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.
Published or updated May 29, 2008.