You’re a Bad Investor. Here’s How to Get Better.

The chances are good that you're a bad investor. I'm sorry if that comes as an unpleasant surprise, but if you have any doubt about it, I encourage you to compare your performance against that of the S&P 500 (SNPINDEX: ^GSPC  ) . I did, and it was humbling.

If it makes you feel any better, you're not alone.

An annual study completed by DALBAR, a leading source for information on investor performance, found that the average investor underperformed the broader market on a multi-year time frame in 15 out of the past 15 years. That's right, 100% of the time!

It's all spelled out in the following figure, which I included in an article yesterday to show the most recent decade's worth of 20-year returns for the average mutual fund investor compared against the S&P 500.

What's behind the underperformance? Overconfidence.

Not unlike driving, where we all consider ourselves above average, investors think they're better at investing than they actually are. This overconfidence leads them to trade too often and thereby exposes their portfolios to higher transaction costs and a bevy of cognitive biases that almost invariably produce substandard returns.

So, what's the solution?

Quite simply, you have to come to terms with the fact that overconfidence, as my colleague Morgan Housel has pointed out, is an investor's worst enemy. To believe that you have an informational edge over other market participants is, to put it mildly, fanciful.

The insider-trading allegations against hedge fund giant SAC Capital serve as a strong reminder. Its portfolio managers knew how Dell (UNKNOWN: DELL.DL  ) , which is currently in the midst of a takeover battle between founder Michael Dell and activist investor Carl Icahn, would fare on its quarterly earnings before all but a select few of the computer company's own employees did.

And they had advance notice of how the Irish pharmaceutical company Elan (UNKNOWN: ELN.DL2  ) , which is in the process of being acquired by U.S.-based Perrigo (NYSE: PRGO  ) , had performed on drug trials far in advance of the public announcement.

Frequent trading by individual investors that seeks to exploit some type of imaginary advantage in the market should thus be recognized for what it is (i.e., foolish) and eschewed for good.

Does this mean we don't have an edge? No. In fact, nothing could be further from the truth. Yet that edge is diametrically opposed to a strategy of frequent buying and selling. The edge is, quite simply, time.

"Holding stocks for less than a year amounts to little more than flipping a coin," Housel found after surveying broader market data dating back to 1871. "But the odds of success grow perfectly with time. If you hold for five, 10, 15, years or more, the odds of earning a positive return on stocks after inflation quickly approach 100%, historically."

And the authors of the DALBAR study agree, concluding that the best way to avoid market-timing pitfalls is to "adopt a buy and hold strategy that has rewarded prudent and patient investors for decades."

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  • Report this Comment On August 03, 2013, at 6:51 PM, AgAuMoney wrote:

    What if one does not trade often (average less than 2x per month) and one has trounced the S&P 500 over the past 10+ years?

    I invest for the long-term, seeking dividend growth.

    Tho I am not sure I agree with the DALBAR or Housel re. risk vs. time. Studies like those typically use a "random walk" to model returns. That approach is convenient but not realistic.

    Instead of trying to misapply a mathematical model, instead use a logical model. Since there is no limit to the amount of loss in any given year, the gain from increased holding time does not reduce your risk of loss. Instead, a longer holding period increases the risk that a loss will occur, and the amount of loss is determined by chance and the amount invested.

    Yes, that contradicts current academic theory. But theory can be wrong.

  • Report this Comment On August 03, 2013, at 6:55 PM, AgAuMoney wrote:

    Oh, John Norstad has a nice treatise on risk vs time in investing: http://www.norstad.org/finance/risk-and-time.html

  • Report this Comment On August 05, 2013, at 6:03 PM, MartyTheCanuck wrote:

    Overconfidence means bad investors believe they are good. But it's probably true that good investors are confident too, their prior success making that confidence appropriate. The good investors might know their limitations, their circle of competence, but they should be confident too.

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