Why You Suck at Investing

["Dave Farber" <dave () farber net>]

------- Original message -------
From: Barry Ritholtz  <ritholtz () optonline net>
Sent: 31/3/'05,  7:41

Hey Prof,

I thought the IPers might find a different perspective on Social
Security reform interesting:


The discussion of the private accounts side of Social Security Reform
(as opposed to strengthening its finances) relies on a single premise:
That Human Beings are rational economic participants.  That's the
theory underlying a range of behaviors, from retirement planning to
privitization schemes.

Problem is, it has been very well documented as false.

Humans are terrible at making the risk/reward analysis. As a species,
we are emotional, tend to have a very weak comprehension of time beyond
hours or days, are given to herd behavior, and have an awfully good
ability to self-rationalize. Oh, and we are just a tad on the emotional
side.

These reasons (and others) are why most people do such a lousy job at
handling their own investment monies. Its not just mom and pop, though
-- most pros stink, too. 80% of all professional money managers
underperform the S&P 500. Making it even more complex, its a different
80% that underperform each year!

I suspect most people know this intuitively. It's a large part of the
explanation why a majority of the public prefers a guaranteed insurance
plan (the current Social Security structure) versus private accounts
(The President's plan for privatizing risk).

If you want more details as to why Humans are not hardwired for the
capital markets, see these comments:


> Why You Suck at Investing
> http://bigpicture.typepad.com/comments/2005/03/you_suck_at_inv.html
>
>
> USA Today had an interesting article this past week (it happens). The
> discussion was on the fact that Most Americans no good at investing.
> A more accurate title would have been "Humans not good at investing."
> There's a very specific reason for this; It is something I am in the
> middle of writing up, and will address very soon in print.
>
> Meanwhile, here's an excerpt:
>
> ?"A study by Hewitt Associates that analyzed the 2003 investment
> behavior and account activity of 2.5 million employees eligible for
> 401(k) plans exposes a trove of investment mistakes by average
> investors:
>
> ?* Three out of 10 employees eligible for 401(k) plans don't
> participate, Hewitt says. That means investors are passing up free
> money in the form of matching contributions from their employers.
>
> ?* Despite horror stories about employees at scandal-scarred companies
> such as WorldCom and Enron having their 401(k) accounts wiped out
> because they had all their money riding on their own company's stock,
> 27% of 401(k) investors still have more than half of their money in
> their employer's shares.
>
> ?* And proving that investors are hardly hands-on, only 17% made
> 401(k) transfers in 2003.
>
> ?Another Hewitt study, done in fall 2004 with Harvard University and
> the Wharton School at the University of Pennsylvania, found that a
> "non-saving mentality" persists. The study focused largely on "low
> savers," those who do not stash enough in their 401(k)s to earn the
> company match. When "low savers" learned they were passing up $1,200 a
> year in matching contributions, one-third said they intended to raise
> their savings rate. Only 15% actually did."
>
> This factor, more than any other reason, explains why the President's
> Social Security Privitization idea has generated so little positive
> response amongst most Americans.
>
> Put aside the Social Security issue for a moment. I find the argument
> that people are not hard wired to be investors is quite fascinating.
> Wall Street uses a variation of this to suggest "professional
> management;" indexers use it to argue against active management;
> discount brokers say if you can do as well as the mediocre pros, then
> why pay big commissions?
>
> All of these positions miss the bigger picture: Why are Humans Beings
> so ill suited to investing?
>
> I first came across one of my favorite explanations as to why we
> simply aren't hardwired to undertake risk reward analysis in capital
> markets many years ago; It was from Michael Mauboussin , now Legg
> Mason Funds chief investment strategist, formerly chief U.S.
> investment strategist at Credit Suisse First Boston. In a cogent and
> persuasive manner, Mauboussin explains
> <http://www.capatcolumbia.com/Articles/FoFinance/Fof2.pdf> the reason
> why: "the mind is better suited for "hunting and gathering" than it is
> for understanding Bayesian analysis."
>
> Simply put, you just ain't built for it. Mauboussin breaks down the
> emotional and psychological impediments into 7 subtopics:
>
> ?· Desire to be part of the crowd.
> ?· Overconfidence.
> ?· Inability to assess probabilities rationally.
> ?· We love a story, especially when it links cause to effect.
> ?· Use of heuristics, or rules of thumb.
> ?· Chance.
> ?· Fitness landscapes and the role of the inductive process.
>
> Each of these are explained in more detail, but the bottom line
> remains: Most people simply do not posses the counter-intuitive
> skillset, or the emotional detachment, or the discipline required for
> long term outperformance in the markets . . .





Source:
Most Americans no good at investing
<http://www.usatoday.com/money/perfi/general/2005-03-23-investing-
cover_x.htm>
Adam Shell
USA TODAY, Posted 3/23/2005 12:12 AM
Updated 3/23/2005 1:14 PM
http://www.usatoday.com/money/perfi/general/2005-03-23-investing-
cover_x.htm

What Have You Learned in the Past 2 Seconds?
<http://www.capatcolumbia.com/Articles/FoFinance/Fof2.pdf>
Michael Mauboussin
March 12, 1997
http://www.capatcolumbia.com/Articles/FoFinance/Fof2.pdf





Cheers



Barry L. Ritholtz
Chief Market Strategist
Maxim Group
405 Lexington Avenue,
New York, NY 10174
(212) 895-3614
(800) 724-0761
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
The Big Picture: Macro perspectives on the Capital Markets, Economy,
and Geopoliticsá
http://bigpicture.typepad.com/comments 

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