A Rational Explanation for Irrational Investing

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It can be frustrating being an advocate for evidence-based investing. The data supporting a simple buy-and-hold strategy (with periodic rebalancing) of a globally diversified portfolio of low-management-fee index funds is overwhelming.

Few investors understand the data

In his recently released book, Simple Money, my colleague, Tim Maurer, notes that "if you invested $10,000 in the U.S. stock market in 1926 and 'let it ride,' you'd have roughly $40 million today, 87 years later."

In my book, The Smartest Investment Book You'll Ever Read, and in this article, I explain how you could implement this tried-and-true strategy by purchasing only three index funds directly from Vanguard or other fund families.

As Maurer observes, the annualized rate of return for the U.S. stock market since 1926 has been approximately 10 percent per year. In stark contrast, one analysis found that the average investor earned an annualized return of a measly 2.1 percent for the 20-year period from 1992-2011. During that same period, the S&P 500 index earned 7.8 percent.

Why investors chase returns

While the trend toward investing in index funds is encouraging, most investors continue to chase returns, relying on brokers who claim to be able to "beat the markets." The reason is simple: Brokers are motivated by commissions. Bouncing in and out of stocks and mutual funds generates more income for them, often at the expense of their clients.

Why do so many investors fall for the lure of active management? One study, Social Transmission Bias and Active Investing, may have an explanation. The authors, Bing Han and David Hirshleifer, focused on the social aspects of investing. They noted that investors like to discuss their investing outcomes in social settings and in blogs and chat rooms. The study found these discussions conveyed the perception that investing actively (trying to "beat the market") generated higher returns than index-based investing.

Unfortunately, as the study found, investors tend to exaggerate their successes and minimize their losses. When this misinformation is conveyed, recipients often believe it's accurate and seek to emulate the "successful" outcomes.

As noted by Robin Powell in his blog on this study, "active investors are, quite literally, talking each other into investment behaviour that, over the long term, will produce lower returns than simply buying and holding index funds."

Investors overstate returns

There's ample evidence that investors overstate their returns. One study found that individual investors were unable to accurately estimate the returns of their portfolios. It also found investors who had fared poorly made terrible estimates of their individual returns. In the sample studied, more than 25 percent of investors had negative returns but less than 5 percent believed this was the case.

A perfect storm

This is the perfect storm for investors and a bonanza for the securities industry:

  • Your broker encourages you to try to beat the market because that strategy generates more fees.

  • Your social acquaintances extoll the merit of active investing by focusing on their "winners."
  • The financial media reinforces the benefits of active management because it's in the interest of its advertisers to do so.
  • You don't realize your actual returns are most likely lower than you would obtain by purchasing a globally diversified portfolio of low-management-fee index funds.
  • It's the best explanation I've found for why so many investors continue to ignore the odds and chase returns.

    Dan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.

    The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.