Usat

USA Today had an interesting article this past week (it happens). The discussion was on the fact that Most Americans no good at investing.

A more accurate title would have been "Humans not good at investing." There’s a very specific reason for this; It is something I am in the middle of writing up, and will address very soon in print.

Meanwhile, here’s an excerpt:

"A study by Hewitt Associates that analyzed the 2003 investment behavior and account activity of 2.5 million employees eligible for 401(k) plans exposes a trove of investment mistakes by average investors:

• Three out of 10 employees eligible for 401(k) plans don’t participate, Hewitt says. That means investors are passing up free money in the form of matching contributions from their employers.

• Despite horror stories about employees at scandal-scarred companies such as WorldCom and Enron having their 401(k) accounts wiped out because they had all their money riding on their own company’s stock, 27% of 401(k) investors still have more than half of their money in their employer’s shares.

• And proving that investors are hardly hands-on, only 17% made 401(k) transfers in 2003.

Another Hewitt study, done in fall 2004 with Harvard University and the Wharton School at the University of Pennsylvania, found that a "non-saving mentality" persists. The study focused largely on "low savers," those who do not stash enough in their 401(k)s to earn the company match. When "low savers" learned they were passing up $1,200 a year in matching contributions, one-third said they intended to raise their savings rate. Only 15% actually did."

This factor, more than any other reason, explains why the President’s Social Security Privitization idea has generated so little positive response amongst most Americans.

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UPDATE  March 27, 2005 9:12 am

Put aside the Social Security issue for a moment. I find the argument that people are not hard wired to be investors is quite fascinating. Wall Street uses a variation of this to suggest "professional management;" indexers use it to argue against active management; discount brokers say if you can do as well as the mediocre pros, then why pay big commissions?

All of these positions miss the bigger picture: Why are Humans Beings so ill suited to investing?

I first came across one of my favorite explanations as to why we simply aren’t hardwired to undertake risk reward analysis in capital markets many years ago; It was from Michael Mauboussin , now Legg Mason Funds chief investment strategist, formerly chief U.S. investment strategist at Credit Suisse First Boston. In a cogent and persuasive manner, Mauboussin explains the reason why: "the mind is better suited for “hunting and gathering” than it is for understanding Bayesian analysis."

Simply put, you just ain’t built for it. Mauboussin breaks down the emotional and psychological impediments into 7 subtopics:   

· Desire to be part of the crowd.
· Overconfidence.
· Inability to assess probabilities rationally.
· We love a story, especially when it links cause to effect.
· Use of heuristics, or rules of thumb.
· Chance.
· Fitness landscapes and the role of the inductive process.

Each of these are explained in more detail, but the bottom line remains: Most people simply do not posses the counter-intuitive skillset, or the emotional detachment, or the discipline required for long term outperformance in the markets . . .

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Been round here long . . . ?

Capital markets have not been around all that long (relatively speaking).

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Source:
Most Americans no good at investing
Adam Shell
USA TODAY, Posted 3/23/2005 12:12 AM
Updated 3/23/2005 1:14 PM
http://www.usatoday.com/money/perfi/general/2005-03-23-investing-cover_x.htm

What Have You Learned in the Past 2 Seconds?
Michael Mauboussin
March 12, 1997
http://www.capatcolumbia.com/Articles/FoFinance/Fof2.pdf

Category: Apprenticed Investor, Investing, Psychology, Rules

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

35 Responses to “(Why) You Suck at Investing”

  1. John says:

    Does this fact (humans naturally are bad invetsors) create opportunity for those who can detach themselves from human nature? Does it suggest that those who excel are… less human?

    If one can be honest in self evaluation it might help identify when a professional should be chosen over do-it-yourself investing. Provided you can find an investment professional who is a humble, self critical, a loner and member of Mensa.

    It would seem that the more you can detach yourself from (the need for) personal relationships of all kinds the greater your objectivity in the financial game. Total immersion in the game.

  2. Ahhh, grasshopper, you are on to something.

    Once you learn the limits of your own bad instincts, only then can contemplate overcoming them.

  3. We are bad investors not only because our brains are poorly designed for the task, but because predicting the evolution of particular firms is, actually, pretty tough. Betting on the whole ecosystem (ie the index) is much easier since we humans always improve the profitable tools and build new ones, such as Windows.

  4. spencer says:

    My experience with portfolio managers is that most make fairly good buy decisions, but that most are very, very poor at making sell decisions.

  5. bhaim says:

    According to E.O. Smith, “the vast majority of our evolutionary history took place in the context of a nomadic lifestyle, with hunting of wild game and gathering of vegetable foods…. we functioned in small groups and with a simple technology until very recently. Survival of the fittest in that archaic environment profoundly shaped our biology—our dietary, health, emotional, and also our psychological needs.”

    It’s obvious but primitive homo sapiens were not thinking about finance theory.

  6. bhaim says:

    Here’s William Bernstein in Barron’s:

    [Scary] are the results in the 401(k) plans of the most prestigious financial services corporations: For 1995-1998, the annualized returns of the 401(k) plans at Morningstar, Prudential, and Hewitt Associates were 13.5%, 10.5%, and 11.8%, respectively, versus a 21.2% return for the global 70/30 mix. If employees at the nation’s most sophisticated financial companies can’t get it right, what chance do folks on the assembly line at Ford have?

    http://www.efficientfrontier.com/ef/102/401.htm

  7. Law says:

    Welcome to the Carnival of the Capitalists!!!

    Law

  8. Law says:

    Welcome to the Carnival of the Capitalists!!!

    Law

  9. BEER AND BRATWURST CARNIVAL

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  31. Paolo Thompson says:

    The reason humans are generally poor investors has to do with our emotions. When you look at your statement, you do not just see shares and dollars, but also your future well-being, your child’s college, a new house or car. I would argue that fear is one of the main reasons that people do not sign on to their 401(k) systems. This is the fear of being responsible for something you are not sure about, fear of making a mistake etc. As an example, I am reluctant to attempt to cook gourmet cakes because I am pretty sure that I will ruin the recipe. My fiance, who is a pastry chef, would have no problem with this, but try and get her to name the mutual funds she owns and you are out of luck. When a stock takes a plunge, our stomach does flips and the normal emotional reaction is to sell. However, depending completely on the circumstances of course, it may prove wise to double your position if you believe the downturn is temporary. Some humans are more able to divorce themselves from their emotions, whether in relation to buying stocks or skydiving, than others. Does this make them less human? I would argue that this would might make them more highly evolved to succeed. Warren Buffett does not buy companies when they are flying high and everyone wants in on them. He buys them when they are out of favor and reaps the benefit. Which kind of investor are you?

  32. Jon Tait says:

    Poalo, I’ll agree that the least risky place to double down on a position is right up next to your threshold for closing out the position, but averaging down without discrimination is a surefire way to wipe your account out. Successful investors/traders have a grasp of when to double down and when to fold, among other things.

  33. Thanks for the headline…

    I think if USA Today did a bit more research they would have mentioned who won the 2002 Nobel prize for economics.

    The fact that humans experience myopia, overconfidence, mental accounting, hot hands, heuristic bias, obfuscations, plus several other widely explored disabilities, is very strong evidence that we can’t make efficient decisions under conditions of uncertainty.

    As a financial planner, I am completely flabbergasted by the plight of the ordinary public consistently making stupid financial decisions. Picking stocks for example. Failing to calculate retirement needs, procrastination, failure to retain advisors (has to do with regret..amongst other things) etc…

    Anyways…for all you guys hoping to profit from other people being cogitatively disabled…take note that you are in the same boat. Human tendency to shade decisions in subjectivity is universal…turning subjectivity “off” will do very little improving your finances…

    …try diversifying your income, minimisizing tax liability, and conservatively leveraging into a portfolio of index funds over a period of 20-40 years. Your result will be 200%+ better than that of 99.5% of “investors” out there.

    By the way..it brings up an interest point: people can’t properly account for returns from their investments…they never take into account risk, opportunity costs, tax and compounding. (it’s called mental accounting…. a hereditary human disability inflicting everybody).

  34. Ricky Neva says:

    I could not agree more with the writer. It does not take a rocket scientist to figure out why that M.F.er George Bush wants to trash Social Security. He knows we don’t know how to invest and all his M.F.ing billionaire friends want Amerikkkans to shovel their money into their coffers! Investing helps nobody but the rich! When I was working I knew I was too un savy to invest my deferred compensation (meager 100 bucks a pay period) but it accrued fast and you know that money never got more than 2 percent! I could have done better in a damn savings account! Then I got nicked real big when I cashed it in to pay off credit cards. They have us by the balls and they know it. I say screw the two party system and bring in Communism pure and simple!

  35. Rick says:

    You forgot about another reason why not to invest, especially if you are married. No one can stop a wife from deciding one day she wants to have an affair, get a divorce, AND get half of the husband’s worth (ie. 401K). Thank you CA “no-fault” divorce laws, you just cost me 250K.