Stock-picking is hard, even for the professionals — and it is only getting harder. A recent study found evidence that it’s getting harder and harder for active mutual funds to outperform index funds. Why? Because the mutual fund industry as a whole keeps getting bigger.
The more investors there are looking for great investing ideas and exciting, underpriced stocks, the harder it is to find anything the rest of the world hasn’t already discovered. In fact, the researchers found that active fund managers are actually getting better: they are more skilled at investing, but it doesn’t matter, because the industry is simply getting too big. Managers have to be more skilled just to keep up with the increasing competition.
If the pros are getting more and more skilled without getting ahead, then why do individual investors think they can beat the market? Data from San Francisco investment firm SigFig shows that the more individual investors trade, the less they earn. Individual investors also tend to bet too heavily on single stocks: 60 percent of investors have more than 10 percent of their portfolio invested in a single stock. Picking stocks and trading actively in an effort to beat the market simply doesn’t work for individuals.
So why do investors keep doing it? What makes people think they can succeed where so many others, including highly educated professionals, are doomed to fail? According to a review of the research on investor behavior, there are three reasons why individual investors engage in the self-defeating effort to beat the market:
1. Investors are overconfident. Research shows that individual investors are overconfident–they think they know more than they do, and they think they know more than the average person. In fact, the more an investor thinks they are knowledgeable about investing, the more they are likely to trade frequently. And, of course, the more they trade, the worse they do. Incidentally, men tend to be more overconfident than women, and tend to trade more often. They are also more likely to lose money in the market than women are.
2. Human emotions get in the way. Individual investors have an unfortunate habit of selling their winners and holding on to their losers. From a tax perspective, it makes more sense to let gains run and sell losing stocks for the tax credit. But individual investors tend to get a little rush of pride when they sell a winner and realize a gain. When they sell a losing stock, on the other hand, they feel pain and regret. Basically, investors hold on to losing stocks to avoid that pain. This effect might be particularly strong for investors who have chosen the stocks in their portfolio themselves and attach their feelings to it as a result.
3. The media encourages ‘herd mentality’ behavior. Investors tend to rush into stocks that receive media coverage. Companies that hit a new stock price high or beat earnings predictions are showered with affection from individual investors, because those news events draw investors’ attention. After all, there are way too many stocks out there for any investor to be knowledgeable about them all. A news story about a stock offers information that some may believe is enough to act on, without going through the trouble of doing additional research.
News stories can also spark selling, of course. A current example are the headlines blaring that Greece is about to default on its debt to the IMF. Investors who sell when stocks start to fall, however, take a loss–and miss the upside when the markets rebound. The best move during a downturn is often no move at all. Stay put, stick to your plan, and keep buying at regular intervals.
If individual investors cannot beat the market — and even professional investors, on the whole, can’t — the best plan isn’t to try. Choose a diversified set of low-cost index funds and stick with them, avoiding the temptation to trade heavily or jump on the latest over-hyped winner. And remember, if you still think you can do better than the average investor, that may just be your overconfidence talking.
•Are You Paying the Price for Bad Investing Advice?
•Dreaming of Early Retirement? Make Your Nest Egg Last Longer
•How to Save and Invest for a House Down Payment
Leave a Reply