Barry Ritholtz is a well-informed investor. He writes a good blog, The Big Picture. Recently, he wrote an article on three factors that undermine most people’s investment plans: (1) the market, (2) the professionals, (3) their own selective overestimation of their investment skills.
The market, meaning all organized capital markets, price every asset in terms of the investors’ collective best guesses. So, the next move is going to be the result of not-quite-accurate forecasts. In most cases, the move will be random. That is because the best information is already factored in.
In this sense, the market is your opponent.
He likes to make you look a fool. Sell him shares at a nice profit, and he happily takes their prices so much higher you are embarrassed to even mention them again. Buy something from him on the cheap, and he will show you exactly what cheap is. And perhaps most frustrating of all, Mr. Market has no ego – he does not care about being right or wrong; he only exists to separate the rubes from their money.
This is only one-third of your problem. The next is the investment industry.
It doesn’t matter where these traders work – they may be on prop desks, mutual funds, hedge funds, or HFT shops – they employ an array of professional staff and technological tools to give themselves a significant edge. With billions at risk, they deploy anything that gives them even a slight advantage.
These are who individuals are doing battle with. Armed only with a PC, an internet connection, and CNBC muted in the background, investors face daunting odds. They are at a tactical disadvantage, outmanned and outgunned.
Then there is your third opponent. Here, Ritholtz relies on the work of behavioral economics. The best book on this is David Kahneman’s Thinking, Fast and Slow. I am reading through it for the second time in two weeks.
You are your own third opponent. And, you may be the opponent you understand the least of all three. It is more than time constraints, lack of discipline, and asymmetrical information that challenges you. The biggest disadvantage you have is that melon perched atop your 3rd opponent’s neck. It is your big ole brain, and unless you do something about it, it is going to lose all of your money for you.
What is wrong with your brain?
It is overrun with desires, emotions, and blind spots. Its capacity for cognitive error is nearly endless. It was originally developed for entirely other purposes than risk assessment in capital markets. Indeed, when it comes to money, the way most investors use those 100 billion neurons or so of gray matter, they might as well not even bother using their brains at all.
He notes that surveys indicate that most people think they are above-average drivers. But this is statistically impossible. “The same applies to how well we evaluate our own investing skills. Most of us think we are above average, and nearly all of us believe we are better than we actually are.
As it turns out, there is a simple reason for this. The worse we are at any specific skill set, the harder it is for us to evaluate our own competency at it. This is called the Dunning–Kruger effect. This precise sort of cognitive deficit means that areas we are least skilled at – let’s use investing decisions as an example – also means we lack the ability to identify any investing shortcomings. As it turns out, the same skill set needed to be an outstanding investor is also necessary to have “metacognition” – the ability to objectively evaluate one’s own abilities. (This is also true in all other professions.)
Unlike Garrison Keillor’s Lake Wobegon, where all of the children are above average, the bell curve in investing is quite damning. By definition, all investors cannot be above average. Indeed, the odds are high that, like most investors, you will underperform the broad market this year. But it is more than just this year – “underperformance” is not merely a 2011 phenomenon. The statistics suggest that 4 out of 5 of you underperformed last year, and the same number will underperform next year, too.
He notes that “4 out of 5 mutual fund managers underperform their benchmarks every year.” They make the same mistakes that you do.
But if 80% of managers underperform each year, who beats the market consistently. Warren Buffett and a few others. No one knows how they do it.
Can you pick the next Warren Buffett? Probably not. Picking investment funds is like picking stocks. The next winner is random.
This leads to a variety of problems when it comes to investing in equities: our instincts often betray us. To do well in the capital markets requires developing skills that very often are the opposite of what our survival instincts are telling us. Our emotions compound the problem, often compelling us to make changes at the worst possible times. The panic selling at market lows and greedy chasing as we head into tops are a reflection of these factors.
The sort of grinding market we had in 2011 only exacerbates investor aggravation, and therefore increases poor decision making. Facts and logic go out the window, and thinking gets replaced with naked emotions. We get annoyed, angry, frightened, frustrated – and that does not help returns.
Ritholtz offers some suggestions. So does the man who published his article, my partner in the 1980s, John Mauldin. My view: extra help is a good thing. But this reality is this: your best source of wealth is your career, where you have an advantage. Invest in what you really do know better than most people.