Why So Many Fail at Investing | The Motley Fool

Professor Barber who is referenced in this article, was one of my professors in my MBA program.  This article provides great insight into the psychological dynamics behind investing.  Here is the link and article below.

Most investors underform the market

This might be the most important investment statistic you ever hear. According to a US study of investor returns, over a 20-year period ending in 2008, the S&P 500 index gained an average of 8.4% per year but the average investor earned just 1.9% a year. 

Not only do most investors underperform the market, but they do so by quite a wide margin.

Why do investors do so badly?

This has long been a matter of debate. The most convincing answers usually come from the world investor psychology. Emotions cause us to buy high and sell low. We think we can time the market. We act impulsively on rumors. We have very short memories. We're just not hardwired to be good investors. Terrible, actually.

A paper from the Center for Financial Studies adds a twist to this discussion. The paper's conclusion might not be surprising, finding "that lack of understanding of economics and finance is a significant deterrent to share ownership."

Even after controlling for age, education, and income, financial literacy has a profound effect on people's willingness to invest in the stock market. The more financially literate we are, the more comfortable we become around stocks and shares.

That's how it should be, right?

Can financial education help?

Maybe. A separate paper by Lauren Willis at Loyola Law School adds yet another twist. Willis shows, quite convincingly, that financial literacy can actually be detrimental to people's financial health. 

Here's a few examples:

"Data from the Jump$tart nationwide survey of highschool seniors has consistently shown that financial education does not increase financial knowledge among high-school students and that students who take a personal finance course 'tend to do a little worse ... than those who do not.'"

"A program to teach low- and moderate-income consumers about money management and Internet banking ascertained one year afterward that 'members of the treatment group were less likely to plan and set future financial goals at follow-up than they were at baselines.'"

"A study comparing bankruptcy debtors who received financial training with those who did not found that, once controls for other differences between the groups were added, the training was associated with a small negative effect on outcomes."

Willis offers a few explanations. One, literacy itself isn't enough to overcome the emotional hurdles of finance. More importantly, financial education "appears to increase confidence without improving ability, leading to worse decisions."

Willis doesn't explicitly tie her findings to the stock market, but the jump seems logical. A major reason many investors fail at investing may indeed be because their financial education and literacy improve confidence without improving ability. 

An often-quoted study by Brad Barber and Terrance Odean (pdf) found that investors "who trade the most realize, by far, the worst performance." Those who think they're savvy enough to trade in and out of the market and for short-term profits almost invariably fail. 

Delusions of grandeur are one of the biggest poisons of successful investing.

What should we do?

The answer to this problem isn't to discourage financial education. Nor is it to discourage people from investing. It's acknowledging that the single most important aspect of personal finances and investing is not technical expertise, or even financial literacy. It's understanding investor psychology, knowing our limits, having control over our emotions, and recognizing the myriad biases we fall victim to.

Warren Buffett gets the last word: 

"Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."

Selling at a loss and the psychology of investing

One of the most challenging aspects of being an investment advisor is understanding and working with the psychological aspect of investors holdings.  Often, an investor will come to me and need help with their investment portfolio.  They usually understand that they need help, but often they are reluctant to sell investments they have been carrying for some time at a loss.  One of the common investment maxims of tenured investors is "let your winners run and cut your losses" which may or may not be correct, but nevertheless, our brains seem to be wired up in exactly the opposite way.  Some examples help to illustrate this.

If someone offered you either $100 with no strings attached or the option to flip a coin for the chance of winning $200 or nothing, which one would you choose?  Mathematically they are exactly the same but most people choose the $100 guaranteed.

On the other hand, you could either lose $100 for sure or flip a coin for no loss or a $200 loss.  In this instance, almost everyone chooses to flip the coin.  People would rather risk a larger loss than bear a guaranteed loss, but would take a guaranteed return over a volatile return.

This happens all the time with investors.  This week, I sat with an investor and we determined that his current portfolio had almost no hope of good performance.  I suggested he move his portfolio to something that looked like it should perform very well over the next several years.  Even though he agreed with me, he decided not to move his portfolio because "it just felt like too much of a loss".

We all have emotional issues about investing but it is always important to remember, you can't change the past.  All you can do is the best with what you have and move forward.