Your Brain May Not Let You Be a Smart Investor

Retirement savers often ignore evidence when selecting investments.

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There is an overwhelming amount of research supporting the view that intelligent investing involves capturing the returns of the global market place using low management fee stock and bond index funds in an appropriate asset allocation. This research is exhaustively set forth in my books and those by many others including Burton Malkiel, John Bogle, Jason Zweig, Larry Swedroe, Mark Hebner, Jonathan Clements, and William Bernstein. This investment strategy is endorsed by Nobel Laureates in economics, including Paul Samuelson, William Sharpe, Daniel Kahneman, and Merton Miller.

[See The 10 Best Places to Retire in 2012.]

In an article in the New York Times, David Swensen, the chief investment officer at Yale University and author of Unconventional Success: A Fundamental Approach to Personal Investment, noted that: “For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors.”

For most individual investors, this data and advice has made no impact. They still rely on brokers and advisers to pick stocks, time the markets, and pick hot mutual fund managers, in a quest for market beating returns that have proved to be very elusive. I have often wondered about the inability of these investors to make a fundamental change to the way they invest. Is it greed? Slick marketing? Ignorance? Cognitive dissonance?

Meir Statman may have the answer. He is a professor of finance at Santa Clara University and an expert in behavioral finance, which attempts to explain the reasons why investors make investment decisions. In a recent interview, Statman tackles the question that has been troubling me: Ordinary investors are unlikely to beat the risk-adjusted returns they can get with index funds, so why do they keep trying?

[See Why Investors Make Terrible Decisions.]

Statman believes investors are not just looking for market beating returns. They want status or they enjoy the competitive element to trying to win. They engage in this activity even though, in Statman’s view, “individual investors should treat the market as unbeatable and realize that when they try to beat it, because it is inefficient, they are likely to injure themselves, rather than gain at the expense of another.”

Statman believes investors don’t understand the “nature of the game”. He likens this misunderstanding to the difference between playing tennis against a wall (which is the way most investors view the market) and playing against an opponent with potentially vastly greater skill (like Goldman Sachs).

He also notes the problem with misleading advertising. Mutual funds don’t advertise their losers, only their winners. The implied message is there are a lot of winners. How difficult could it be to select one of them?

[See Your Broker Is Probably a Master of Illusion.]

Finally, he points to the problem with hindsight, which gives investors false confidence in their ability to tell the future. He believes hindsight “fools you into thinking visibility is good.”

Statman concludes that the highest ratio of return to risk is achieved by those who invest in index funds. To those who chase returns by looking for a mutual fund manager they believe will “beat the markets”, he says: “Don't try to tell me you are maximizing return to risk. You are doing it because you like the game. It's hard to admit.”

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.