Success has many fathers

January 15, 2014

Jan 15 (Reuters) – If you are like most investors, you
probably mistake catching a wave for being able to swim fast.

And considering that you also very likely can’t swim fast or
invest well, that is a dangerous combination.

It is easy to observe that people are more likely to give
themselves credit for good investment returns while blaming
their reverses on things outside their control, but now at last
we have data.

A new study by Dutch academics Arvid Hoffmann and Thomas
Post of Maastricht University (here)
was able to quiz customers of a discount brokerage about how
good they felt they were while also gaining access to their
trading records. The results are startling, if not
surprising. Investors who beat the median return agree more with
a statement asserting that their performance reflects skill, and
the higher their returns go the more they agree. What’s more,
overall market returns have no bearing on how investors rate
themselves, suggesting they invest in a bit of a psychological
bubble.

This destructive human foible, sometimes called the
self-attribution or self-serving bias, may well help us to
survive a hostile world and still keep plugging. That might have
been a useful trait when looking for berries or animals to eat
thousands of years ago, but it has the potential to be highly
destructive when it comes to managing finances.

The study looked at 787 clients of an online Dutch brokerage
during 2008-2009 with an average portfolio at that firm of just
over 54,000 euros. Some may find it significant that 93 percent
of the sample of these deluded fools were male. After all, the
old saying is that “success has many fathers, but failure is an
orphan”. Nobody mentioned mothers.

Now, you might say all of this is obvious, but if you do I
hope you are an index fund investor. Anyone looking at
investment returns in the real world can see evidence that
investors, as a breed, are not in touch with their actual level
of skill.

Take data from research company Dalbar Inc, which looked at
aggregate mutual fund sales, redemptions and exchanges and found
that in the 20 years to 2011 the average U.S. mutual fund
investor made just 2.1 percent annually. That’s partly split
between 3.8 percent returns on equity funds and just 1.0 percent
on fixed income, but still.

For comparison’s sake, the S&P 500 stock index
returned 7.8 percent annually during this period, gold
made 7.6 percent, bonds 6.5 percent and single-family houses 2.5
percent. Given that inflation was 2.5 percent, we clearly have a
lot of bad investors out there, and based on the new data, many
probably think this is someone else’s fault.

THE REAL COSTS

But why is it so costly to think you are good and fail to
reckon with your actual faults?

Earlier studies linked over-confidence with a host of
destructive behaviors. For example, a study by Barber and Odean
in 2001 showed a strong association between over-confidence and
over-trading. Trading costs money, even at an online brokerage,
and the more you do it the better you have to be to beat the
costs. Trading often also exposes the lucky to repeated chances
to outlast their good fortune. Very few people have the
discipline to leave a casino after winning their first hand of
blackjack, but statistically most people ought to.

Over-confidence also leads to under-diversification,
according to a 2008 study by Goetzmann and Kumar. Diversified
portfolios produce better returns with less volatility. That
lower volatility is crucial, in that investors have a marked
tendency to react to downdrafts in their wealth by selling up,
crystallizing a loss.

The deeply ironic thing, and here I speak only on the basis
of personal observation and anecdote, is that over-confidence
may well be one of the best traits to have in order to convince
someone else to give you money to manage. Other than good three-
or five-year returns, I am betting that an air of calm
confidence is a money manager seeking new assets’ best friend.

For a bit of context, hedge funds, which charge a massive 2
percent of assets under management and 20 percent of returns,
only made about 13 percent last year as an industry, as against
20-38 percent returns from the major indices.

This suggests two potential strategies.

First, find an unassuming, modest, self-doubting fund
manager and give them your money.

Second, put it in index funds.

On the whole, I’d advise solution two.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

One comment

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Index funds…..anything else is just gambling.

Posted by Missinginaction | Report as abusive