at least $100,000 – a simple question. Was it more likely that 1. ABC Fund would earn good returns for its investors or that 2. ABC Fund would earn good returns and was led by a successful former Goldman Sachs trader and employed PhD experts?

Those who endorsed the role of hard work were much more likely to fall prey to the conjunction fallacy

Again, simple logic dictates the former must be more likely, but 31 per cent fell prey to the conjunction fallacy, with the researchers concluding people believed in a “causal connection between hard work and success”.

A second question asked participants whether they agreed or disagreed with the statement that a person or business can achieve better results on any task by working harder than its competitors. Those who endorsed the role of hard work were much more likely to fall prey to the conjunction fallacy, the survey showed. The authors suggest that two psychological factors influence this faith in the investment work ethic. First, there is the illusion of control. People like to control outcomes, but when you put your money in passive funds, you have to accept your returns are completely dependent on the stock market. With active funds, investors like the idea that you control your fate by working hard to identify winners and losers.

Second, psychological research confirms the existence of the “just world” phenomenon – the tendency to see the world as a “fair, predictable place” where your merit and your fate are “closely intertwined, and where hard work can be expected to yield just rewards”. This “encourages investors to overcomplicate what should be a relatively simple decision”, believing “a more complex investment scheme is necessary to achieve good outcomes”. It may, the study concludes, “simply be too difficult for a substantial number of investors to believe that superior returns are available by doing nothing but investing in an index fund rather than investing with active managers”. Funds are aware of this instinct, they add, and their marketing invariably emphasises the hard work and research that goes into their products. The notion that hard work pays off is a perfectly reasonable one in most areas of life. The idea this is also true of investment, that hard-working experts should be rewarded with better returns, has an inherent plausibility about it that should be noted by regulators, argue Heaton and Bennington.

The usual warning about past performance not being a guide to future performance is insufficient, they say, instead proposing a “clear, evidence-based warning attached to actively managed products” disclosing that on average, cheap passive strategies do better.

Dream selling

They compare the active management industry to the tobacco, alcohol and gambling industries. All “sell products that are considered bad for their customers”, but the financial industry is the only one that sells a dream of financial security and better investment performance.

Heaton elaborated upon this comparison in a recent interview with Robin Powell of the Evidence-Based Investor blog, saying he thought of billionaire hedge fund managers as more like tobacco barons than good money managers. An extreme view? The study argues otherwise, saying the case for regulatory intervention is strong given the high financial stakes for retirees and the evidence that the financial industry does more harm than good for many investors. "Until regulation catches up to that view," they warn, "the financial industry will continue to exploit the conjunction fallacy, misleading investors with the work ethic and making billions of dollars in the process".