How to avoid foolish behaviour

By LARRY SWEDROE

During my 25 years as the chief research officer at Buckingham Wealth Partners, I have witnessed investors make many costly mistakes. These mistakes were made for a variety of reasons, including lack of knowledge. However, some were made simply because, as human beings, investors are prone to behavioural errors. For example, individuals have a strong tendency to be overconfident of their skills. And overconfidence can lead to many errors, including excessive risk taking. In order to help you avoid making such mistakes with your investment behaviour, we’ll review some of the more common ones, including wanting more from investments than returns.

Ego-driven investments

Meir Statman is one of the leaders in the field of behavioural finance. His book, What Investors Really Want, exposes many of the costly errors we make as investors. If you want to improve your chances of reaching your financial goals, it is a must-read. He explained that investors want more than returns from their investments: “Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds. … We may not admit it, and we may not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and for software that promises to tell us where the stock market is headed.”

Statman went on to explain that some invest in hedge funds for the same reasons they buy a Rolex or carry a Gucci bag with an oversized logo—they are expressions of status, available only to the wealthy. Statman cited business and finance author John Brooks, who in 1973 wrote: “Exclusivity and secrecy were crucial to hedge funds from the first. It certifies one’s affluence while attesting to one’s astuteness.” Statman went on to explain that hedge funds offer what he called “the expressive benefits of status and sophistication, and the emotional benefits of pride and respect.” He cited the cases of investors who complain when hedge funds lower their minimums. Those expressive benefits explain both why Bernie Madoff was so successful and why high-net-worth individuals continue to invest in hedge funds despite their lousy performance—they are ego-driven investments, with demand fuelled by the desire to be a “member of the club.”

The desire to be above average

Jonathan Burton, in his book Investment Titans, invited his readers to ask themselves the following questions:

Am I better than average in getting along with people?
Am I a better-than-average driver?

Burton noted that, if you are like the average person, you probably answered yes to both questions. In fact, studies typically find that about 90 percent of respondents answer positively to those types of questions. Obviously, 90 percent of the population cannot be better than average in getting along with others, and 90 percent of the population cannot be better-than-average drivers.

While by definition only half the people can be better than average at getting along with people and only half the people can be better-than-average drivers, most people believe they are above average. Overconfidence in our abilities may in some ways be a very healthy attribute. It makes us feel good about ourselves, creating a positive framework with which to get through life’s experiences. Unfortunately, being overconfident of our investment skills can lead to investment mistakes. And so does what seems to be the all-too-human desire to be above average.

In What Investors Really Want, Meir Statman shows how the desire to be above average leads investors to trade too much, and how costly a mistake that can be:

The trading records of thousands of investors at an American brokerage firm showed that the returns of the heaviest traders trailed those of index investors by more than 7 percentage points a year, while the lightest traders trailed by only 0.25 percentage point per year. That means the heavy traders were taking the risks of stocks while earning Treasury bill-like returns.

However, this is not solely an American phenomenon:

The trading records of thousands of investors at a Swedish brokerage firm revealed that on average the losses of heavy traders amounted to 4 percent of their net worth each year.

Statman noted that beat-the-market investors trail the market and passive (e.g., index) investors because they tend to buy high and sell low. For example, he showed:

Investors who switched mutual funds frequently trailed buy-and-hold mutual fund investors by about 1 percentage point if they switched between large-value funds, 3 percentage points if they switched between small growth funds, and 13 percentage points if they switched between technology funds.
Switching hedge fund investors did no better than switching mutual fund investors, underperforming buy-and-hold hedge fund investors by about 4 percentage points a year. And those that switched among the funds with the highest returns trailed by about 9 percentage points per year.

These statistics are supporting evidence for what academic research has demonstrated: There is no persistence in outperformance beyond the randomly expected among either mutual funds or hedge funds. And while the average mutual fund underperforms its risk-adjusted benchmark by about 1.5 percentage points a year (pretax), the average hedge fund has provided risk-adjusted returns that have had a hard time keeping up with Treasury bills!

Overconfidence is such a huge problem that it even causes people to delude themselves—the truth is so painful that the delusion allows them to continue to be overconfident. Statman offered up this statistic: “Members of the American Association of Individual Investors overestimated their own investment returns by an average of 3.4 percent, and they overestimated their returns relative to the average investor by 5.1 percent.”

Statman also noted that overconfidence leads to unrealistic optimism, causing investors to concentrate their portfolios in a handful of stocks rather than gain the benefits of diversification (the only free lunch in investing).

Framing the problem

Many of the errors we make as human beings and investors are a result of how we frame problems. Consider the following examples from Jason Zweig’s Your Money & Your Brain:

One group of people was told that ground beef was “75 percent lean.” Another was told that the same meat was “25 percent fat.” The group that heard about fat estimated that the meat would be 31 percent lower in quality and taste 22 percent worse than the lean group estimated.
Pregnant woman are more willing to agree to amniocentesis if told they face a 20 percent chance of having a Down’s syndrome child than if told there is an 80 percent chance they will have a normal baby.

Statman used the analogy of playing tennis against a practice wall to show how individuals frame the “game” of investing in the wrong way, leading to costly errors. He noted that playing tennis against a practice wall, where you can watch the ball hit the wall and place yourself at just the right spot to hit it back when it bounces, is very different from the game of investing, where you are playing against professionals who are much better players and won’t tell you where they are going to hit the ball. However, Statman went on to note that: “It is natural for us to adopt the frame of the beat-the-market game as tennis played against the practice wall because that frame is generally correct in our daily work. We gain competence at our work as surgeons, lawyers or teachers by study and practice just as we gain competence playing against a tennis wall. In time, with practice, we get it right.” He added: “We cannot be competent surgeons with little knowledge of the human body, nor can we be competent lawyers with little knowledge of the law.” However, investing is entirely different; we can be competent investors with virtually no knowledge of the companies in which we invest. While surgeons or lawyers with little knowledge in their fields cannot hope to earn average salaries, investors with no knowledge of the stocks they buy can earn market returns by simply investing in index funds. Since the average fund underperforms its benchmark index fund, and the average active investor underperforms the very funds in which they invest, by simply earning market returns, the know-nothing index investor earns above-average returns.

Legendary investor Peter Lynch put it this way: “[Investors] think of the so-called professionals as having all the advantages. That is total crap. They’d be better off in an index fund.” [1] Warren Buffett agrees. “By periodically investing in an index fund the know–nothing investor can actually outperform most investment professionals.”

There is an old saying that if you don’t know who the sucker is at the poker table, it’s you. The analogy for investors trying to beat the market by trading is that for every buyer there must be a seller, and only one of them can be right. And since the vast majority of trading is done by institutional investors, the other side of the trade you make is likely to be a big hedge fund, mutual fund or other institutional investor, not another individual. Once you learn to frame the problem of trying to beat the market this way, it’s easy to see who the sucker is likely to be and why individuals who trade are highly likely to underperform.

Confirmation bias

Many of the costly errors investors (like you) make are the result of “confirmation bias” — the tendency for people to favour information that confirms their preconceptions or hypothesis regardless of whether the information is true. They disregard evidence that is contrary to their preconceived notions. As a result, people gather evidence and recall information from memory selectively, and interpret it in a biased way. The biases appear especially in emotionally significant issues and established beliefs. They also tend to interpret ambiguous evidence as supporting their existing position. Biased search, interpretation and/or recall have been invoked to explain “attitude polarisation” (when a disagreement becomes more extreme even though the different parties are exposed to the same evidence), “belief perseverance” (when beliefs persist after the evidence for them is shown to be false), the “irrational primacy effect” (a stronger weighting for data encountered early in an arbitrary series) and “illusory correlation” (in which people falsely perceive an association between two events or situations).

Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Hence, they can lead to disastrous decisions, especially in companies, the military or governments.

In his book, Meir Statman provided the following example of confirmation bias: “Investors who believe that they can pick winning stocks are regularly oblivious to their losing record, recording wins as evidence confirming their stock-picking skills but neglecting to record losses as disconfirming evidence.” He quoted physicist Robert Park: “People are very good at fooling themselves. They’re so sure they know the answer that they don’t want to confuse people with ugly-looking data.”

Statman cited the case of an investor he encountered who would only realise gains on his stocks but never losses. The reason he ignored the opportunity to “harvest” losses and have Uncle Sam share the pain (via a tax deduction) was that he considered realised gains as confirming evidence of his stock-picking ability and never had to confront losses because, by his accounting, unrealised losses are no losses at all.

Moral of the tale

As humans, we make all kinds of behavioural errors. Thus, it should not be a surprise that we make them when investing. My book, Investment Mistakes Even Smart People Make and How to Avoid Them, covers 77 mistakes. The unfortunate truth is that lessons are easier to teach than to learn. The moral of this tale is that smart people are humble and able to admit when they have made a mistake. In fact, they rejoice in learning that they have made a mistake because going forward they will be less wrong. They also know that what differentiates them from fools is that they don’t repeat their mistakes, expecting different outcomes.

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