Why So Many Fail at Investing

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This might be the most important investment statistic you ever hear: Over a 20-year period ending in 2008, the S&P 500 index gained an average of 8.35% per year. The average investor, however, earned 1.87% a year. Not only do most investors underperform the market, but they do so with astounding vigor.

Why has long been a matter of debate. The most convincing answers usually come from the world investor psychology. Emotions cause us to buy high and sell low. We think we can time the market. We act impulsively on rumors. We have very short memories. We're just not hardwired to be good investors. Terrible, actually.

A paper from the Center for Financial Studies adds a twist to this discussion. The paper's conclusion might not be surprising, finding "that lack of understanding of economics and finance is a significant deterrent to stock ownership."

Even after controlling for age, education, and income, financial literacy has a profound effect on people's willingness to invest in the stock market. The more financially literate we are, the more comfortable we become around stocks.

That's how it should be, right?

Maybe. A separate paper by Lauren Willis at Loyola Law School adds yet another twist. Willis shows, quite convincingly, that financial literacy can actually be detrimental to people's financial health. A few examples:

"Data from the Jump$tart nationwide survey of highschool seniors has consistently shown that financial education does not increase financial knowledge among high-school students and that students who take a personal finance course 'tend to do a little worse ... than those who do not.'"

"A program to teach low- and moderate-income consumers about money management and Internet banking ascertained one year afterward that 'members of the treatment group were less likely to plan and set future financial goals at follow-up than they were at baselines.'"

"A study comparing bankruptcy debtors who received financial training with those who did not found that, once controls for other differences between the groups were added, the training was associated with a small negative effect on outcomes."

What's the deal?

Willis offers a few explanations. One, literacy itself isn't enough to overcome the emotional hurdles of finance. More importantly, financial education "appears to increase confidence without improving ability, leading to worse decisions."

Willis doesn't explicitly tie her findings to the stock market, but the jump seems logical: A major reason many investors fail at investing may indeed be because their financial education and literacy improve confidence without improving ability. One good example: A study by Brad Barber and Terrance Odean found that investors "who trade the most realize, by far, the worst performance." Those who think they're savvy enough to trade in and out of the market and for short-term profits almost invariably fail. Delusions of grandeur are one of the biggest poisons of successful investing.

The answer to this problem isn't to discourage financial education. Nor is it to discourage people from investing. It's acknowledging that the single most important aspect of personal finances and investing is not technical expertise, or even financial literacy. It's understanding investor psychology, knowing our limits, having control over our emotions, and recognizing the myriad biases we fall victim to.

Warren Buffett gets the last word: "Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own any of the shares mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insightsmakes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (13) | Recommend This Article (75)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 21, 2011, at 8:33 AM, daveandrae wrote:

    I started investing in June of 1998. The s&p 500 was trading at 1133. Friday it closed at 1333. Last year, at this time the index was trading below the June 1998 cost basis. It was at 1071 and falling.

    Over the course of the last thirteen years, we have had two howling bear markets, one in which the Nasdaq sank by more than 75%, and the other, in which the s&p 500 sank by more than 67%.

    let us not forget to sprinkle on top two recessions, the second the greatest since 1937, 9/11, two wars, and the "flash crash" of 2010.

    This is the kind of volatility that you are signing up for in order to actually "get" that 8.35% annualized 20 year rate of return.

    Unfortunately, most people are unaware that they just got on a financial roller coaster until it starts going downhill.

  • Report this Comment On May 21, 2011, at 11:01 AM, BleacherEd wrote:

    Another couple of possible explanations include:

    Those with low to moderate finances are much less likely to be able to "afford" not to panic or to become emotionally involved when the market takes a financial down turn. Some may just need the money, other's will be significantly exceeding their comfort level as their dwindling finances threaten their home and family.

    The second possible reason is simple. Of course, the less total capital you are investing, the more transaction fees etc eat into any potential earnings in the market

  • Report this Comment On May 21, 2011, at 11:12 AM, Momentum21 wrote:

    Solid article Morgan...nice work...

  • Report this Comment On May 21, 2011, at 2:46 PM, Katommy wrote:

    Investing is 90% emotion and 10% knowledge & education. Master the 90% and your probability of success increases exponentially! Good article.

  • Report this Comment On May 21, 2011, at 4:02 PM, mm5525 wrote:

    Good article. Here are a few things I've learned and would like to add: #1 I strictly only invest in companies that pay decent dividends. When I see a ton of red on my screen, I realize the lower stock price will give me more shares via dividend reinvestment in the long run. That keeps me from making boneheaded decisions. #2 I realize there are many reasons why your stock specifically may be down that seem totally unrelated to "logic" as there frankly are very few players in the stock market anymore. Big hedge funds can move a stock price easily. Sometimes they simply have to sell their winners to pay for their losers, or for margin calls. I have learned that in watching day-to-day fluctuation in stock price = anything can happen. #3 One day does not a trend make. Especially watching the CNBC or finance tv in general. One day it seems like the world is coming to an end, and then a few days later everyone is chasing, afraid they've missed the rally. You just have to tune out the day-to-day noise. #4 Read good books about trading/investing psychology: I highly recommend Nassim Taleb's Fooled By Randomness. I don't agree with the author completely, but simple luck has plenty to do with successful investing. Buying at the right time, buying into fear, selling into strength. Someone can do a ton of analysis on why a stock should go up, but that doesn't necessarily mean it will. Also Benjamin Graham's The Intelligent Investor. He is who inspired Warren Buffett for those who don't know. I have made the most money in buying in the face of fear/blood on the streets, etc. To me, investing is about buying good companies on the cheap. I never look to buy when the market is up. I certainly don't go around quoting Jim Cramer, but he does mention "never run away from a sale" like at the grocery store. If you see something on sale at the store, aren't you more likely to buy it? Investing should be no different, yet the retail guy thinks the talking heads on tv know something they don't know, and so they don't buy into that fear. Investing is about patience to me. I have bought too early on the way down, and I am willing to ride it out for months or even years as long as I have dividends. That's my take on the psychology of the markets for what it's worth. To me, it's kind of like sports. One team should clearly beat another on paper, but the game is not played on paper. Sometimes it's emotion, not skill. How often do you see the underdog win in sports? Quite often.

  • Report this Comment On May 23, 2011, at 2:31 AM, BuyloPESellHiPE wrote:

    Couple of simple things that people can do in order to make money in the stock market.

    1) Invest only in Mega Blue Chips like Exxon, Coke, Merck, Boeing, MMM etc.

    2) Make sure you are buying these equities at very low prices. During market corrections you can buy a boat load of these stocks for very good prices. For example, I acquired Boeing around $35, Exxon around $55 and so on.

    This way you will not be too worried about day to day or week to week or month to month fluctuations. This is the best way to perform well on stocks. Buy them cheap otherwise stay out of it.

  • Report this Comment On May 23, 2011, at 8:26 AM, mtf00l wrote:

    Nice article and I don't feel overly compelled to go check the reference material. =D

  • Report this Comment On May 23, 2011, at 2:11 PM, maryjo62 wrote:

    great article! good comments.

  • Report this Comment On May 25, 2011, at 10:05 PM, inkstainedwretch wrote:

    "A little learning is a dangerous thing..."

    Alexander Pope

    The meaning of that passage (which I'm too lazy to complete here, too much googling, awful memory) is not to avoid learning but rather to appreciate your ignorance. Study hard, be humble, be patient. Chances are, you're dumber than you think but smarter than most others imagine.

  • Report this Comment On May 26, 2011, at 7:41 AM, SpaceVegetable wrote:

    Buying high and selling low is not always about fear. As BleacherEd said, sometimes those with moderate means are forced to sell at a low point due to job losses or other financial hits that those with better finances are able to ride out.

  • Report this Comment On May 26, 2011, at 11:57 AM, arizonamike303 wrote:

    The trouble with trying to 'ride a stock out' is that sometimes you ride it right out of the market when the company declares bankruptcy.

  • Report this Comment On May 27, 2011, at 1:39 PM, TimothyVR wrote:

    The average investor earned only 1.87% a year? That is interesting and surprising. Investing in a few dividend paying stocks - with reinvested dividends - should yield more than that.

  • Report this Comment On May 28, 2011, at 5:19 PM, Viljams wrote:

    In general this article is okay. I understand your point in the opening quote, but the opening statement on the S&P's returns is really misleading. I'm so tired of hearing people selectively choose data to "impress" people as to stock returns. Why choose those 20 years? Frankly if you look at the last 11 years the market has been a lot less productive (-13% total returns) and very volatile. If you're a "buy and holder" you got hammered and it will be a long while before you'll recoup your losses. Acquisition of good stocks in a bear market is the real key to success. So getting into the market was a great idea from 1988-1995 (and 2003 and 2009) but not such a great idea from 1999-2001 and 2005-2008. Frankly, a lot of people would have been happy to have their portfolio make 1.65% during the 2000's.

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