Is Your Brain a Barrier to Smart Investing?

The evidence showing that most individual investors significantly underperform the market is compelling. A study done by Dalbar, a leading financial services market research firm, found that, during the 20 years from 1991 through 2010, the average stock fund investor earned returns of only 3.83% per year, while the S&P 500 returned 9.14%.

The ramifications of this study are startling. It’s very easy to capture the returns of the market. All you have to do is purchase index funds that track the returns you are seeking to replicate. You will pay low transaction fees, but your returns should be pretty much in line with the indexes.

There is overwhelming support for buying a globally diversified portfolio of low management fee index funds in an asset allocation suitable for you. It is summarized in my new book, which is co-branded with Mint.com, The Smartest Money Book You’ll Ever Read. Yet, most investors stubbornly ignore this research and persist in stock picking, market timing and trying to find the next “hot” mutual fund manager, often with the encouragement of their broker or investment advisor. The results of pursuing these flawed strategies are predictable, as indicated in the Dalbar study, chasing returns and trying to predict the random moves of the stock market are disastrous strategies for investors.

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.”

The financial media plays an insidious role in misleading investors. It is largely premised on the purported ability of stock market pundits to make sense of random events and predict the future. At year-end, these pundits make their predictions for the following year. They give us their views on where the Dow is headed or pick stocks that are likely to outperform. Sometimes they are right but often, they are wrong. There is no way to tell into which category their current predictions will fall.

The question is: Why do so many investors repeat the same mistakes year after year? Is it collective cognitive dissonance? Is the enticement of hundreds of millions of dollars of advertising by the securities industry too powerful to resist? Is there an irresistible desire by some investors to engage in socially acceptable gambling?

While all of these factors may play a role, it turns out that your brain may be the biggest barrier preventing you from becoming a successful investor. Consider this:

You Seek Order When None Exists

Daniel Kahneman is an Israeli-born psychologist and winner of the 2001 Nobel Prize in economic sciences and he is best-known for his work in behavioral economics, which attempts to explain how investors make decisions. In a thoughtful article adapted from his book, Thinking, Fast and Slow, Kahneman reached this insightful conclusion: “We are prone to think that the world is more regular and predictable than it really is, because our memory automatically and continuously maintains a story about what is going on, and because the rules of memory tend to make that story as coherent as possible and to suppress alternatives.”

The stock market is random and unpredictable and efforts to seek order and direction are likely to undermine your returns.

You Confuse Luck with Skill

When stock gurus get it right, they attribute their accurate predictions to skill. Their success is most likely due to luck, as indicated in studies by well-credentialed authors. The subtle difference between luck and skill is lost on many investors, who are quick to anoint the next investment guru. Kahneman’s study (reported in the same article) led him to his conclusion: “The results [of the performance of wealth advisers over an eight year period] resembled what you would expect from a dice-rolling contest, not a game of skill.”

Your Level of Confidence is Not Reality-Based

According to a recent blog by David B. Armstrong in USNews.com., 80% of the drivers surveyed in Sweden thought they were better than average drivers. Most investors probably feel the same way. The Dalbar and other studies demonstrate that most investors are below average, if you consider “average” as the ability to capture the returns of the market. This level of overconfidence leads to poor investing decisions which are not based on peer-reviewed research.

Your Emotions Overcome Your Logic

Most investors find the “agony of defeat” (losing money) more intense than the “thrill of victory” (making money). Armstrong notes that this reaction to losses causes emotions to overtake logic, resulting in bad investing decisions.

You Can’t Resist the Thrill of the Hunt

According to Meir Statman, a professor of finance at Santa Clara University and an expert in behavioral finance, many investors enjoy the competitive element involved in to trying to “win.” They pursue efforts to obtain outsized gains with their investments 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.”

The next time you are confronted with an investing decision, remember that you may be influenced more by the involuntary reaction of your brain than the solid research which should be your guide.

Do you have a question you’d like to have answered by Dan Solin? Join us on the Mint.com Facebok page on January 11th for a LIVE reader Q&A session with Dan. In the meantime, you can submit your questions to editor@mint.com

Dan Solin is a Senior Vice-President of Index Funds Advisors (ifa.com).  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, The Smartest Retirement Book You’ll Ever Read and The Smartest Portfolio You’ll Ever Own.  His new book, The Smartest Money Book You’ll Ever Read, will be released January 3, 2012. You can buy the book at several retailers and in various formats, including: Amazon, Barnes & Noble, Nook and  iBooks.

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.