Explore the complexities of investment decisions in a world filled with choices. Discover how the paradox of choice impacts both novice and experienced investors. File photo.
By: Daniel Dos Passos
To quote Barry Schwartz from his book: “The Paradox of Choice: Why More Is Less”, “On the other hand, the fact that some choice is good doesn’t necessarily mean that more choice is better”. Paradoxically as financial markets and investment products evolve, it has never been easier to invest, yet more complicated to decide on an investment. This “Paradox of Choice” scenario means there are too many investment options that could result in uncertainty or hesitancy in making an investment decision. This sometimes leads to investors not investing at all or being dissatisfied with their investment decisions.
However, research has also shown that the more informed or experienced an individual is, the more confident they are in making a decision and prefer having more options. As a result, experienced investors are more likely to make investment decisions and subsequently tend to have less dissatisfaction with any decisions made. Part of this is also attributable to the fact that experienced investors might be looking to invest in very specific sectors, themes, or factors, considering their own experience and forward-looking market expectations.
As such with many things in life, we often need to consider the past and the present, to help inform our expectations of what the future might hold, before making an investment decision.
A brief history of active versus passive investment management
Unit trusts, commonly known as mutual funds internationally, have been a popular investment choice in South Africa for decades. Unit trusts are managed by professional portfolio managers, who invest in various assets on behalf of investors, within the constraints of an investment mandate. Given the volatile and uncertain nature of financial markets, portfolio managers often seek to actively manage their portfolios by deciding on which assets to buy, hold, or sell over various market conditions and economic cycles. This is commonly known as “active” portfolio management.
Then, back in 1976, John C. Bogle, who founded the Vanguard Group in 1974 created one of the first index mutual funds available to the public. Indexation funds aim to track the performance of a specific index, a strategy that is commonly referred to as “passive” portfolio management, ever since then, fiery debates on subjective views around active versus passive portfolio management have sparked up around the world.
Starting in the 1990s, the first exchange-traded fund (ETF) was listed on the New York Stock Exchange. Initially, ETFs were passively managed funds tracking various well-known indices. It wasn’t until 2008 that the first Actively Managed Exchange Traded Fund (AMETF) was listed. Locally in South Africa, ETFs have been listed on the Johannesburg Stock Exchange (JSE) for over two decades, but similarly, it took a long time until the first AMETF was listed on the JSE in 2023.
As traditional active portfolio management pioneered investment products such as unit trusts, passive portfolio management arguably pioneered ETFs. However, with numerous AMETFs now listed on the JSE and passive unit trusts readily available for some time, investors are now able to access various portfolio management strategies across both unit trusts and listed ETFs. AMETFs aim to combine some of the benefits of listed products, such as intra-day trading and liquidity, while still offering investors access to actively managed portfolios. Additionally, with ETFs being listed on the JSE, investors can invest directly through their own preferred stockbroker without the requirement of opening an account with an investment platform.
The way forward on active versus passive investing
You might be asking yourself, why is this brief history relevant? Over time as the number of actively managed funds increased, experienced investors welcomed the increased competitiveness and choice in the market among active managers. This allowed them to select funds or managers with various investment styles, strategies, and philosophies while considering the investment cycle, macroeconomic views, and market expectations. These investors understand that historical performance does not always indicate future performance and that investment decisions are also forward-looking.
Initially, the introduction of passive portfolios indirectly simplified part of the investment decision. Instead of trying to select an active manager and possibly being dissatisfied with their performance relative to other active managers, passive portfolios typically deliver returns in line with their benchmark, which is often the same or similar to the benchmarks of actively managed funds. Although investors always want higher returns, it is arguably easier to be satisfied with returns related to an industry benchmark or index than relative underperformance.
A new world of possibility with ETFs
With the introduction of ETFs, experienced investors quickly understood the benefits and intra-day trading and liquidity with reference to an underlying benchmark. ETFs tracking traditional market capitalisation indices continue to be popular due to their diversification, lower costs, liquidity, familiarity, and transparency. ETFs issuers also started offering products referencing various other indices, with varying exposures within a specific market or to a specific sector and various other fundamental and mathematical factors such as momentum, value, growth, capping, or equally weighting, for example, with some indices including multiple factors plugged into the index calculation methodology.
As experienced investors, it is not uncommon for active managers to invest directly or indirectly into traditional or specialised indexation products and strategies for various reasons, as part of their overall strategy as greater choice also offers increased opportunities.
However, just because some investors might have more experience, it doesn’t necessarily mean that they always make better investment decisions, especially after taking into consideration the various costs associated with making an investment decision. Often, on a relative basis, simple cost-efficient investments into established traditional market benchmarks or indexation exposures can deliver better returns over the long term, although not necessarily the best. However, with ever-increasing investment options and alternatives, selecting the best is an ever increasingly daunting task. This is further complicated when one considers historical performance as a comparative measure, even though future performance is uncertain and investments are also forward-looking.
Remain biased towards action to stay in the game
As with all decisions, investors need to determine their own investment objectives, requirements, and expectations. This typically requires research and potentially seeking advice from an investment professional, as part of gaining investment knowledge and experience. It is, however, important to remember that ultimately the main decision is to invest.
To quote Barry Schwartz again: “Learning to accept ‘good enough’ will simplify decision-making and increase satisfaction.” So instead of being overwhelmed by the “over-choice” or “analysis paralysis” of making an investment decision, sometimes a simple decision that makes sense to you can be good enough and just as rewarding. After all, experience needs to start somewhere.
* This article is not “advice” as defined and/or contemplated in terms of the FAIS Act.
** Dos Passos is a portfolio manager with FNB.
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