Do You Let Your Ego Dominate Investment Decisions?
by
Member of the Firm
Behavioral finance is a fascinating field. Behavioralists could be considered “investment psychologists,” whose research can help us understand why investors act the way they do, which is often irrationally. One insight from this field is that individuals allow their egos to influence investment decisions. Let’s explore some of the ways egos can cause irrational decisions.
Many investors believe they can identify which actively managed funds will outperform their benchmarks. It may surprise some investors to learn that Morningstar, with all of its resources, has admitted that its star rating system has no predictive value. If investors use past performance to identify future winners, evidence has shown that such an approach is likely to fail. Why then should individual investors with fewer resources believe they are likely to succeed?
Of course, it is easy to identify in retrospect actively managed funds that have outperformed. When faced with the evidence, some people even admit it’s hard to identify future winners. Their egos, however, lead them to conclude that somehow they will succeed. They end up playing a loser’s game — the odds of winning are so low that they are better off not playing.
Here’s what Edward C. Johnson III, chairman of Fidelity, said about investors’ expectations in Ben Warwick’s book Searching for Alpha: “I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best.” This message appeals to the all-too-human need to be above average.
Wall Street Journal columnist Jonathan Clements commented on the subject in his 1998 book 25 Myths You’ve Got to Avoid If You Want to Manage Your Money Right. He said, “It’s the big lie that, repeated often enough, is eventually accepted as truth. You can beat the market. Trounce the averages. Outpace the index. Beat the Street. An entire industry stokes this fantasy.”
Many within Wall Street want investors to confuse market returns with average returns. Index funds earn market returns. A study in The Journal of Portfolio Management found that investors who earned market returns received greater returns than the average investor because the average actively managed fund underperformed its benchmark by almost 2% per annum on a pretax basis and by even more after taxes.
One of the reasons why some individuals might invest in actively managed funds is to protect their ego. If the active manager’s fund beats the index benchmark, the investor can take credit. If the fund underperforms, the investor can blame the fund manager. From the ego’s perspective, it is an “I win/I don’t lose” game.
When investors choose an index fund, they have no one to blame if returns are lower than expected. This becomes an “I win/I lose” game, and the ego might prefer not to play a game it could lose.
The same theory applies to stock picking. If the stocks that individuals choose outperform, they take the credit. If they underperform, they blame the advisor or publication that recommended the stocks.
Investors can avoid costly investment mistakes by not letting their ego into the investment decision-making process. One way to accomplish that objective is to accept market returns by investing in index (or other passively managed) funds. And this investment lesson bears repeating: The surest way to be above average is to not try.
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice.