Seven Ways to Fool Yourself

Article by Jim Parker of Dimensional Fund Advisors Australia.

 

The philosopher Ludwig Wittgenstein once said that nothing is as difficult for people as not deceiving themselves. But while most self-delusions are relatively costless, those relating to investment can come with a hefty price tag.

We delude ourselves for a number of reasons, but one of the principal causes is a need to protect our own egos. So we look for external evidence that supports the myths we hold about ourselves, and we dismiss those facts that are incompatible.

Psychologists call this “confirmation bias”—a tendency to select facts that suit our own internal beliefs. A related ingrained tendency, known as “hindsight bias,” involves seeing everything as obvious and predictable after the fact.

These biases, or ways of protecting our egos from reality, are evident among many investors every day and are often encouraged by the media.

Here are seven common manifestations of how investors fool themselves:

1. “Everyone could see that market crash coming.” Have you noticed how people become experts after the fact? But if “everyone” could see a correction coming, why wasn’t “everyone” profiting from it? You don’t need forecasts.
2. “I only invest in ‘blue-chip’ companies.” People often gravitate to the familiar and to shares they see as solid. But a company’s profile and whether or not it is a good investment are not necessarily correlated. Better to diversify.
3. “I’m waiting for more certainty.” The emotions triggered by volatility are understandable, but acting on those emotions can be counterproductive. Uncertainty goes with investing. Historically, long-term discipline has been rewarded.
4. “I know about this industry, so I’m going to buy the stock.” People often assume that success in investment requires a specialist’s knowledge of a sector. But that information is usually already in the price. Trust the market instead.
5. “It was still a good call, but no one saw this coming.” Isn’t that the point? You can rationalize a stock-specific bet as much as you like, but events or external influences can conspire against you. Spread your risk instead.
6. “I’m going to restrict my portfolio to the strongest economies.” If an economy performs strongly, that will no doubt be reflected in stock prices. What moves prices is news. And news relates to the unexpected. So work with the market.
7. “OK, it was a bad idea, but I don’t want to sell at a loss.” We can put too much faith in individual stocks, and holding onto a losing bet can mean missing opportunities elsewhere. Portfolio structure affects performance.

This is by no means an exhaustive list. In fact, the capacity for human beings to delude themselves in the world of investment is never-ending.

But overcoming self-deception is not impossible. It just starts with recognizing that, as humans, we are not wired for disciplined investing. We will always find one way or another of rationalizing an emotional reaction to market events.

But that’s why even experienced investors engage advisors who know them, and who understand their circumstances, risk appetites, and long-term goals. The role of that advisor is to listen to and acknowledge our very human fears, while keeping us in the plans we committed to at our most lucid and logical.
We will always try to fool ourselves. But to quote a piece of folk wisdom, the essence of self-discipline is to do the important thing rather than the urgent thing.

Jim Parker - Broccoli and Pizza Portfolio

This article, written by Jim Parker of Dimensional Fund Advisors, is made available strictly for educational purposes only and should not be considered investment advice or an offer of any security for sale. 

For some of us, it’s hard to give up on the idea that investing should be exciting. Picking stocks can be fun, after all, and there’s nothing like getting your timing right and bragging about it later with friends.

For all the accumulated wisdom about asset allocation, risk, diversification, and discipline, some people seem bound to see investing as an end in itself rather than a means to an end. For these folks, picking stocks is a hobby. They follow the gurus and soak up the financial media. Despite evidence to the contrary, they’re convinced they can build a consistently winning strategy by exploiting perceived mistakes in market prices.

Part of the reason is the human tendency toward overconfidence. For instance, we all like to think of ourselves as above-average drivers, when that’s simply not possible. Likewise in investing, many of us believe we have powers of foresight not evident in the wider population. A Duke University study of corporate executives published in 2010 found a dismal record of prediction among a group you might think would do well. Indeed, of 11,600 forecasts for the S&P 500 over nine years, the survey found executives’ estimates of future returns and actual outcomes were negatively correlated.1 (This is a technical way of saying the executives were hopeless forecasters).

Research also suggests the tendency to trade a lot and make confident forecasts about stocks has a gender bias. Whether it’s a testosterone-driven instinct among men to boast or something else, study after study shows men find it harder to accept that they are unlikely to “beat” the market.2 For these red-meat eaters, an investment approach that advocates working with the market, diversifying around risks related to an expected return, trading efficiently, exercising discipline, and watching fees and taxes is going to sound like the financial equivalent of a broccoli and walnut salad: healthy but boring.

Surely the point of investing is to try hard and, Don Quixote-like, to charge at those market windmills? Are we not men? There are a couple of ways of confronting this mindset. One is to hope for a change in human nature and persuade each would-be master of the universe to separate his urge for ego gratification from his need to build wealth patiently and efficiently. This is not impossible, of course. But one suspects it would take some time and would require a lot of face saving.

A second approach is to separate the investment nest egg from the play money. If someone really wants to speculate, he can be allowed to do that with the proviso that long-term retirement money be invested the boring way. This way, the investor can buy some (expensive) entertainment and accumulate a few war stories to share at his next golf game without compromising the asset allocation painstakingly designed for him and his family.

It’s understandable that investing is a kind of a hobby for some people. After all, this is what keeps much of the financial services industry and media in business. But in separating the concepts of speculation and investing, you can still enjoy the occasional treat while maintaining a balanced diet. Call it the broccoli and pizza portfolio.

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1. Ben-David, Itzhak, John R. Graham, and Campbell R. Harvey, “Managerial Miscalibration,” Duke University (2010). 
2. Barber, B.M., and T. Odean, “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment,” Quarterly Journal of Economics 116 (2001).

First Post - Why Indexing?

I have had a interest in passive, index linked, or enhanced indexing portfolio construction since 2007 and I took some major steps to further develop my understanding and use of these solutions over the past 12 months with a career shift into a fee-based financial planning practice here in the beautiful Fraser Valley.  For years, working at a different bank-owned brokerage, I was a prolific earner of trailer fees, which is a rather opaque and undesirable way to conduct business from my point of view.  Now, working for a different and more open bank-owned brokerage, I operate a fee-based financial planning practice to provide transparency and objectivity for my clients. 

In terms of portfolio construction, after determining client needs, asset mix and a financial plan, currently, I almost exclusively use index based solutions when building client portfolios with only a few exceptions for tax or other planning reasons.

My hope with this blog is to deepen my own understanding of the plethora of index based products available to Canadian investors by featuring and analyzing the various products from time to time.  Additionally, I hope to provide insight to readers that will help them understand why index based investments are the preferred method of portfolio construction after developing a suitable asset mix.  Lastly, I hope to profile why fee-based financial planning, in combination with a passive investment approach, works out exceptionally well for clients over the long-term.

Enjoy

And to finish today's post I quote William Sharpe:

"Today's fad is index funds that track the Standard and Poor's 500. True, the average soundly beat most stock funds over the past decade. But is this an eternal truth or a transitory one?"

"In small stocks, especially, you're probably better off with an active manager than buying the market."

"The case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets."

"Any graduate of the ___ Business School should be able to beat an index fund over the course of a market cycle."

Statements such as these are made with alarming frequency by investment professionals¹. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.

If "active" and "passive" management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.