Inexplicable Behavior Explained

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For many years, I’ve viewed the behavior of most investors as inexplicable. Here’s a summary of their bad choices.

Bad choices

You rely on brokers for the most critical financial decisions in your life, even though they have no obligation to place your interest above theirs. They can (and often do) have conflicts of interest, which they don’t have to disclose, much less resolve in your favor. You could avoid this issue entirely by only doing business with registered investment advisors, but most of you don’t.

You reject simple investment solutions that are likely to outperform the stocks, bonds, mutual funds and complex, opaque investments recommended by your broker, even though the returns on index funds have historically outperformed your returns and are likely to do so in the future.

I’m not suggesting Vanguard’s Balanced Fund (VBIAX) is suitable for everyone, but let’s assume it was the only investment you ever made for both your retirement and after-tax accounts. Since inception (on November 13, 2000), it’s average annual performance is 6.13%. It’s expense ratio is only 0.07%. The fund invests roughly 60% in stocks and 40% in bonds by tracking two indexes that represent broad barometers for the U.S. equity and U.S. taxable bond markets. Because of its asset allocation and broad diversification, the fund is suitable for investors who can tolerate moderate risk.

What are your long term-returns, using a far more complex strategy and relying on “expert” advice?

You buy actively managed funds, where the fund manager seeks to outperform a designated benchmark index. More often than not, and especially over the long term and after taxes, the fund underperforms a less expensive, comparable index fund.

Not only do you pay significantly more for the actively managed fund, you agree to fees based on assets under management, which makes no logical sense. Since you can capture the returns of the index (less low management fees) with 100% certainty, the fund manager should only be rewarded when the returns of the fund beat the returns of the index. Yet you pay a fee that rewards the fund manager even when the returns underperform the index.

You listen to “gurus” who make all kinds of predictions about the direction of the market and how individual stocks will perform in the future, despite the overwhelming evidence they are emperors with no clothes, touting an expertise that doesn’t exist.

I could go on (investing in hedge funds comes to mind), but you get the drift.

Why you make bad choices

While this behavior seems irrational, here’s an explanation for it.

According to a blog post by Tom Scheve, stress may be the culprit. It seems we’re hard wired to avoid making bad choices. This fear causes us to experience high levels of stress which, in turn, clouds our judgment.

Scheve notes we’re likely to make better choices in a game of high stakes poker when playing with matchsticks, instead of real money. Our brain isn’t distracted as much and we’re thinking more clearly.

We’re also more tempted by the possibility of immediate gratification than long-term rewards. This may explain why so many investors chase returns and react to current news.

We tend to place undue importance on choices of people we know, rather than on average outcomes. This is particularly harmful to investors, who may be influenced more by a friend who “scored big” with a risky investment, than by data supporting a buy and hold strategy over the long term.

Scheve makes this compelling observation that should resonate with you: “Bad information leads to bad choices.” If you’re relying on a broker who inundates you with expensive investment choices, or dangles the possibility of high returns without explaining commensurate risk, it’s unlikely you’ll make an objective, intelligent decision

Here’s the bottom line: You can overcome investment decisions only when you understand the factors that subtly influence them.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

Any data, information or content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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