Lucky You're Smart

One of the most famous lines from the 1970s comic strip Pogo is “we have met the enemy, and he is us.” Nowhere is that truer than with investing. We could spend hours covering all of the psychological biases we must overcome to invest well, but I want to focus on something simple, overconfidence.

Most of us believe we know more than we can possibly know. Are you of above average intelligence? Of course, you are. Are you a better driver than most? Yeah, but these other bleeping idiots on the road aren’t.

We also believe that we are in control of our emotions. Think back to the crash of 2008. At the time, it scared the daylights out of most investors. Now, looking back we see it as an opportunity missed and kick ourselves for not recognizing it at the time. Fear of the next market crash freezes far too many into a state of inaction.

Panicking after the market has fallen, fearing investing because it might do so again are symptoms of out-of-control emotions. Logically, we know that it's a fact that stocks, in aggregate, have always risen more that they have fallen. We just can’t bring ourselves to act on that knowledge by investing and rebalancing regularly. 

At some point, our above average intelligence leads us to realize that we aren’t very good at managing our own investment portfolio and we seek out “experts” to help us choose the best time to invest and the right securities in which to invest. The most common choice, for most investors, is an actively managed mutual fund. 

Our belief that a highly-paid, well-connected expert stock picker can “beat the market” seems reasonable. The majority of the mutual fund industry certainly claims success. However, the reality is at odds with the industry's implications.

Recently, the mutual fund research firm, Lipper, reported that, over the past 25 years, only 38.6% of active large company stock fund managers beat the Standard & Poor’s 500 (S&P 500). That’s less than you would expect based on just dumb luck (where 50% should win and 50% lose). Even worse, when you factor out the effects of luck (as two different studies have done. One from the Swiss Finance Institute, shown below, and the other, a joint study by University of Chicago and Dartmouth professors Eugene Fama and Kenneth French), 1% or fewer of all active fund managers show any possible stock selection skill. In other words, more than 99% of active managers fail to add any value for the extra fees charged.

Barras, Laurent and Scaillet , O. and Wermers, Russ, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas (April 20, 2009). Journal of Finance, Forthcoming; Swiss Finance Institute Research Paper No. 08-18; Robert H. Smith School Research Paper No. RHS 06-043. Available at SSRN: http://ssrn.com/abstract=869748

Maybe you believe that you can find the one fund in that successful 1% of fund managers. How will you know which ones have shown skill and which were lucky. Basing your selection on past performance won’t work; as numerous studies have show that the vast majority of best funds over the past five years tend to be among the worst funds for the next five years. Plus, even if you get lucky enough to pick a fund that wins for another few years, how do you know they didn’t just continue to be lucky?

Source: Dimensional Fund Advisors

Here’s the painful truth: You can’t beat the market consistently based on any identifiable data. The occasional successes are more likely a result of being "charmed," rather than smart (although, our tendencies to be overconfident precludes most managers from attributing success to mere luck).

The most you can reasonably expect is to “be the market.” You need to “be” the entire market, not try to guess which piece will “be” best in the future (remember, you’re not that smart). To continue being the market means always investing (whether the market “feels” too hot, too cold, or just right), always staying invested, and regularly selling the stuff that feels good (securities that have been rising) to bad the stuff that feels bad (securities that have been falling). 

In a perfect world, we would all be able to invest regularly, stay the course, rebalance and build great wealth. Yet, most of us allow our other emotions (particularly fear and greed) to lead us astray. That means that, once again you have to be smart enough to recognize your need for help. Just make sure you get the right kind of help.

Don’t go to a stockbroker who will likely try to sell you a commissioned, ongoing expensive active fund from the latest hot manager (we’ve shown that won’t). Avoid that friendly insurance salesperson who promises big returns with no risk (and tax advantages, to boot). They collect big, fat commissions, too. Instead, find a fee-only investment advisor, who uses inexpensive funds to emulate the market for a fair fee (1.25% or less per year to the advisor, 0.5% or less per year for the funds).

Even though I am part of just such an advisory firm, there are others like us. Because I want everyone to get the right advice (and avoid falling into the greedy clutches of the majority of the financial advice business), if you need helping finding one, get in touch and I’ll send you a list of advisors who I believe (bit, of course, can’t guarantee) will act in your best interests, not theirs.