What Makes Us Bad Investors?
The Motley Fool
Clinton State of the Union, 2000
“We begin the new century with over 20 million new jobs; the fastest economic
growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest
poverty rates in 20 years; the lowest African-American and Hispanic unemployment
rates on record; the first back-to-back budget surpluses in 42 years. And next month,
America will achieve the longest period of economic growth in our entire history.
We have built a new economy. And our economic revolution has been matched by a
revival of the American spirit: crime down by 20%, to its lowest level in 25 years; teen
births down seven years in a row; adoptions up by 30%; welfare rolls cut in half to
their lowest levels in 30 years.
My fellow Americans, the state of our union is the strongest it has ever been.”
[Soon after, markets collapsed and the economy suffered its worst decade in 80 years]
Obama State of the Union, 2010
“One in 10 Americans still cannot find work. Many businesses have shuttered. Home
values have declined. Small towns and rural communities have been hit especially
And for those who'd already known poverty, life has become that much harder. This
recession has also compounded the burdens that America's families have been dealing
with for decades -- the burden of working harder and longer for less; of being unable
to save enough to retire or help kids with college.”
[Soon after, stocks surged.]
What Makes the Market Tick?
0.06 0.06 0.05
0.01 0.01 0 0 0 0
1= Very strong predictability
0= Very weak predictability
Variance of 10-year real stock returns explained by various metrics, since 1928
What Makes Stocks Tick?
• 3,000 stocks from 1983-2011
• 39% of stocks were unprofitable
• 19% of stocks lost at least 75%
• 64% of stocks underperformed the index.
• 25% of stocks were responsible for all the
market’s gains. Source: LongBoard Asset Management
We’re Not Very Good at What We Do …
• In 2011, 84% of actively managed U.S. stock
funds underperformed their benchmark. –S&P
>(20%) (10%)-(20%) 0%-(10%) 0%-10% 10%-20% >20%
Median S&P 500 stock earned more than the benchmark. Majority of
managers concentrated in the minority of losing stocks.
Source: S&P Capital IQ
And It’s Nothing New …
• Vanguard Group: “The percentage of funds that
underperformed the market was 62% for the 10-
year period, 67% for the 15-year period, and 72%
for the 20-year period.”
• "The 50 stocks in the S&P 500 with the
lowest analyst ratings at the end of 2011 posted
an average return of 23 percent [in
2012], outperforming the index by 7 percentage
points." – Bloomberg.
Worst, we are oblivious.
• Franklin Templeton asked 1,000 investors if the S&P 500
went up or down last year.
• 2009: Stocks rose 26.5%. 66% of investors thought
• 2010: Stocks rose 15.1%. 48% of investors thought
• 2011: Stocks rose 2%. 53% of investors thought market
Not as good as you think …
• Markus Glaser and Martin Weber, University of Mannheim.
• Surveyed investors, then checked brokerage statements.
• Lake Wobegon: Most considered themselves above average.
• On average, investors overestimated their annual returns by
11.6% each year.
• Those with lower actual returns were the worst at judging
• “The correlation between self ratings and actual performance
is not distinguishable from zero.”
So, what happened?
• Standard response is that we’ve been through
an unprecedented period, or the market has
changed, or Wall Street has cheated you, or
some other level of blame.
• Reality is that very little has changed. Markets
have been working like this for centuries.
S&P 500 has been one of the greatest
generators of wealth ever known
• $1 invested in 1900 was worth $1,016 by 2013
(annual return of 6.3%).
• $1 in Treasuries was worth $6.36
• $1 in gold worth $1.92.
• $1 in cash worth $0.07.
1% to 10% 11% to
NumberofyearstheS&Phasreturnedthismuch S&P 500 total real return distribution
Buy high, sell low!
• 2007: $85 billion put into stock mutual funds.
• 2008-2009: $230 billion pulled out of stock
• 2013: $68 billion put into stock mutual funds.
The Three Terrors of Investing
• Trying to predict things.
• Not having enough time.
• Cognitive biases.
“It is difficult to
make predictions, especially about
the future." -- Yogi Berra
Economist Alfred Cowles dug through forecasts of
William Hamilton, a popular analyst who "had
gained a reputation for successful forecasting"
made in The Wall Street Journal in the early 1900s.
Among 90 predictions made over a 30-year
period, exactly 45 were right and 45 were wrong.
Examples are everywhere
• 2003-2007, Standard & Poor’s predicted 0.12% of a
certain type of mortgage bond would default.
• In reality, 28% did.
• In 2008, Gazprom CEO predicted oil would soon hit
$250 a barrel.
• It soon hit $33 a barrel.
• In 2008, analysts predict the S&P 500 will earn $94.
• It earned $15.
• In 2010, analysts predict the S&P 500 will earn $53.
• It earned $83.
“Analysts are terribly good at telling us what has
just happened but of little use in telling us what
is going to happen in the future.”
Source: Dresdner Kleinwort
It takes skill to be this bad …
• Ron Alquist and Lutz Kilian, 2007.
• Looked at analyst projections of future oil prices, futures
prices, econometric models, company projections.
• Best predictor of future oil prices is to assume it will be
whatever today’s price is.
• Does it work? Not even close. But it’s better than most
• Studied 27,450 predictions.
• Grand conclusion: Statistically, most expert predictions
are the equivalent of random guesses.
• Most famous = least accurate.
• Least accurate = most confident.
• “Some experts are so out of touch with reality, they're
borderline delusional.” Yet we don’t mind it.
Front page of a Wall Street Journal article, December 2008:
“Igor Panarin posits, in brief, that mass immigration, economic
decline, and moral degradation will trigger a civil war next fall and the
collapse of the dollar. Around the end of June 2010, or early July, he
says, the U.S. will break into six pieces -- with Alaska reverting to
Russian control ...
California will form the nucleus of what he calls ‘The Californian
Republic,’ and will be part of China or under Chinese influence. Texas
will be the heart of ‘The Texas Republic,’ a cluster of states that will go
to Mexico or fall under Mexican influence. Washington, D.C., and New
York will be part of an ‘Atlantic America’ that may join the European
“We need to believe we live in a
predictable, controllable world, so we turn to
authoritative-sounding people who promise to
satisfy that need.”
But we live in an unpredictable world.
Predictions give us a false sense of security that
causes us to take dumb risks.
Three steps to avoiding predictions
-- Carl Richards
• If I make this change and I am right, what impact will
it have on my life?
• What impact will it have if I'm wrong?
• Have I been wrong before?
Time is Everything
-4.4% 0.7% 3.2% 4.7%
23.5% 18.3% 13.0% 10.2% 9.2%
1 2 5 10 20 30 50
Minimum and maximum total real returns by holding period
Source: Robert Shiller.
“Timing the market is a fool’s game,
whereas time in the market will be
your greatest natural advantage." -- Nick Murray.
“If you talk to a lot of investment managers, the
practical reality is they're thinking about the
next week, possibly the next month or quarter.
There isn't a time horizon; it's how are you
doing now, relative to your competitors. You
really only have ninety days to be right, and if
you're wrong within ninety days, your clients
begin to fire you.”
The single most important question an
investor ever needs to ask is ….
How long am I investing for?
Mental misadventures …
• Cognitive biases that lead us astray when
we have the best of intentions.
• They are most pronounced at the worst
• The are very hard to overcome.
• They are almost entirely what separate
good investors from the rest. --Pabrai
• Starting with an answer, then searching for evidence to back it up.
• Munger: “The human mind is a lot like the human egg, in that the
human egg has a shut-off device. When one sperm gets in, it shuts
down so the next one can’t get in.”
• There are thousands of blogs, reports, news sites. Whatever you’re
looking for, you can find it.
• Charles Darwin regularly tried to disprove his own theories, and
was especially skeptical of his own ideas that seemed most
compelling. The same logic should apply to investment ideas.
• Assuming the future will resemble the recent past.
• Flip a coin ten times. Last three flips have almost all control
over your pattern-forming neurons.
• Causes you to fight yesterday’s war while missing that the
world is always changing.
• Why do people buy at the top and sell at the bottom?
Because they extrapolate the most recent experience into the
• When education and training causes confidence to
increase faster than ability.
• Lauren Willis of Loyola Law School: “There is no
reliable empirical evidence that financial-literacy
programs are effective."
• In investing, humility is worth its weight in gold.
Long Term Capital Management. "The young geniuses
from academe felt they could do no wrong.”
Warren Buffett on the firm's sixteen-person
“They probably have as high an average IQ as any sixteen
people working together in one business in the country ... just
an incredible amount of intellect in that group....And essentially
they went broke. That to me is absolutely fascinating.”
Thinking past events were obvious.
Out of literally millions, only a handful of investors truly
saw the financial crisis coming.
If you disagree with that statement and
respond, "No, any idiot could have seen it coming from
a mile away," you're suffering from hindsight bias.
Only after the fact do all the puzzle pieces make sense.
That's why bankruptcies outnumber billionaires.
Risk perception bias
• Attempting to eliminate one risk, but exposing yourself to a
more harmful risk.
• German professor Gerd Gigerenzer estimates that the
increase in automobile travel in the year after 9/11 resulted in
1,595 more traffic fatalities than would have otherwise
occurred. Add in the impact stress had on our health, and the
reaction to 9/11 may have been more deadly than the attack
• "People jump from the frying pan into the fire."
What you can do to avoid biases.
• Avoid most financial news. Almost none of it is
• Talk to others about investments as much as
possible. Especially those who disagree with you.
Read financial news you know you’re going to
• Sleep on every investment idea for one week.
• Use a checklist.
It’s up to you.
“People do not get what they want or what they
expect from the markets; they get what they
deserve.” – Bill Bonner