Investing secrets of the dumb money

Proinsias O’Mahony on the pitfalls to which the ordinary investor are all too prone

 

Most investors are awful at investing, with countless studies confirming that ordinary punters consistently underperform the wider market. Some investors, of course, are more awful than others. What’s their secret? What makes the dumb money so dumb?

They don’t know their portfolio performance

Everyone has heard the old chestnut about how those who cannot remember the past are condemned to repeat it. Similarly, how can you learn from your past investment mistakes if you don’t realise you made any?

The authors of Why Inexperienced Investors Do Not Learn: They Do Not Know Their Past Portfolio Performance, an award-winning study that surveyed online investors in Germany, found inexperienced investors are “not able to give a reasonable self-assessment” of their past investment returns. On average, investors believed they had earned 15 per cent annually over the previous four years; in reality, their returns averaged 3.7 per cent annually.

There was, the researchers noted, no connection between how well an investor had done and how well they thought they had done. 

In another study, members of the American Association of Individual Investors (AAII) and a group of professional architects were asked about their retirement plan investment returns. AAII members overestimated the previous year’s returns by 3.4 percentage points, the architects by 8.6 percentage points; both groups overestimated their returns relative to investment benchmarks.

The researchers concluded that cognitive dissonance – the tendency of people to experience discomfort when faced with evidence that contradicts what they want to believe – was at work, with investors blinding themselves to the less palatable reality and seeing what they wanted to see.

The most famous example involving inflated estimates of past returns concerns the Beardstown Ladies, an investment club consisting of older women that achieved fame in the 1990s due to their apparent investing acumen.

The Beardstown Ladies penned five books detailing the investing secrets that helped them bag reported annualised returns of 23.4 per cent over a 10-year period. However, they made an elementary mistake in calculating their returns; it later emerged their actual returns averaged 9.1 per cent, way below the S&P 500’s returns over the same period.

They’re undiversified

A 2004 study examining more than 60,000 accounts at a US brokerage found the average investor held only four stocks; more than a quarter held just one stock; more than half held three or fewer. Younger and less wealthy investors were the least diversified; worryingly, this same tendency was also “more severe in retirement accounts”.

It’s a costly error – the most diversified group outperformed the least diversified by more than two percentage points annually.

Ordinary investors also put too much faith in their employer, resulting in dangerously lopsided portfolios. One of the most infamous examples concerns Enron employees, who had 62 per cent of their retirement plan assets in company stock prior to the firm’s collapse in 2000.

Similarly, ordinary investors tend to be too loyal to their home market, overweighting their home country while steering clear of large international markets. Domestically, investors prefer local stocks to those further from home, as confirmed by a number of international studies. This home bias has diminished somewhat in recent years, although it remains a global problem.

People often mistakenly assume that, while an undiversified portfolio carries more risk, it is as likely to outperform as it is to underperform. After all, every stock has a 50:50 chance of outperforming – right? Wrong.

In fact, most stocks are losers. A recent study examining US returns over the last century found more than half of stocks failed to generate any profits. Most stocks, even if held for many years, don’t keep up with inflation, while the vast majority underperform the wider market. A small minority of big winners – the likes of Amazon and Apple, both of which have yielded gargantuan returns – are responsible for the bulk of index returns.

If your portfolio doesn’t hold this small minority of big winners – and the chances are it won’t, if you only own a few stocks – then you are almost certain to underperform the wider market.

There is a second reason why undiversified portfolios usually underperform. Such portfolios are likely to be highly volatile; placing your money on a small number of stocks is liable to fry your nerves and catalyse foolish acts of self-sabotage.

They pay too much heed to the media

“Real investors are influenced by the media”, note behavioural finance experts Brad Barber and Terrence Odean in their paper, The Behaviour of Individual Investors. Unlike institutional investors, they plump for “attention-grabbing” stocks as they are not in a position to analyse the thousands of stocks available to buy. They therefore buy stocks when those stocks are in the news, and this “attention-based buying” drives speculative trading.

There’s a second reason why media-driven investing is problematic. The stock market is only ever a front-page story if something dire has occurred. Journalistic stock market coverage is asymmetric; the negative is emphasised while positive returns are downplayed. This has always been the case, one study noting that this negativity bias “has barely changed from the 1920s”.

A 2016 study by Nobel economist Robert Shiller showed that while both ordinary and institutional investors overestimated the probability of a future stock market crash, retail investors were much likely to be swayed by negative media coverage during market corrections. Stock markets rise over time, so being under-invested is costly.

They chase hot stocks

Amateur investors were all over the recent Snap initial public offering (IPO), ignoring widespread warnings about the company’s stratospheric valuation in the hope of bagging the “next big thing”.

However, it’s often joked that IPO stands for ‘It’s probably overpriced’, and with good reason – research shows IPOs traditionally lag the overall market in each of their first three years as a public company. IPO underperformance has been notable in each of the last four decades. The median IPO has been overvalued relative to its peers by up to 50 per cent, according to one study of more than 2,000 IPOs.

Similarly, ordinary investors tend to be seduced by glamour stocks and eschew cheap, less fashionable stocks. Again, this bias costs this them dearly. A study by the Brandes Institute, Value vs Glamour: A Global Phenomenon, found the cheapest stocks over the 1968-2012 period delivered annualised returns of 14.8 per cent, compared to just 6.5 per cent for the priciest stocks.

They sell winners and hold onto losers

A raft of studies confirm investors tend to sell winning stocks whilst holding onto their losers. The so-called disposition effect is driven by emotional rather than intellectual considerations. It also tends to be a lousy idea from a tax point of view – selling a winning stock usually generates tax liabilities that could be postponed by offloading losing stocks.

Institutional investors are also prone to the disposition effect, but not to the degree seen in ordinary investors. Similarly, most money managers underperform their benchmarks, but not as badly as retail investors.

In other words, it’s not that money managers represent the smart money; rather, they’re just not as dumb as the dumb money.

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