Pinocchio traders with fantastic returns are lying to themselves
Barry Ritholtz,
Washington Post, February 23





Michael: I don’t know anyone who could get through the day without two or three juicy rationalizations. They’re more important than sex.

Sam: Ah, come on. Nothing’s more important than sex.

Michael: Oh yeah? Ever gone a week without a rationalization?

— “The Big Chill” (1983)



In my last column, we discussed my annual rite of Mea Culpa. That’s where I look back at the prior year to evaluate what I got wrong and why. It is a humbling experience designed to make me a better investor, and I have been doing it — in public — for several years. Numerous readers have told me that this is a rarity in the world of finance.

But every year, I hear from a small segment of active traders who misread what the discussion is about, seeing it as an invitation to brag about their best trades. Astonishingly, these e-mailers have all significantly outperformed the markets over the years, putting up fantastic return numbers. They never seem to have a losing trade. They sold Apple at exactly $705 and bought gold precisely at the bottom. Even more amazingly, they got out at the market top in October 2007 and bought in at the exact lows in March 2009.

The polite term for these people is “fibbers.” Personally, I say it’s lying.

Mathematical probabilities make these claims of uniformly spectacular track records extremely unlikely. And what I find most intriguing is that these Pinocchio traders (as I call them) are not really lying to you or me, but, rather, to themselves.

Little white lies are told by humans all the time. Indeed, lying is often how we get through each day in a happy little bubble. We spend time and energy rationalizing our own behaviors, beliefs and ­decision-making processes.

As investors, we want to believe we are smart, insightful and uniquely talented — even though we often fail to do the heavy lifting, put in the long hours, and make the uncomfortable but necessary decisions to achieve success.

But self-deception is especially costly when it comes to investing. So let’s consider some of the lies that a lot of you may be telling yourselves and the impact they may have on your portfolios.

You know what your investment returns are. You would be surprised at how few people actually know what their returns are. Even fewer understand their performance relative to a benchmark.

According to a study of online investors by Markus Glaser and Martin Weber, “The correlation coefficient between return estimates and realized returns is not distinguishable from zero.” In other words, what we think our investment returns are and what they actually are have literally nothing to do with each other.

It is not that complicated to correct this. Set up a simple spreadsheet using Microsoft Excel or Google Drive or one of the available online tools. Keep careful records of your portfolios, cumulative and YTD returns, and you will avoid the “performance delusion.”

You can predict the future. You may not say you believe you can forecast what will happen next year, but you certainly behave that way.

Whenever you try to pick market tops and bottoms, you are making a prediction. Guessing what stock is going to outperform the market is forecasting, as is selling a stock for no apparent reason. Indeed, nearly all capital decisions made by most people are unconscious predictions.

We’ve discussed this many times, but it bears repeating: No one can consistently predict the future with any degree of accuracy. If your investing approach requires that you become Nostradamus to succeed, then you are destined to fail.

You know how costs, fees and taxes impact your returns. Not too long ago, an acquaintance was bragging about what a great year he was having. And truth be told, his gross returns were impressive.

Then I had him calculate his net returns. Once he figured in his turnover, commissions and especially taxes, he realized he had an enormous cost structure that ate into his P&L. After all costs, his great gross returns turned into below-market returns.

I informed him, “My retired 75-year-old mom bought an S&P 500 index last January, paid an $8 commission and forgot about it for the year. She kicked your professional butt.” He was not happy about that.

Perhaps we need a corollary rule about active trading: Gross returns don’t count, net returns do.

You can pick fund managers. Yes, we all know who the great fund managers of the past 20 years were, but that’s after the fact. What makes you think you have the skill set to evaluate the best ones of the next 10 to 20 years — their investing approach, discipline, character and ability to express their investing thesis?

Only 1 percent of fund managers actually earn their fees: Why do you believe that you can pick them out?

You understand mean reversion. Every year, it seems, some fund manager gets the hot hand and becomes a media darling. He attracts lots of assets as investors chase past performance. The size of his fund balloons. Then the disappointments come.

Here’s why. Outperformance is often random among the 20 percent who manage to do better than their benchmark each year. But it’s always a different 20 percent. Following that run of good fortune, they typically follow with a subpar year, as their chosen style or sector cools off — it reverts to the mean, or average. (Math is a cruel mistress.)

You have a plan. I am constantly astonished at how few people actually have any sort of long-term plan other than throwing some money into a 401(k) or IRA and hoping for the best.

You can pick stocks. Let’s be brutally honest about this: Discussing specific stocks during a bull market is loads of fun. Chatting about new products, management and exciting new technologies makes for great cocktail party chatter.

The problem is that most of you lack the specific skill set to do this well. This includes understanding valuations, recognizing problems early and, perhaps most of all, following your discipline to limit losses when things don’t work out.

Most investors are better off owning a set of broad indexes for their main retirement accounts.

You are saving enough for retirement. I’ll spare you the lecture, but for most of you this is not true.

The average retirement account held by 60 percent of Americans is less than $25,000 (according to the Employee Benefit Research Institute). The average 401(k) is $77,300 (Fidelity). According to EBRI, only 14 percent of American workers are very confident they will have enough money to live comfortably in retirement.

This has been a short list. As Mark Twain wrote: “Everybody lies — every day; every hour; awake; asleep; in his dreams; in his joy; in his mourning.”

What are you lying to yourself about?

Category: Apprenticed Investor, Psychology

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.

18 Responses to “What Do Investors Lie To Themselves About?”

  1. VennData says:

    1) The Fed will let inflation run rampant

    2) The economic numbers are lies

    3) Tech companies will have the relatively same relative positions in the relative future.

    4) Buy and Hold is the same as Buy, Hold and Rebalance.

    5) America spends only 18% of our gov’t spending on Defense and it’s not enough.

    6) Obama hates America

    7) I understand politics, and Washington will screw things up for me, personally, because they are out to get me.

    8) Social Security Needs to be cut way back to save the nation’s finances.

    9) I’m going to be healthy.

    10 ) I’m special

  2. financeboomer says:

    People only mention their winners. You make a lot of good points that investors should consider.
    Boomers, Markets & Money

  3. Old Rob says:

    In evaluating fund managers, this article left out a very important aspect. In addition to selecting ‘good’ managers, there are the costs to consider. While it is true that many fund managers earn their bread by having a credible success rate, there is a cost associated with this; and it can or cannot be justified. However, not too many people (ordinary people) pay attention to the loads. So the question in selection of funds is how well do they do, does their style of fund management fit my style ( i.e. risk), and at what cost?

    I have been able to do 4% to 5% (tax free) in my retirement years with not too many loosers to contend with; my managed funds do about a half of a percent less (tax free). My age-peers (also old fogies) seems to do ~ 8%, but I wonder at what risk.
    If I were under 50, I would have to select a different scenario in my investment approach; but not if you’re over 70.

    BR seems to be astonished that people just throw money into an IRA/401-k without doing much else. I would counter that most of employer sponsored plans have very few options to select from. That would be a study in and of itself.


    BR: That’s a different article — one I’ve published repeatedly over the years (See here, here and this 2-parter — here and here).

    Each new article is well, new — I cannot simply repeat what I have said before every article!

  4. joe2012 says:

    Touché. Your describing the mythical “My guy” who people babble on about incessantly when discussing investment prowess. “My Guy” imparts a smug, self serving righteous air that simply says, “I’m special” and know how to navigate the financial world!
    Too bad it’s a croc.
    I’ve learned over the years what your Mom has….Index investing ETF/Mutual funds via passive management ( low costs) has a greater chance for success than all the “My Guy’s” or Cramers in the world!!

    Great article!!

  5. changja says:

    Generally agree with you on almost all these points however a couple things stick out:

    1) Tax impact. Agree that net returns are importance but did your mom’s return calculation also include the deferred tax she has? If you chop off 30-40% off any realized gain, it’ll almost guarantee underperformance. Even if you didn’t sell, the tax is there and will be taken out eventually.

    2) Predicting the future/stock picking. Agree its impossible to predict the future perfectly but you don’t need to be 100%. Even you use indicators to give you a probability of whether the market will go up or down in the short/mid/long term. Like your recent post on risk on/off. Aren’t you using that to “roughly” predict the future? People shouldn’t say this is the absolute bottom or top but it’s not unreasonable for people at the height of the housing market to look at the buy:income ratios and say its too high and expect there’s a high likelihood of housing to drop. Its more nuanced in my opinion.

    BR: Taxes? N/A — She held SPY for more than a year, and still hasn’t sold.

    Agree about Probability, but again most people don’t understand it, and tend to veer into prediction. (Note whenever I discuss the future I try to ALWAYS use probablistic language; See this)

    Here’s your money quote:

    Investing is about making the best probabilistic decisions using imperfect information about an unknowable future.”

  6. theexpertisin says:

    The assumption that everyone lies on occasion has merit.

    Of amusement to me are those who lie and believe their own bullshit. Then, there are those who lie, believe their own bullshit and then are offended when not believed by others.Social media allows these folks to pontificate their self delusions to a larger circle of recipients. Huffington Post, in the cross hairs….

  7. MikeW says:

    Near & dear to my heart –

    I hold two contradictory ideas in my head – a cold, analytical understanding that small investors do best with indexing (which I indeed do with half or more of my equity stake), and the conceit that I can pick individual stocks which, with dividends re-invested, will outperform an S&P index fund over time.

    Do I ever run the numbers on the individual stocks and back-check my performance? No, but what a lovely little hobby it makes, and how clever and in control of my fate it makes me feel. Just as most of us regard ourselves better-than-average drivers, I somehow imagine that I can pick stocks.

    Barry, I don’t know if you meant this essay as an endorsement of indexing, but it amounts to that.

  8. RW says:

    What MikeW said.

    A long time ago, Harry Browne convinced me that I needed two portfolios: A ‘permanent’ one and a speculative one.

    His permanent model was a start although I’ve modified the strategy considerably but the discipline remains constant — no mid-stream tactical or allocation deviation permitted until a thorough analysis indicates a change would augment total, risk-adjusted return — and I’ve gained (just) enough acumen that the speculative portfolio does add a bit of alpha albeit not as much as I’d like to brag about.

    The speculative portfolio also does something else that is really important: It keeps my stupid hands off the permanent one because one of the (ironclad) rules is I can move money from the speculative to the permanent but not vice versa.

    My pappy taught me that when he taught me poker and took me to the casinos for a workout: my walk-in money was $50 and I either won and stayed to play some more or lost it and had leave the table; that usually meant I had to wait for the old man too (he won a lot more than I did) but only a sucker would persuade himself that he could “win it back” or played with money he couldn’t afford to lose so that was that.

  9. TennesseeTrader says:

    It’s hard to lie to yourself about your financial asset net worth if you track it. I think like most endeavors you learn from experience. In my case it’s trade management that matters the most. I think where people get misled about their prowess it is in times like the current run from the lows in 2009. The FED has basically been handing out free money if you didn’t fight their liquidity, and it’s easy to think it’s something you’re doing. But I disagree with how some define investing versus gambling as basically making fewer trades and watching American Idol being an investor, while someone noticing the nuances of “risk on” and “risk off” being a gambler. If the FED is hell bent on the market going up, I’m not going to fight it. I’m a good little soldier and will pretty much play from the long side in this environment, but I absolutely take money off of the table, and put money back into play more frequently than some. I basically view periods of time with little money in the market as a form of risk management and I happen to be reasonably good at timing (coupled with managing those trades). And if I do happen to miss out on a portion of the run, I am happy knowing my risk profile is much lower during those periods of time.

  10. faulkner says:

    Maintaining a positive sense of self is more important than facts or effectiveness. (See Roy Baumeister)

    Deception, prediction and stereotyping (among others) are natural and unconscious System 1 processes. We naturally lie that our conscious minds are in charge, that our desires and decisions are logical, that we see and understand the real world, that we are effective even in complex situations, that we are responsible for our successes, and that our intentions in all of this are good. How could we not lie about our trading and investments?

    As you noted at the beginning, honest self reflection (especially in public) is a rarity. Probably as rare as someone who stops to use probablistic language.

  11. slowkarma says:

    I’ve done fairly well investing and I know how much I gain, because I get quarterly reports that tell me that, and they go all the way back to 1990.

    When I first began making enough money that I could take investing seriously, I started by knowing that I didn’t know jack shit about investing. I spent several months researching it, and when I was done I realized (a) I could never be a trader, because I’d never know enough compared to the people who do it fulltime, and so for me, the only option was long-term investing in which I tried to minimize fees and taxes; and (b) for me, reading economic and market history was more important than reading the newspapers and watching TV. What history teaches you is that the market will gain and correct, and soar and crash, and it always reverts.

    My formula for making money in the stock market is simple: hardly ever sell. I make my money through my job, and my only goal with my investments is to stay two or three points ahead of inflation. As a result, with stocks I am in mutual funds and ETFs only — ANY single stock is too risky. I also keep a varying percentage of money in bonds and money funds. Calling either exact tops or bottoms is almost impossible for somebody like me, but calling “around tops” and “around bottoms” is actually pretty easy.

    Right now, I think we’re around a top — could be weeks or months before we get there, but I think we’re around one. When I get around a top, I simply stop putting investable money in stocks, and instead, put it away in money market accounts. Sooner or later, a major correction or crash will come along, and when I get around the bottom for that, I put the money back in stocks. I don’t worry if I put it in 10% too early or too late for the exact bottom, because I’ll still make some money anyway.

    What I’m doing is, not losing. I got hurt in 2000, but a few years later, I was pretty much back to even. When the market started coming apart in 2007-2008, I got scared early enough that I’d stopped investing and had built up a pretty good money fund, and when it crashed, I got back in a little too early, but still made a buttload. In 20 years, that’s the only time I did something that might have been called “trading,” that is, trying to make money by getting in the market at the right time.

    Since I don’t need to trade hardly at all, I keep my money in two bank investment accounts. I give the managers very explicit instructions of what I want done (mostly invest in large value and growth stocks, and in-state municipal bonds.) We meet only once a year to review things and, if necessary, rebalance, though that’s not often necessary. I also have a Fidelity fund where I park money that I don’t want in the bank accounts, where I accumulate cash when I think we’re around a top.

    To me, this all seems pretty elementary. And it works. I think a lot of people get in trouble because they read too many newspapers and read too many on-line blogs and watch too much television. From those, they get the impression that it’s necessary to DO something. But, most of the time, it isn’t.

    I read this blog because I value the readings that Barry provides. But this blog, like most others, really is about trading…even when it says it isn’t. It’s always about what the market is doing, and where it’s going, and what’s going on with it, and what the Fed is doing, and what famous traders think. Traders may need to know that, but if you’re really a trader you shouldn’t be getting your advice from a blog, because it’s not specific enough. For a long-term investor, most of that information is simply noise. You should really try to avoid the stuff that either explicitly or implicitly gives you the itch to do something, because if you have an intelligently layered portfolio, you probably shouldn’t. What you should probably do is rely on the fact that the market may or may not go up, but it could do either; and eventually it’s going to correct, or maybe even crash, and then it will recover, etc. You can know that for sure. And knowing that, you can make some money — it just might take a while.


    BR: Yes, what other traders are doing gets discussed occasionally, often skeptically. But I am genuinely perplexed by your comments

    I’ve written too many things like this: “Don’t Just Do Something – Sit there!” to think of myself as a trader

  12. spencer says:

    In thinking about costs of trading never forget that every brokerage house employee has a major vested interest in getting you to trade.

  13. Melvis says:

    If one of your investments blows up and it impacts your standard of living, you probably took too much risk. Gamble only when the risk reward ratio makes it worth while. I increasingly see people reaching for yield because of the low interest rates. People often will not do due diligence because they need the story to be true.

  14. Do not you think it is somewhat contradictory “You can predict the future” and “You have a plan”. Maybe that is why a lot of people do not have plan, as they could not predict future?

    I was in a meeting once with second in command of a company worth more than 200 billion dollars. He said : “do not try to predict or plan your career longer than 3-5 years. It is OK to think about the next job and perhaps about the job after that with a stretch of imagination beyond that it is not worth of time spent on it”.

    On financial side of things most of us are bond to follow your retired mom – keep working and throwing money in a mutual funds. It is day job that keeps bringing in money and cost of error over long period of time is relatively low to the earnings at work. The thing is early retirement is hardly possible for the most of us. Even if your save 15-20% you would be lucky to maintain your income during the retirement. What is the point to delay life and fighting for financial independence? The government does not do it, why should we?


    BR: No, they are not contradictory at all. There is the inevitable, which falls into the fact category, then there are the unknown variables, which fall into the future prediction category.

    Fact: Most of you will get old (if you are lucky). Many of you will get to stop working (If you are luckier still). Regardless of your luck, you will all eventually die. These are not future predictions, they are facts. You can make plans so you will have a comfortable retirement. Or you don’t have to make any plans, and just “think happy thoughts.”

  15. Matt P. says:

    Great article Barry. Well done sir. I would bet that many of the the few who actually track their investments in a spreadsheet are still a bit cloudy on their actuall returns. The best way to calculate your return is to use the Excel XIRR function. This gives you a dollar-weighted return because it takes into account the timing and amount of your cash flows into and out of your retirement funds. It is surprisingly easy to calculate. All you need to know is the amounts you have put in or taken out of the account and the dates on which you did that. THere are some tutorials on this that are easily found.

  16. Chad says:

    Tracking and creating a long-term plan were key for me. On pace to hit retirement at 60, which gives me a few work years of cushin if needed. Though, I wish I could get my 401k cash in my IRA without switching jobs, which would allow me to lower my fees and at least keep the same returns.

  17. carchamp1 says:

    I’ve found the key to investing for me has been my inability to lie to myself. Seriously, I have this amazing ability to see things for what they are. I lack delusional thoughts. I had several serious bouts of brain trauma through sports and racing, especially when I was younger. I suspect this has a lot to do with it.

    Let me tell you it’s a hard way to live. I’ve been severely depressed for many years. I see others with delusions about money, relationships, marriage, kids, etc. and I think to myself I could really use that. People lie to themselves for mental sanity. I get it.

    Anyway, the upside to this is the ability to see through other’s delusions and figure things out. I don’t accept conventional wisdom at all. It’s meaningless to me. As for investing, I don’t believe in traditional fundamental or technical analysis. The only thing I’ve found that matters is human behavior. I try to buy the lepers of the stock world and stay away from the loved. I avoid crowds. When I talk to people about my most recent stock picks the general consenus is that I’m “crazy”. I hear that a lot.

    Averaging about 13% per year since 1/1/2000. I’m too big a fan of you and people like Bogle and Taleb to be sure I’m onto anything, yet. Give it five or 10 more years and maybe I’ll be convinced.

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