How Good People Make Bad Investments

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Here’s another article by Jonathan Clements that I enjoyed – How Good People Make Bad Investments from the Wall Street Journal. It points that some traits that help us success in other parts of our lives actually hurt our investing performance.

For example, you would like to think the more energy you put into researching and trading stocks, the better your returns would be. But the research and historical data simply doesn’t support that. Here are some excerpts:

Athletes who train hard are more likely to win. Students who study conscientiously are more likely to get good grades. What about investors who diligently research their stocks? They’ll probably earn mediocre returns.

The fact is, the markets are full of savvy investors, all hunting for cheap stocks. Result: If there are any bargains to be had, they don’t stay that way for long. Indeed, much of the time, share prices are a pretty good reflection of currently available information.

“If you put in more effort, you’ll end up with worse results,” reckons Terry Burnham, co-author of “Mean Genes” and director of economics at Boston’s Acadian Asset Management. “It’s not the work. It’s the action that comes out of the work that’s the problem.”

Every time we buy a supposedly bargain-priced stock, we incur commissions and other trading costs. In addition, if we trade in our taxable account, we may trigger big tax bills, further denting our returns.

[…]

Your index funds will simply replicate the performance of the underlying markets, minus a small sum for fund expenses. Sound dull? You may be more excited when you look at your results — and you realize they’re so much better than those earned by optimistic, hard-working active investors.

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Comments

  1. The argument sounds reasonable, but is the assertion backed up with data or statistics?

    One paragraph starts out that athletes who train hard are more likely to win. I could draw a different conclusion. Many athletes who train hard don’t win. Why because there are many “savy” athletes who “fill the market” and train hard and don’t win. So training hard is useless. Training hard is needed for winning, studying conscientiously is needed for good grades, but those activites don’t assure success. They are generally considered prerequisites for success.

    Peter Lynch wrote in one of his books that the people who run activley managed mutual funds have all sorts of pressures that have nothing to do with picking the best stock.

  2. The assertion is backed up by all kinds of data, but I was too lazy to actually find all the studies 🙂

    Here is a book review that contains a few stats:

    Index Funds: 12 Step Program For Active Investors

    It’s easy to pick apart the article, I could say that my training simply taught me that racing in the stock-picking sense is simply a random walk for the most part.

  3. broknowrchlatr says

    I definately agree with your conclusions. When I was in college, I wanted to figure out how to beat the market. So, I took about $5k and started investing. I spent abou 16 hours a day doing research. Rather than pay attention in class, I would study the market from my laptop. there were about 50-100 stocks that you could ask me about and I would know every detail about how they did business, what affected their stock, and investor sentiment about them. I thought I could make a living out of it. I ended up about $1000 at the end of a year. But, looking at my results, they were basically random. I’d loose 500-1000 or gain that much in a day at random. I was just smart enough to stop while I was ahead.

    As un-elegant as they seem, I’m sticking to mostly index and lifecycle funds now. I’ll get good results (and sleep, too). In about 10 years, I’ll brobably move to a buy and hold strategy. Effectively, though, that will be an effort to make my own index fund.

  4. I totally agree with going with index fund, like vanguard S&P 500 or total market index fund, after getting burnt very badly during the dotcom boom and even as recent as 2005 when I bought nortel and symantec, both burnt me badly. Therefore, I learned my lesson well and well – I would not touch individual stocks any more. I’m not good at anything related to market timing, or anything of a gambling nature. I even bought some American Century mutual funds before, they also lose money. So I get to my conclusion that I will stick with index funds only, and only the index funds show positive returns.

    I’m not saying index fund is perfect for everyone. I just think that I have not been lucky with other options, only index funds have been winners for me. I feel content with index funds. Now I’m chartering other waters, like the vanguard REIT, and life cycle funds. I figured, over the long run, the worst I can do is on par with the market, nothing more, nothing less (less index fund fees), at least I’m not losing like I did with individual stocks and non-index mutual funds.

    For company 401K’s, I max out, and spread out evenly on all the available funds. The international funds have been doing good the past year in my 401k. I have the temptation to rebalance it, but I thought I can afford a bit more risk on 401k as I can’t touch it for anther 25+ years. So let the international fund continue its course.

    Lately I’ve been pondering what’s the best investment vehicle for me? I thought buying an appropriate rental property that could generate both residual rental income plus housing market appreciation would be a double growth engine for my money, but it does not seem to be that sweet, due to the cost of mortgage interest, property maintenance, management, and much headache associated with rental properties, etc. So this ends up with my decision to buy vanguard REIT fund, which invests in property owner and management companies. I hope this will help me to indirectly take advantage of the double growth engine.

    I guess my expectation on the stock market and investment is extremely down to earth (or low, if you will). I don’t expect to beat the market, I will feel fine just riding along with the market.

    Talking about making money, investment is just one way of doing it. For most of us regular joes (that is, before I becoming another “Bill Gates”), a more realistic way is to start something at the side to make some extra money while maintaining a full time reliable income source. After starting my software company for 5 years, without making it much, this is the conclusion that I reached.

  5. Risk-averse investors who want to invest in the market and create their own mutual fund might do a Google search for the Dogs of the Dow technique. Basically you take the 10 stocks on the Dow that pay the highest dividend yields and buy equal parts of each, the once per year, rotate based on that year’s top ten dividend yields.

    The dividends partially mitigate your risk. If a stock falls out of the top ten in yield that means the stock’s price has outpaced the yield (i.e. you’re making money on the stock) or that the dividend has changed for some reason. But since you’re in ten stocks, if that happens, it’s not a portfolio killer.

  6. The Dogs of the Dow underperforms index investing with more risk, so it’s not really a good idea unless you want to mess around.

  7. I disagree. I think you can beat the market by buying blue chip, dividend paying companies when they are undervalued and holding them until and unless something dramatically changes the company’s long-term earning power.

    I’m 35. My horizon is at least 30 years. I can keep my transaction costs even LOWER than an index fund by buying individuals stocks because my turnover will be much lower.

  8. I disagree with the notion that one can’t beat the market. Perhaps for the average investor, it’s better to invest in index mutual funds. However, there are people who are better investors than others. There are people who has the common sense and innate knack for picking the right investments. Otherwise, you wouldn’t have the Warren Buffets and Peter Lynches of the world.

    Of course like what the author of the article indicated, the problem is that we’re a bunch of optimistic investors, the Lake Wobegon investing affect. We over-estimate our ability to invest successfully.

    I self-manage about a 30% of my 401K. In over 5 year period I’ve to doubled the money by simply buying stocks of solid companies that I believe in and hold on to them. And this includes the dot-bomb period. Am I the next Warren Buffet? Of course not, but I do believe individuals can beat the market average.

    Of course, I hedge my bets by putting the rest in in indexed and relatively safe mutual funds.

  9. While I think it’s possible to beat the market, I think it’s very hard to prove it. Even if all portfolio managed picked stocks at random we would end up with Warren Buffets, and Peter Lynchs just as function of normalized distribution. Some people will beat the market year to year just because they are lucky. I don’t actually believe that’s the case but pointing out succesful investors as proof is not that simple. The preface of the Intelligent Investor by Warren Buffet (in my copy) lays out a more credible tenant that if a set investors are consistently succesful because of a correlation to a factor other than success itself (in this case being disciples of Benjamin Graham) then there’s something to be said about beating the market.

    I think everyone wants to beat the market, but I think before having visions of doing so the first step is controlling cost because that’s a no brainer. Index funds, well managed specialty mutual funds (foreign, etc) should be the core of any portfolio before delving into riskier classes such as individual stock holdings.

  10. there’s 2 ways to beat the market – get lucky, or learn technical analysis. I prefer technical analysis. The reality is that if you learn technical analysis well, and have the right tools, you can beat the market in a handful of profitable trades.

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