If this is such a well-known fact, why do we so enthusiastically consume speculative commentary on the markets? Or rather, why do we believe that we can make the jump from "expert speculation" to successfully timed investment?
The field of behavioural finance strives to answer questions like these with a scientific approach. On an individual level, we can also perform a thought exercise to find our personal stumbling blocks. Here's my list. I encourage you to think about your own, and share them in the comments.
In no particular order:
- It's comforting to believe that someone has an expert handle on this stuff. In many parts of our lives, we make use of products and services that we do not fully understand. In many ways this requires a leap of faith. For instance, that cell phones are safe and are not causing us brain tumors, that the formula we feed our babies is a good substitute for breastmilk, or perhaps that the water filter we just bought makes the water more fit for drinking (how many people know what those filters actually do?). We assume that somewhere along the way, some experts have proved that the products we use do what they say the do (and don't do anything else). In financial matters, where are our experts, and where is their proof?
- We're all above average (the Lake Wobegon Effect). Since I'm smarter than the average person, I can make use of information to formulate and execute a superior plan.
- Spectacular stories of people who have made it big. Is it luck? Is it skill? I don't know, but every once in a while, we'll hear about someone who bet it all and made a fortune. We all want to be that person.
- Market timing is fun and exciting. Feel the thrill of a money-making trade! Quickly forget the rest.
- Not tracking personal portfolio after-tax performance against a representative benchmark. You might think that you did a great job earning a 10% return, but if your benchmark (not a benchmark of your choosing, but a representative benchmark) returned 12%, you actually did poorly.
- Lack of understanding of the investment products. Sure, you could read about bonds, stocks and other investment instruments so that you could judge investments for yourself, but isn't it easier to just take the recommendations of experts? They're experts, after all.
- We don't know the track record of experts' opinions. This is a complicated issue:
- We need to separate a commentator's own advertised performance (maybe through the fund he/she manages) from the performance of the expert's recommendations that we hear or read about.
- The "experts" may make frequent recommendations. Make enough guesses frequently enough and you'll eventually get it right. Maybe we should count each recommendation as a buy or sell execution in our tracking system.
- Recommendations on an investment does not make a portfolio. Did Mr. Expert recommend buying ABC 5 years ago? Has he said anything about it since then for those who added it to their portfolio? Maybe your expert concentrates only on tech stocks and consequently a portfolio of his recommendations would be unbalanced.
- No indication of investment horizon. This is linked to (b) and (c) above. Maybe you buy something based on a recommendation. How long is that recommendation supposed to stand for? Maybe a new recommendation (based on better information, of course) will be made soon (b). Or perhaps your expert will become bored with that particular security and you'll never hear about it again (c).
- There are lots of other issues I invite you to think about, but the point is that until we have a good way of tracking the experts' opinions, we don't have a basis for taking their recommendations.
When it's so easy to make very close to benchmark earnings, and study after study shows that the average investor is making less than that, it is really an interesting exercise to think about your own situation and decide how average you want to be.
