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Thinking Will Cause Your Investments to Lose

by Flexo on May 29, 2008

in Investing

Behavioral economics, a mix of psychology and finance, is an interesting field, and has taught those who choose to listen why they’re less likely to benefit from thinking they can predict the performance of a stock price.

The human brain is simply not wired to make good choices in the stock market. Traders will lose 3.8 percentage points annually (in a recent study) due to fees and poor decisions compared with a benchmark index. This is simply because we are overconfident. We know what we know, but we don’t know what we don’t know, and tend to discount the latter while giving more importance to the former.

As ordinary investors in the market, why do we believe that we have an advantage over the market as a whole? Why do traders insist that they have some knowledge of a bargain that no one else has? This recent article from the Washington Post, How Thinking Costs You, touches on behavioral economics and why we think we can make “informed” decisions about stock market transactions. I’ve heard this over and over again. Don’t believe you can beat the market. Don’t look at index funds as providing “average” returns; over long periods of time, this is the best you can get for the risk that you take.

[Terrance Odean, professor at the University of California at Berkeley] has gathered trading records from discount brokerage houses for hundreds of thousands of investors, and in several published studies, he has shown that when people had a choice of two stocks to sell, more often than not they sold the stock that did better in the future and held on to the one that did worse. And when they bought something new, they tended to buy a stock that did worse than the stock they just sold. As Kahneman once told Odean, “It is expensive for these people to have ideas… “What I believe is that individual investors probably as a group create the dynamics by which they lose money and institutions make money,” Odean said. “They create mispricings.”

Not all of my investments are in index funds. My 401(k) doesn’t offer pure index funds, and I had a small amount of free money to put into ETFs and individual stocks. But every large investment I make, if the time horizon for withdrawal is at least a decade away, will be in an index fund. There are hardly any expenses and my returns will match or come close to the overall market.

Since “thinking” (i.e., considering trades and acting on decisions) has a detrimental effect on investments, and investing in an index for the long term frees your mind from these decisions, index funds have been again proven to be the best option for long term investments.

I’m a smart guy but it would be egotistical for me to think that I know something about a publicly traded stock that the rest of the investing world doesn’t already know, even if I pored over quarterly reports and had lunch with the CEO every other day.

Would I invest in a private business? Possibly.

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Tagged as: behavioral economics, Investing, psychology, stock market



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Flexo, the owner and creator of Consumerism Commentary, has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow him on Twitter.

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  • The data is surely correct, but the spin on the headlines and your conclusion are all wrong. How Thinking Costs You? How about The Price of Learning?

    I can duplicate the study by taking a bunch of babies and notice that when they are just learning to walk they fall down a lot and get hurt more than when they just crawled. In fact, if you take the average of all humans (the index) you will notice that the babies all do much worse. They should just just give up and continue to be carried by their mommies and daddies (the index) because they clearly are not as successful.

    You just don't know what you are doing, and until you learn you won't do well. But you don't have to assume that people can never do well just because the majority don't.
  • If you admit that the data is correct then you must also concede that the trend will continue on average. I will agree that not everyone is average, some are above and some are below. But over time, on a whole, the average is what it is because it will be reverted to. Depending on whose stats you believe, the S&P; index outperforms 80% to 90% of managed funds -- this is not an "average" return, nor is it "carried by their mommies and daddies." It's admitting that you don't know nearly as much as you think you know.

    That means that there may be 10% or 20% who can beat the market. Maybe you're in that 10% ot 20%, but the most likely you're not, and your chances don't improve with more knowledge.

    The analogy to learning to walk is seriously flawed. Walking is learned by every child -- every creature on this planet with legs -- based on instinct and imitation. That's a very low-level motor function, so far removed from decision-making based on perceived information. Your point is to show that more practice is necessary before you can truly evaluate whether "thinking" (evaluating and making trading decisions) will be beneficial to your performance, but the data already show that practice and experience will not make a difference in the long run. Otherwise stock brokers wouldn't be required to say "past performance does not indicate future results." They would say, "We've learned how to beat the market and will guarantee that we will continue to do so," and the SEC wouldn't mind.
  • KC
    Sounds to me like the guy in the article was panic selling - selling his C shares at the bottom. It's clear now that he made a mistake in buying them and it should have been clear at the time that it was a bad buy (why would anyone touch financials since last August). But those shares will rebound. They have a handsome dividend. And even if it is cut by 20% it'll still be around a 5% dividend. C is not Bear Stearns - they will not be sold off at pennies on the dollar. He obviously wasn't buying for the long-term or he'd still be in those shares.

    I own some financials and I've had them for 10 years. I've bought some financials more recently, too. And I have to say I've been like this guy and wondered if I shouldn't sell. But I keep telling myself...long term, you made this decision for the long term. You researched this decision based on long-term. It's no different than the indexes I own - long term. If I wanted to turn a fast buck I'd head down to the casinos.
  • Whenever you discuss single-stock investing versus indices, the comment conversations always follow the same pattern. The majority of commenters fit into one of these categories:


    - Smug person who only invests in indices because people who stock-pick are foolhardy and stupid. Gets irate when you mention sub-30 tech IPO millionaires and GOOG.

    - Smug stock investor who thinks indices are for uneducated sheep/babies. He is most likely making money, and like the highschool quarterback who "knows" he's going to go pro, he "knows" he is smart enough to be in the minority that won't go broke. Gets upset when you bring up Warren Buffet or the 100% unreliability of any form of charting.

    - Real-estate evangelizer who thinks the market as a whole is for plebians, and that the "only sure path towards wealth" is owning property. Mention Miami, Fresno, or Tokyo and he'll never visit your site again.


    To end my comment on an entirely hypocritical note, I like to think I split the difference of those three categories. For my retirement investments and the bulk of my net worth, I invest in index funds. I like stock-picking for the same reason I like blackjack and Vegas; I know the odds are against me, it's mainly just for fun and excitement, and I never buy a stock without making sure that if it pulls an Enron or Bear Stearns I'll be fine losing 100% of that "investment" (read:gamble). Oh, and sure, I'd like to own rental properties eventually...however the concept that somehow real estate is some magical sure-bet is laughable.

    Talking about investing is a lot like talking about sex. Not many like being told when they're wrong, most think they're doing it the best way, and few want to look at themselves in a mirror to stoically see what's going on.
  • I guess it helps that I know nothing about investing! I have my retirement accounts in targeted mutual funds. I also have a single mutual fund that I've had since I was 16....
  • I don't buy these arguments that thinking makes you perform more poorly than the index. If the index performs at a certain level, then there around half of stocks (and mutual funds) perform better than the market. So is it really that hard to do better even if you sit and hold a stock or mutual fund? I would think not. Then, if you have a knack for timing when one type of fund or stock is peaking or a good opportunity, you help the odds towards your favor. I have some techniques I use that have worked well for me over the last ten years and I have measurable results that show that I've outperformed the market over the last 3 years. All the indexes on average have returned about 7% per year annualized over the last three years and I have gotten about 13%. Perhaps there's luck involved, and I'm not foolish enough to say that I've got a system that always works, but there's a chance that my "thinking" will continue to give me better returns. One clue as to what I do is rebalance a lot. If rebalancing 4 times a year is good, nobody can prove to me that rebalancing 12 times a year, (while avoiding fees or penalties) is not better.
  • For customers revenge: There are people who can beat the market. I hear Buffett, Munger, Templeton, and Lynch mentioned all the time. I always say there are a few people who can shoot 66 at Augusta on Sunday of the Masters - Tiger, Nicklaus, Palmer. Chances are you ain't one of them. It isn't to say you aren't, but the odds are against you. Just look at the professional mutual fund managers and hedge fund managers who fail to match their benchmark.

    If the odds are against you, why not go index fund and spend the time you would have used to study stocks and actually do something worthy like a charitable event, spend time with your family, or work more (you can make more from increasing your salary than improving your return).
  • Ruth
    Do your research~that's all we can do really, the rest is somewhat of a guessing game.
  • I don't think the walking analogy is flawed at all. Walking is darn hard, just like language, or learning addition or just about anything we do when we're young. The stuff we do when we grow up is all relatively easy. Buy and sell stock at a profit? Simple. You probably have a skill that you're better than average at. You or I likely won't be Warren Buffet since he's the best, but you only supposed whether we could, or should try, to beat a weighted average of stocks called the market, or the index.

    For example, you could hypothetically beat "the market" simply by selecting even one below average stock from the index and then removing that stock from your portfolio while keeping the rest. Are you saying that you could not find one dog given a list of every company in the index? That's a hypothetical, since you may not have enough money to create your own index, etc, etc, but it's an easy example of a way that you could probably beat the market.
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