Studies have shown that the typical investor underperforms the broader market. Why is this? It's because we tend to make decisions based on emotions, not reason.
In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and contributor John Maxfield dig into the dynamics of the ideal investor's thought process.
A full transcript follows the video.
This podcast was recorded on Sept. 21, 2016.
Gaby Lapera: People are bad at making decisions. John and I were talking before the show started about something called the Dalbar studies. Do you want to expound on that, John?
John Maxfield: Critical thinking really impacts all aspects of our life, but what's so interesting about investing is that you can actually study the quantifiable impact of how good your thought process is. That's what the Dalbar study, among other studies, allows you to do.
What the Dalbar study does is, it compares how it uses a proxy for an individual investor's performance, and it compares it to the broader market, the S&P 500. What they have found over the years -- they've been doing the study for multiple decades -- is that the typical investor underperformed the S&P 500 by about half. So, the S&P 500 in the last couple decades has returned 8%, the average investor has returned 4%. And what they have found is that the reason for this all boils down to the way investors make decisions.
Lapera: The problem with the way a lot of investors make decisions is that they're making decisions based on emotions, rather than rational, evidence-based, thought-out ideas. This is something that Warren Buffett harps on all the time.
Maxfield: Yeah. What scientists have found -- and behavioral finance has really become a popular study over the past couple of decades, as the efficient market hypothesis has left the scene -- and what they have found is that the human brain is designed to make emotional decisions. This goes all the way back to when we were cavemen and cavewomen. If you were scared of something, you didn't sit down and analyze whether it was rational to be scared of, say, I don't know, a sabertooth lion?
Lapera: Those are sabertooth tigers.
Maxfield: Yeah, sabertooth tigers, whatever they were! (laughs) You acted instinctively, you were scared and you immediately ran. And that whole process, that didn't just stop when we were cavemen. It still impacts how the human brain works today.
Lapera: Correct, it's your fight-or-flight response. And not just that, but humans in general, because we have to make snap judgments -- or our ancestors had to make snap judgments in order to keep themselves alive -- we tend to make a lot of shortcuts in our thinking. So, for example, I was at the barn the other day, and I wasn't really paying attention, but out of the peripheral of my eye, I see something sliding across the ground. And without even thinking about it, I jumped up -- jumped back in the stall with the horse, and the horse was staring at me like I was crazy. And I looked down, and it's just a hose that someone was dragging farther down the hallway. I thought it was a snake. My mind took the circumstances and thought, "Green sliding thing on ground = snake." It didn't think, "It could be a hose, it could be any number of things." It was that instinctual taking very little information and fitting it into a mold that already exists and spitting something out, without critically evaluating what was going on. Like John said, that was a great survival mechanism back in the day, but not a great way to invest.
Maxfield: That's such a great example, because it really boils down to, you're talking about shortcuts. In the behavioral finance literature, they call these behavioral biases. There's things like authority bias. Let's say you read an article by somebody you consider to be an authority, as opposed to going out and doing your own independent research, you will just rely on them because you think they are an authority. Well, there could be a problem in their thought process. But we can't sit down and analyze every single thing to death, every decision that we have in our life. So you have to make shortcuts. And that's fine -- 80% of the time, that's going to be fine, because you're just deciding whether to stop at a red light, who should go first at a four-way stop, whatever it is. Those are instinctive, you don't have to analyze those. But there are certain decisions where you have to slow down your process, think things through logically, and come to a more reasoned opinion. And that's really where that critical thinking is. And when you do that, you are in a better position to avoid the behavioral biases or shortcuts that could otherwise lead to a bad decision.
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