Which is more likely? A manager who has successful returns, or a manager who has successful returns and gets up early, works hard all day, and spends half the night reading current research. Which one will you choose to run your money?

A recent paper discusses the persistence of active management relative to passive in spite of their underperformance through using the conjunction fallacy, another behavioral bias. (See “How Active Management Survives” by JB Heaton and Ginger Pennington.) Their argument is that the persistence of money in active management is spite of the empirical evidence supporting passive investing is based on the view that hard work and successful active management go hand in hand. This is an error in simple probabilities.

The general idea is fairly simple and well documented. It has been referred to as the Linda Problem whereby it is assumed that a specific condition is more likely than a general one. This condition is false.

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which is more probable?

  • Linda is a bank teller.
  • Linda is a bank teller and is active in the feminist movement.

The majority chose option 2 even though the probability of a joint result is less than the probability of the broader classification. This often is the basis for the representativeness bias.

The authors in the paper conduct survey work to see if investors engage in the conjunction fallacy through matching hard work with performance. There results are consistent with the cognitive error. We are not very good at simple probability rules.

We could call this the “work ethic” fallacy. Investors place more stock in hard work than luck. We want to believe that hard work will generate better returns. It could also be thought of as a “just world” view. Investors believe that higher returns are the just rewards for hard work. Certainly there may be a “peace of mind” view that managers who are working hard will better serve investors and generate higher returns and oversee successful portfolio performance. This is all consistent with the “feeling as information” theory in psychology. Many use their feelings as an effective form of judgment.

There are counter-arguments for the conjunction fallacy based on how the experiments are phrased based on the idea that framing and relevance matters. While adjusted language has diminished the cognitive error, it still proves to be consistent in testing.

There have been many theories for the persistence of funds in active management in spite of underperformance. None seem to explain the persistence well except for some form of irrationality or bias. The conjunction fallacy provides another credible theory.

I like to invest with hard working managers. I like to see hard work rewarded. I believe that hard work will generate an edge although I accept that hard work is not the same as investment skill. I may try and avoid it, but I make the “feeling as information” and conjunction fallacy. The adage, “don’t confuse hard work with results” is well known; however, we often cannot help ourselves with the confusion. Most in money management work hard, so forget effort sympathy and just look at the numbers and the process.