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

John Maxfield
August 3, 2013

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 (INDEX: ^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 (NASDAQ: DELL), 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 (NYSE: ELN), which is in the process of being acquired by U.S.-based Perrigo (NYSE: PRGO), had performed on