Apprenticed Investor: Know Thyself
Barry Ritholtz:
Apprenticed Investor: Know Thyself: Statistical evidence suggests a high probability that you underperformed the broader market last year, and most investors will likely underperform again this year. But it's not just retail investors. The pros are barely any better. In fact, four out of five investors will do worse than the S&P 500 this year.
The problem, it seems, is a design flaw.
Indeed, many classic investor errors -- overtrading, groupthink, panic selling, marrying positions (i.e., refusing to sell), chasing stocks, rationalizing, freezing up -- are mostly due to our genetic makeup. Humans have evolved to survive in a harsh, competitive landscape. To do well in the capital markets, on the other hand, requires a skill set that is very often the antithesis of those innate survival instincts.
Why is that? The problems lay primarily in our large mammalian brains. It is actually better at some things than you may realize, but (unfortunately) much worse at many others you are unaware of. Most people are unaware they even have these (for lack of a better word) "defects." The fact is, when it comes to investing, humans just ain't built for it.... Humans have a tendency to see order in randomness. We find patterns where none exist. While that trait might have helped a baby recognize its parents (thereby improving the odds for its survival), seeing patterns where none exist is counter-productive when it comes to investing.
We also selectively perceive data, hoping to find something that confirms our prior views. We ignore data that contradicts those prior views. We even reinterpret old evidence so it is more in sync with our perspective. Then, we only selectively remember those things that support our case. Last, we overuse Heuristics, which is defined as simple, efficient rules of thumb that have been proposed to explain how people make decisions, come to judgments and solve problems, typically when facing complex problems or incomplete information (call them mental short cuts). These short cuts often generate "systematic errors" or blind spots in our analytical reasoning.
And that's only a partial list of analytical imperfections you have inherited....
Most investors are overconfident to a fault. Don't believe me? Consider the following anecdote: A man was terrified to fly, yet thought nothing of roaring down the street -- sans helmet, no less -- on his Harley. That reveals a high degree of confidence in his own skills vs. a highly trained pilot's. That's some risk-analysis engine you got there, bub. That blind faith in our own abilities may have come in handy on mammoth hunts, but it is hardly beneficial when to comes to picking stocks.... The natural reactions to discomfort or threat -- coupled with a natural inability to be patient -- doesn't serve us well in the market. During market bottoms, most of the herd is selling. To buy during periods of intense selling means leaving the safety of the crowd, standing out, risking humiliation....
Most investors -- the 80% who underperform -- would probably be better off going the index route. If you're still interested in trying to outperform -- despite all we discussed today -- then I admire your gumption.
As somebody I was talking to last week said of their friends who went into the hedge fund industry two years ago: "They're very smart, they work like dogs, and they trailed the S&P by 3 percentage points last year."
