The efficient market hypothesis contends that it is not possible to consistent beat the market on a risk-adjusted basis, as overall people are rational and all of the information available is already priced in the investment values.
On the flip side, the field of behavioral finance contends that humans are inherently irrational, and we, well, do stupid things. Here’s a list of such stupid things. I don’t know about you, but I think some of them definitely apply to me.
- People remember losing a dollar a lot more than gaining a dollar. The losses stick with you.
- You care how much you paid for a stock, and take into account if you are gaining or losing when deciding to sell, when in reality it really shouldn’t matter. Your selling price should only matter on the fundamentals of the company.
- People tend to buy investments when they have had a recent run of good performance. Most mutual fund purchases are made in the funds that have the best 1-year returns.
- Overconfident investors tend to trade too much and underperform the market.
I definitely would agree that the losses stick with you. It’s the same with gambling, which is pretty close to what short-term trading is anways.
In my limited individual stock trading, I definitely do care about my original buy price. I love seeing the green Up arrows in my Yahoo! Finance tracker, and hate to see the red Down arrows in the overall Gain column. It’s true, I know it shouldn’t matter, but it does. Hmm.
So who performs the worst?
You may think that the worst investors are the more uneducated ones. Surprisingly, a study by Vanguard of their 401k account holders revealed that the worst-performing accounts belong to those people with the highest education, the highest incomes, and who rate themselves as the most skilled investors.
On other words, they think they know what they’re doing, but they don’t. That’s the worst kind of investor (and gambler!) to be. I got this tidbit from the previously-mentioned book All About Asset Allocation, but I can’t find any mention of it online.
Something to chew on.