We’re Not That Smart: Why Humility Wins in Investing
The Trouble
The Overconfident Investor
Andrew, 40 years old, single, and an always-in-demand skilled tradesman in the Greater Toronto Area, believes he has cracked the code for successful stock trading. Armed with flashy charts and tables as well as stories of success he’s read in the Facebook trading pages that he has joined, Andrew is confident that he is on track to spotting the next Tesla or Nvidia.
Image from an active trader platform
The Twist
However, within six months, Andrew’s portfolio, which consists of a single stock position, significantly underperforms the market. Why? Andrew assumed he was smarter than the thousands of analysts working in financial institutions around the world.
Key Point
Andrew exemplifies the many investors who overestimate their ability to “beat the market.” This misplaced confidence leads to poor decision-making, unnecessary risks, and missed opportunities.
How can intelligent, well-meaning investors like Andrew get it so wrong?
The Struggle
The Harsh Reality
Andrew and other investors who invest using unwarranted strategies fail to recognize that it is extremely difficult to beat the market.
The Efficient Market Hypothesis (EMH)
The EMH was first explained by Eugene Fama in 1965. He wrote about it in a paper called “The Behavior of Stock-Market Prices,” published in The Journal of Business. Fama’s work was important because it showed that stock prices reflect all available information at any given time. This means it is impossible to consistently predict stock prices and outperform the market using information that is already known because prices have already adjusted to that information.
Studies show that most active investors, including professionals, do not outperform the market consistently over time. According to the SPIVA Scorecard, which compares actively managed funds to their index benchmarks (SPIVA = S&P Indices Versus Active), a large percentage of active funds underperform their passive counterparts over various periods. For example, over 10 years, nearly 85% of U.S. large-cap equity mutual funds underperformed their benchmark, which in this case was the S&P 500 index. In Canada, it was even worse, with over 93% of Canadian Equity funds underperforming the benchmark S&P/TSX Composite index.
The research firm, Morningstar, publishes an Active vs. Passive Barometer report also supports this, indicating that only about 29% of active US funds survived and beat their average indexed peer over the decade ending June 2024. These findings suggest that it is challenging for active investors to achieve higher returns without taking on additional risk.
Human Biases at Play
When we try to beat the market, our minds often work against us. Human biases can lead to poor choices. They cloud our judgment, making it hard to make smart investment choices and often leading to results that are worse than the market average. Some examples follow:
Overconfidence Bias
Overconfidence bias in investing happens when we believe we know more than we actually do about the market. This often leads us to make risky investments, thinking we will earn high returns. We might trade too often or ignore important information, which can result in poor decisions and lower returns. Overconfidence makes it hard for us to see our own mistakes and learn from them, which can hurt our chances of achieving acceptable long-term investment returns.
Recency Bias
Recency bias in investing happens when we put too much weight on recent events and trends when making decisions. This can lead us to believe that current market conditions will continue. For example, if the market has been going up recently, we might think it will keep rising and invest more money. This bias can cause poor decisions, as it ignores the fact that market conditions can change quickly. It makes it hard for us to stay focused on long-term goals and can lead to losses.
Confirmation Bias
Confirmation bias in investing happens when we focus only on information that supports our ideas and ignore data that disagrees with them. This can lead us to make poor choices because we do not see the full picture. For example, if we believe a stock will go up, we might only look at positive news and miss signs that the stock could go down. This bias keeps us from making balanced decisions and can result in losing money.
Concrete Examples
The Tech Bubble Up to the Year 2000
During the tech bubble leading up to the year 2000, many investors believed they could easily identify “can’t lose” stocks, especially in internet-based companies. This period saw a dramatic rise in the NASDAQ Composite index, fueled by speculative investments and the widespread adoption of the Internet. However, when the bubble burst in 2000, many of these companies, which had little to no profitability, went bankrupt, leading to significant financial losses. It took 15 years for the NASDAQ Composite index to re-reach its bubble-era peak in 2015. This example highlights how human biases, such as overconfidence and recency bias, can lead investors to make poor decisions, resulting in substantial financial harm.
NASDAQ Composite (.ICOMP) 1998-01-05 to 2024-11-22
The GameStop Saga
The GameStop saga in early 2021 is a classic example of how human biases can lead to irrational investment decisions. Energized by social media hype and a desire to challenge Wall Street, investors on platforms like Reddit’s r/wallstreetbets drove GameStop’s stock price from around $17 to over $500 in a matter of weeks. This situation was not limited to GameStop; other stocks like Nokia (NOK) also saw significant, albeit temporary, price spikes (look at the spike in the Nokia chart in January 2021). The rapid rise and fall of these stocks highlight how emotions like greed and fear of missing out can interfere with sound judgement, leading to poor investment choices and financial losses.
GameStop Corp. (GME) 5-year chart (split-adjusted)
Nokia Oyj (NOK) 5-year chart
The Emotional Struggle
Recognizing the efficiency of the markets and our tendency to make poor decisions is a bit of a “gut punch” to those of us who pride ourselves on being rational and competent. If the market is so efficient, does that mean we as individual investors are powerless?
The Insight
The Epiphany
We don’t need to outsmart the market; we just need to work with it.
Passive Investing
Passive investing is a simple way to grow your money without trying to predict which stocks will do well. It involves putting your money into index funds or ETFs (exchange-traded funds), which are like baskets of investments that copy the performance of the whole market or a part of it. Instead of picking individual stocks, you own small pieces of many companies, which lowers your risk and keeps your costs low. This approach lets you benefit from the market’s long-term growth while avoiding the stress of guessing which investments will succeed.
Passive investing is an approach where a fund or ETF simply copies the performance of a broad market index, like the S&P 500, rather than trying to do better than the market. It is called “passive” because the managers do not make regular changes to pick winners or avoid losers. Instead, they follow the index.
Why This Works
- Lower Costs: No need to pay for expensive fund managers or frequent trades.
- Risk Mitigation: Broad diversification spreads risk across many sectors and geographies.
- Efficiency: Fewer decisions mean less chance of falling victim to emotional trading.
Simple Analogy
Active investing is like trying to choose the one horse that will win a big race, where the chances are not in your favour. Passive investing, instead, is like betting on the entire group of horses—your success depends on how well the whole field performs overall.
Key Takeaway
Investing isn’t about being the smartest person in the room; it’s about following a strategy proven to work over time.
The Joyful Resolution
The Beauty of Simplicity
A disciplined, passive investing approach can bring a sense of peace and freedom. Instead of worrying about the daily gyrations of the investment markets or feeling pressure to pick the next winning stock, we can trust that our investments are working steadily over time. By simply following a plan that tracks the market as a whole, we can reduce stress and save time, knowing that we are participating in the long-term progress of the global financial system.
Furthermore, when we accept that we don’t need to beat the market, we can focus on the things that really matter. We can spend our energy on saving more, managing our spending habits, deciding on an asset allocation, that is, how to split our investment money between stocks, bonds, cash, and other forms of assets, and setting clear goals for our respective futures. These are the choices that we can control and that make the biggest difference in reaching our financial dreams.
A Personal Transformation
Let’s return to Andrew, who decided to follow a low-cost, disciplined, and globally diversified investment strategy. Over the past year, his portfolio has grown steadily, tracking the overall market without the need for constant adjustments or risky bets. Andrew no longer feels anxious when markets drop or jump unexpectedly. He’s stopped worrying about missing out on the latest hot stock or investment trend, knowing his long-term plan is built to handle both ups and downs. Instead of spending hours trying to find the next winning stock, he focuses on other parts of his life and finances that he can control, like increasing his savings. This shift has not only improved Andrew’s financial health but also brought him a greater sense of calm and confidence in his future.
The Unexpected Benefit
The humility to admit “I’m not smarter than the market” leads, somewhat paradoxically, to smarter financial decisions overall.
The Call to Action
Investing wisely doesn’t mean being a genius; it means being disciplined. Embrace humility, let the market work for you, and focus on what truly matters: using your financial goals as a means to live the life you value, whether that’s enjoying retirement, supporting causes close to your heart, or helping loved ones pursue their dreams.
If you’re unsure where to start, consider speaking with a financial planner who can guide you.
This is the 270th blog post for Russ Writes, first published on 2024-11-25
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.
Photo by Kindel Media