Many Investors Are Hopeless Cases

The evidence goes far deeper than just your personal fears, writes MoneyShow's Howard R. Gold, also of The Independent Agenda, and the experts have a number of possible reasons why.

OK, individual investors, do me a favor: go to the mirror and take a good, long look.

Now tell me honestly that you really know what you’re doing with your money.

Not too many of you left? I thought not.

Two huge bear markets, a housing depression, a financial crisis, and sudden market blowups from the flash crash to the Facebomb have sent investors fleeing in terror from stocks, which seemed to offer the promise of easy riches in the 1990s.

But I also suspect many people have realized that investing—or at least active investing—just isn’t for them.

That wouldn’t be surprising, given the findings of a 2011 study by two leading academic experts on individual investors’ behavior.

Brad Barber of UC Davis and his colleague Terrance Odean of Berkeley examined nearly the entire body of research on how individuals invest, covering more than 40 studies.

This is much more than just the usual “review of the literature”; it’s a painful catalogue of how individual investors make every mistake in the book and wind up either losing money or badly trailing no-brainer index funds.

Among the various sins that investors commit—and which cost them dearly—are:

• Trading too much, incurring big fees that more than wipe out their gains
• Selling winners while clinging to losers
• Focusing too much on individual stocks and not diversifying their portfolios enough
• Falling for stocks that get extensive media coverage or are trading near their highs
• Engaging in thrill-seeking behavior that confuses investing with speculation or gambling
• Trading or investing in financial instruments they don’t understand
• And, finally, despite all of the above, believing in their own superior investing ability

This is not everybody, of course—just the vast majority of those who try to actively manage or trade their own money.

Examining a huge database of trades made in Taiwan from 1992 to 2006, Barber and Odean and two colleagues concluded that though the best traders could beat the market after transaction costs, “other investors underperform appropriate benchmarks by a bit more than...3.6% annually...after costs, with about half of the shortfall being traced to trading costs and half to bad stock selection.”

And how many of those “best traders” beat the market after expenses? 10%? 20%? Actually, Barber told me, it’s closer to 1%. Pathetic.

Obviously too much trading racks up fees that make it harder to match the return of low-cost index funds. But individual investors also are very bad stock pickers.

Read Howard’s take on why individual investors shouldn’t buy individual stocks.

They tend to focus on glitzy stocks that make for good cocktail party conversation rather than companies that produce solid earnings and hike their dividends regularly. Bragging about that would put your neighbors to sleep out of sheer boredom—the “boredom” of getting richer every year. And you have to buy many individual stocks to get the diversification you’d get from an index fund.

Here the media can play a destructive role. Some publications and advisory services make their livings pushing individual stocks; others are perpetual hype machines. But concentrating on glamorous stocks adds an enormous amount of risk. Exhibit A: the Facebook (FB) IPO.

NEXT: Investing and Gambling

Behavioral economists say too many people use investing as entertainment. (Wouldn’t a good movie be a lot cheaper?)

A Finnish study showed people who get speeding tickets tend to be more aggressive traders, while a German study found that “trading competes with [gambling and] other activities for the attention of sensation-seeking investors.” In Taiwan, “trading by individual investors declines during periods with unusually large lottery jackpots.”

Unsophisticated investors—the vast majority—are particularly susceptible to speculating in assets they don’t understand, like options. “Most investors incur substantial losses on their option investments, which are much larger than the losses from equity trading,” wrote three Dutch researchers.

I would throw into this group the many people—I meet them all the time—who are “investing” in double- and triple- leveraged exchange traded funds, which I dubbed the worst investment ever.

Read Howard’s analysis of why leveraged ETFs are so bad for investors.

I haven’t met a single person who uses them properly—to hedge other positions for a day or less. Almost everybody I’ve talked to has held them for weeks and months, almost guaranteeing deep losses.

But it’s probably hopeless to try to persuade people like this, because they actually believe they’re superior investors, all evidence to the contrary. Maybe it’s like Lake Wobegon, where all the children are above average.

This overconfidence may be the single biggest stumbling block, Barber told me. “It often leads us to trade more than otherwise would be prudent,” he said.

“Human beings have built up mechanisms for making decisions that don’t serve us well in...investing,” he continued. “I don’t think that these tendencies are insurmountable..., but I think the jury’s out on whether we can move the dial.”

There are some signs of progress. Fewer people own big chunks of their employers’ stock now. Equity index funds represented 16.4% of equity mutual funds’ total assets in 2011, up from 6.6% in 1997. Index funds and ETFs, which are also based on indexes, now each account for $1 trillion in investors’ assets.

And a diversified mixture of those should be the core of everyone’s portfolio, says Barber.

I agree. If you have the money, you might peel off 10% of your investing assets to indulge yourself in individual stocks, ETFs or what have you. But do it because you like it, not because it’s going to make you money. Because most likely, it won’t.

Howard R. Gold is editor at large for MoneyShow.com and a columnist at MarketWatch. Follow him on Twitter @howardrgold and catch his coverage of the 2012 presidential election at www.independentagenda.com.

Read Howard’s post on the big weakness in President Obama’s campaign even after his strong second debate at The Independent Agenda.