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June 13, 2005

Investor Behavior for Beginners

Barry Ritholtz writes:

Apprenticed Investor: Know Thyself: Statistical evidence suggests a high probability that you underperformed the broader market last year, and most investors will likely underperform again this year. But it's not just retail investors. The pros are barely any better. In fact, four out of five investors will do worse than the S&P 500 this year.

The problem, it seems, is a design flaw.

Indeed, many classic investor errors -- overtrading, groupthink, panic selling, marrying positions (i.e., refusing to sell), chasing stocks, rationalizing, freezing up -- are mostly due to our genetic makeup. Humans have evolved to survive in a harsh, competitive landscape. To do well in the capital markets, on the other hand, requires a skill set that is very often the antithesis of those innate survival instincts.... [W]hen it comes to investing, humans just ain't built for it....

Humans have a tendency to see order in randomness. We find patterns where none exist. While that trait might have helped a baby recognize its parents (thereby improving the odds for its survival), seeing patterns where none exist is counter-productive when it comes to investing. We also selectively perceive data, hoping to find something that confirms our prior views. We ignore data that contradicts those prior views. We even reinterpret old evidence so it is more in sync with our perspective. Then, we only selectively remember those things that support our case. Last, we overuse Heuristics, which is defined as simple, efficient rules of thumb that have been proposed to explain how people make decisions, come to judgments and solve problems, typically when facing complex problems or incomplete information (call them mental short cuts). These short cuts often generate "systematic errors" or blind spots in our analytical reasoning....

The vast majority of human history has been spent learning to survive, not analyze P/E ratios. Learning to fight nature won't be easy. To outperform, you sometimes must go against the crowd, despite the appeal and seeming safety in numbers. You must be humble and willing to admit error; meaning you'll have to overcome your ego's predisposition to avoid embarrassment, so as to maintain status amongst your tribe (and thereby enhance survival probabilities).

Most investors are overconfident to a fault. Don't believe me? Consider the following anecdote: A man was terrified to fly, yet thought nothing of roaring down the street -- sans helmet, no less -- on his Harley. That reveals a high degree of confidence in his own skills vs. a highly trained pilot's. That's some risk-analysis engine you got there, bub. That blind faith in our own abilities... is hardly beneficial when to comes to picking stocks. And that's before we even get to the "flight or fight" response. Our natural instinct during periods of volatility is to stop the pain, not to endure it with patience. The natural reactions to discomfort or threat -- coupled with a natural inability to be patient -- doesn't serve us well in the market. During market bottoms, most of the herd is selling. To buy during periods of intense selling means leaving the safety of the crowd, standing out, risking humiliation.

We simply were not designed for that.

This overconfidence leads to the optimistic yet misguided belief that most of us can beat the market. We must believe we can outperform the major indices. Otherwise, the rational thing to do would be to simply buy a major index and forget about it.... Most investors -- the 80% who underperform -- would probably be better off going the index route. If you're still interested in trying to outperform -- despite all we discussed today -- then I admire your gumption....

Posted by DeLong at June 13, 2005 09:21 PM