(James Saft is a Reuters columnist. The opinions expressed are his own)
By James Saft
Jan 15 If you are like most investors, you probably mistake catching a wave for being able to swim fast.
And considering that you also very likely can't swim fast or invest well, that is a dangerous combination.
It is easy to observe that people are more likely to give themselves credit for good investment returns while blaming their reverses on things outside their control, but now at last we have data.
A new study by Dutch academics Arvid Hoffmann and Thomas Post of Maastricht University (here) was able to quiz customers of a discount brokerage about how good they felt they were while also gaining access to their trading records. The results are startling, if not surprising. Investors who beat the median return agree more with a statement asserting that their performance reflects skill, and the higher their returns go the more they agree. What's more, overall market returns have no bearing on how investors rate themselves, suggesting they invest in a bit of a psychological bubble.
This destructive human foible, sometimes called the self-attribution or self-serving bias, may well help us to survive a hostile world and still keep plugging. That might have been a useful trait when looking for berries or animals to eat thousands of years ago, but it has the potential to be highly destructive when it comes to managing finances.
The study looked at 787 clients of an online Dutch brokerage during 2008-2009 with an average portfolio at that firm of just over 54,000 euros. Some may find it significant that 93 percent of the sample of these deluded fools were male. After all, the old saying is that "success has many fathers, but failure is an orphan". Nobody mentioned mothers.
Now, you might say all of this is obvious, but if you do I hope you are an index fund investor. Anyone looking at investment returns in the real world can see evidence that investors, as a breed, are not in touch with their actual level of skill.
Take data from research company Dalbar Inc, which looked at aggregate mutual fund sales, redemptions and exchanges and found that in the 20 years to 2011 the average U.S. mutual fund investor made just 2.1 percent annually. That's partly split between 3.8 percent returns on equity funds and just 1.0 percent on fixed income, but still.
For comparison's sake, the S&P 500 stock index returned 7.8 percent annually during this period, gold made 7.6 percent, bonds 6.5 percent and single-family houses 2.5 percent. Given that inflation was 2.5 percent, we clearly have a lot of bad investors out there, and based on the new data, many probably think this is someone else's fault.
THE REAL COSTS
But why is it so costly to think you are good and fail to reckon with your actual faults?
Earlier studies linked over-confidence with a host of destructive behaviors. For example, a study by Barber and Odean in 2001 showed a strong association between over-confidence and over-trading. Trading costs money, even at an online brokerage, and the more you do it the better you have to be to beat the costs. Trading often also exposes the lucky to repeated chances to outlast their good fortune. Very few people have the discipline to leave a casino after winning their first hand of blackjack, but statistically most people ought to.
Over-confidence also leads to under-diversification, according to a 2008 study by Goetzmann and Kumar. Diversified portfolios produce better returns with less volatility. That lower volatility is crucial, in that investors have a marked tendency to react to downdrafts in their wealth by selling up, crystallizing a loss.
The deeply ironic thing, and here I speak only on the basis of personal observation and anecdote, is that over-confidence may well be one of the best traits to have in order to convince someone else to give you money to manage. Other than good three- or five-year returns, I am betting that an air of calm confidence is a money manager seeking new assets' best friend.
For a bit of context, hedge funds, which charge a massive 2 percent of assets under management and 20 percent of returns, only made about 13 percent last year as an industry, as against 20-38 percent returns from the major indices.
This suggests two potential strategies.
First, find an unassuming, modest, self-doubting fund manager and give them your money.
Second, put it in index funds.
On the whole, I'd advise solution two. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)