There's little doubt that the average investor would be better off buying passive exchange-traded funds than individual stocks. Studies have shown that most people trade stocks too frequently and, even more precariously, have an unfortunate knack for buying high and selling low.
At the same time, it's also clear that few investors would throw in the towel, so to speak, and admit this is true in their particular case. Are they lying? Not necessarily. Instead, they're just overconfident in their own abilities.
The origins of overconfidence
If you're a regular reader of The Motley Fool, then you've probably come across this idea before. In the middle of last month, my colleague Morgan Housel identified overconfidence as an investor's greatest enemy. "The average investor painfully lags an index fund [yet] thinks he's Warren Buffett," Morgan quipped.
There are multiple explanations for this belief. In the first case, the idea that past events seem orderly and predictable with the benefit of hindsight leads us to believe that future events can be confidently foretold as well. In the second case, overconfidence protects our egos from being bruised by the reality that many of us aren't, in fact, any good at picking stocks.
But scariest of all, most investors have no idea how they're doing in the first place. One analysis found that the average investor overestimates his or her returns by more than 11 percentage points per year. And an annual study by Franklin Templeton Investments has consistently found that, with the exception of 2012, more than half of the 1,000 investors surveyed each year didn't know whether the S&P 500 (^GSPC -0.88%) was up or down over the previous calendar year.
But while all of these explanations are insightful, there's at least one that's eluded recognition: laziness. As Daniel Kahneman discussed in Thinking, Fast and Slow: "[M]any people are overconfident, prone to place too much faith in their intuitions. They apparently find cognitive effort at least mildly unpleasant and avoid it as much as possible."
Laziness and stock-picking
Identifying stocks that will outperform the market is far from easy -- and this is assuming that it's even possible to do so in the first place. It takes conscious and consistent mental effort. And it's physically draining. "The evidence is persuasive," Kahneman writes, that "activities that impose high demands on [one's analytical thought process] require self-control, and the exertion of self-control is depleting and unpleasant."
The problem is that most people aren't professional investors. They have day jobs. They're doctors, lawyers, engineers, entrepreneurs, you name it. As a result, the demands of their professions consume their energy, leaving little for the strenuous type of security analysis recommended by the likes of Benjamin Graham.
It doesn't help, moreover, that most people are instinctively lazy. "[I]f there are several ways of achieving the same goal, people will eventually gravitate to the least demanding course of action," Kahneman observed. "Laziness is built deep into our nature."
But herein lies the catch. While most investors are either too drained or too lazy to perform proper stock analysis, very few are willing to admit it. To bridge the gap between these otherwise dissonant realities, in turn, they rely on artificially bolstered self-confidence.
According to the authors of Mistakes Were Made (but not by me), "people will bend over backward to reduce dissonance in a way that is favorable to them and their team. The specific ways vary, but our efforts at self-justification are all designed to serve our need to feel good about what we have done, what we believe, and who we are."
Investors' worst enemy: laziness
At the end of the day, there's nothing wrong with being a lazy investor. Life happens. You have plenty of other things to spend your energy on than calculating a specific company's free cash flow. Yet it's important to recognize this for what it is, and, critically, not to subconsciously compensate with overconfidence.
Plenty of investment products are specifically designed to reward lazy investors -- think passive exchange-traded funds such as the SPDR S&P 500 (SPY -0.87%) or its higher-yielding counterpart, the SPDR S&P Dividend (SDY 0.91%). Alternatively, absent blind luck, few individual stocks will do the same.
