Smart Investors Aren’t So Smart

Commentary by Paul Keck.

You might assume from reading the title that I’m saying investors aren’t as smart as they think. Not exactly. What I am saying is the smartest individual investors know they aren’t that smart.

They know they aren’t smart enough to:

  • consistently beat the market after costs
  • time things
  • pick the best funds consistently

The smartest investors know what they don’t know. They also know the advantages of low cost investing, diversification, risk management, and sticking to a plan.

Most importantly, they know the pitfalls of behavioral mistakes.

Behavioral mistakes are any investor’s tendency to fall into destructive patterns. These patterns have been studied for several decades in the burgeoning academic field of behavioral finance, and can cost investors anywhere from 10% to more than 50% of their potential returns. Making the problem worse, investors who are overconfident (the number one behavioral mistake) are subject to something called the Dunning-Kruger effect. In this context, that’s the inability of unskilled investors to recognize their incapacity to make good decisions. They don’t know that they don’t know.

The decision-making skills needed to invest properly are not intuitive. We enter the arena with two predetermined biases. One is family genetics and the other is experience learned outside the family influence. These built-in biases are a significant factor in how we approach saving and investing, and the development of our emotional risk tolerance. They are why some investors have natural tendencies to be extraordinary risk takers, and others tend to be extremely risk averse. Neither is a good trait. And like overconfidence, most investors are unaware of these biases.

Finally, there is one last natural tendency to overcome. We are competitive by nature, and while this is fine in business and sports, it has no place in investing for individual investors. Competitiveness causes us to compare our returns with everyone else. This leads to taking chances and increasing risk in our quest to be number one. Long term investing is better thought of as a plow horse, not a race horse.

Do a little online research and you can easily find several lists of top- performing funds and a few dozen model portfolios with excellent past performance. The smartest investors know that none of these funds and none of the portfolios are perfect choices. They also know it’s impossible to predict which individual fund or which portfolio will outperform over the next five or ten years. The smartest investors don’t fall for best-of-the month lists, instead they avoid the never ending stream of short-term financial hype and build well-diversified portfolios with measured risk characteristics in accordance with their personal goals.

They pick and choose among these options to build well-diversified portfolios with measured risk characteristics in accordance with their personal goals.

The smartest investors tend to use index funds because they know that while actively managed funds have the potential to outperform, that is not predictable. Using active funds involves higher risks because (1) their performance must overcome higher costs, and (2) fund changes harm performance. In other words, the odds are high that they will underperform, and the long- term record confirms that. Furthermore, fund changes are not uncommon and they force investors to decide whether the changes are temporary or permanent. In turn, investors must make a best guess in deciding to stay or move to another fund.

The more decisions an investor is forced to deal with the higher the chance of making the wrong choice. Slipping back one step requires two steps to get even again.

Investors must be aware of troublesome behavioral problems, built-in biases, and the facts related to strategies touted by Wall Street before they can address them. Unfortunately, many overconfident investors never get this far. If they did, they might begin to realize the smartest approach to investing is to not play the game of individual stock picking or chasing hot funds that Wall Street nets millions getting them to play.

So, if you want to be a really smart investor, start by realizing you may not be quite as smart as you think. Be sure you understand the basics of risk and diversification—and not just the how, but the why. Then learn to recognize the most common behavioral mistakes and build a plan that minimizes potential problems.

*****

A retired chemical engineer, Keck became passionate about investing 11 years ago. Since then he’s made a study of many aspects of investing, including the field of Behavioral Finance and the light it sheds on how we behave with our money. An active contributor to the Bogleheads and Morningstar online investor discussions, Keck has also written an online primer to investing, Investing Essentials. He says the single best investment decision he ever made was in his personal financial education, and attributes this to the discovery of the Morningstar ‘Bogleheads Unite’ forum, and most especially to Taylor Larimore, one of the original founders of the forum, and co-author of  The Bogleheads’ Guide to Investing.  He lives in California and when he isn’t thinking about smarter ways to invest, he likes to play golf and bike ride on a regular basis.

*****

Portfolioist welcomes your comments, suggestions for articles, and potential guest blogs. Contact byrnesn@folioinvesting.com.

2 thoughts on “Smart Investors Aren’t So Smart

  1. J. Weyant

    Interesting commentary. I actually read yesterday a piece online from CNN’s Money Magazine called “7 Secrets to a Richer Retirement” (http://bit.ly/aLaMo9). Also basing their “secrets” on studies in Behavioral Finance, they would seem to agree at a high level with those points raised here by Mr. Keck, save one. Their #2 secret, “Try to beat the other guy.” They argue that there is actual a distinct and valuable place for our naturally competitive nature in investing. That peer influence can inspire investor participation and that it can provide a benchmark against which to compare yourself. Not sure which opinion I agree with, but I thought the counterpoint valuable to share.

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