No amateur tennis player would walk onto the court thinking he could beat the likes of Roger Federer, yet individual investors enter the stock market thinking they can beat an unknown opponent — who could be Goldman Sachs.
That is one of the many "mental mistakes" that investors make, says Meir Statman, a Santa Clara University finance professor and author of the new book What Investors Really Want.
Statman is an authority in behavioral finance, which he defines as "finance with normal people in it — sometimes normal smart and sometimes normal stupid. Standard finance is finance with rational people in it."
His book is full of anecdotes that try to explain things such as why so many people fell for Bernie Madoff. His running theme is that ordinary investors cannot get a better risk-adjusted return than they can in low-cost index funds, yet they continue to try.
The reason: People want more from investments than a decent return. They might want their investments to convey status (owning a hedge fund means I have substantial means), to be socially responsible (I don't want to support tobacco or nuclear power), to stick it to the tax man or to provide the thrill of winning.
That's all well and good, as long as people realize it. Here are excerpts of an interview with Statman about his philosophy:
You pound the drum for index funds. Is that because you think the markets are efficient and therefore unbeatable over the long-term?
The market is not efficient. It's crazy, but the fact that it's crazy doesn't make you a psychiatrist. It's crazy like a wild animal. You wouldn't want to go against a wild lion, because it's crazy. It's crazy in ways you cannot understand and cannot forecast.
People in behavioral finance and standard finance come to the same conclusion — don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it.
Practically speaking, 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.
Do you think pros can beat the market?
Yes, they can. But it's still a zero-sum game. If some people win, it means that some people lose relative to what they can get by being in an index fund. People above average tend to be the professionals and people below average tend to be individuals.
You might say that individuals can beat the market by hiring a professional, but after paying all the expenses of the money manager, they are losing.
What are some of the biggest mistakes investors make?
The biggest mistake is not understanding the nature of the game.
People really think that playing the market is like playing tennis against a wall, instead of an opponent with potentially more skills and smarts. …
If everyone who listened to Jim Cramer buys the stock, the price will go up and it won't be the bargain it was when he suggested it.
What about other mistakes?
Another big one is availability errors. If your friends who go to Las Vegas always tell you when they win but never tell you when they lose, you are left with the impression it is easy to win. Because mutual funds always advertise their winners and never their losers, it seems like there are many winners.
Hindsight is also a big thing. It gives you false confidence in your ability to tell the future. When people look back at 2007, they can look at all the signs that pointed to the market's collapse and think they should have predicted it. ... Hindsight fools you into thinking visibility is good.
Should investors buy nothing but index funds?
People should be clear what it is they want. If they want the highest ratio of return to risk, index funds are the way. If they want to be socially responsible, buy a socially responsible mutual fund.
If they have hope of being a winner, look for a winning mutual fund or manager, but don't try to tell me you are maximizing return to risk. You are doing it because you like the game. …
It's like buying a car. If you want a reliable car at a decent price, buy a Honda. If you want one that also has status and better leather, buy an Acura. If … you really want to impress people, buy a Jaguar or Bentley. If you want to be socially responsible, buy a Prius. … But if you buy a Mercedes and tell me it's high quality, I can tell you, according to Consumer Reports, that the repair record of Mercedes-Benz is inferior. You are lying to yourself or me, or you are ignorant or, in all likelihood, a combination of the three.
If you want to gamble, don't gamble the tuition money. As long as you keep it cheap, the ratio of fantasy to cost is fair. If you buy a lottery ticket or use 5 percent of your money as play money, it's fine, just don't put your retirement money in that.