Originally published on the Huffington Post, January 9, 2018
Academics are fascinated by the way you invest. You shouldn’t be flattered by their interest. They engage in sophisticated analyses in an effort to explain why you invest in a way that so irrational. The underlying premise of their studies is that your investing behavior makes no sense. I find that assumption — with which I am in complete agreement — just as intriguing as their explanations.
A perfect example
Here’s a perfect example, selected at random. It’s one of many.
Professors Cary Frydman and Colin F. Camerer published an article in the September, 2016 issue of Trends in Cognitive Sciences entitled, The Psychology and Neuroscience of Financial Decision Making. The authors sought to explain why “many household [financial] decisions violate sound financial principles.”
Here’s a list of some of these poor financial decisions:
1. Failure to invest in a company retirement plan, where the employer matches the employee’s contribution.
2. Holding bonds on which interest is taxed in a taxable account rather than in a tax-free retirement account, which would defer taxes.
3. Failing to refinance mortgages “which would save thousands of dollars on future interest charges…”
Here’s the one mistake that stood out because of the harm I’ve seen it cause to so many investors:
Another pattern of household investment that appears to be a mistake on average is the household preference for investing in actively managed funds (which try to pick outperforming stocks, usually holding them for months or years). Typical fees charged by such funds are 1–2% per year but almost all studies show that the universe of actively managed funds does not beat the overall market, especially net of fees. Most households in developed countries can easily choose index funds. These funds charge much lower fees (often as low as 0.1% per year) and simply try to match the performance of a large index such as the Standard and Poor’s 500 stock index. These funds have grown over the years but still represent only a small fraction of total investment (about 10%). There is no consensus on why active management is so popular. A plausible psychological principle is that households misunderstand the roles of luck and skill. They expect a fund to perform poorly after a short streak of high returns. When the fund then does well (perhaps luckily), they become mistakenly convinced that the fund’s managers are skilled .
The authors of this study correctly assume investing in actively managed funds is a “mistake on average.”
The authors identify a number of reasons for irrational (and harmful) behavior by investors. Here’s a summary of their findings:
The disposition effect: Investors have a tendency to hold on to losers and sell winners.
Home bias: Investors have a preference for stocks headquartered close to their home, resulting in a portfolio that is not properly diversified.
Overtrading: Investors trade excessively, increasing costs and reducing returns. This “overtrading” is caused by overconfidence “in the sense that investors mistakenly believe they have better information than they actually do.”
Trading biases: Investors “learn asymmetrically from good and bad news”; are “overconfident when learning new information, underweight non-events that are actually informative and over extrapolate from past returns.”
Genes: Elevated testosterone may cause increased risk-taking.
Personal experience: Traumatic experiences, living through market crashes and periods of high inflation, and surviving violent civil wars all impact investing behavior.
The conclusion of the authors of this study is that there are “a large number of trading patterns that are inconsistent with the rational use of information and the ideal balance of risk and return.”
There’s an alternative to recognizing the reasons for your irrational investing conduct and trying to alter them. Educate yourself on the evidence supporting sound and responsible investing and follow those very basic principles.
The good news is that doing so isn’t difficult. For most investors, buying a globally diversified portfolio of low management index funds, a target retirement fund or one of Vanguards’s LifeStrategy funds, in an appropriate asset allocation, is all you have to know.
This blog gives you a sound basis to start your path to rational investing.