Barry Ritholtz of The Big Picture blog and FusionIQ says investors need to know who they are up against when managing their portfolios — and says that to find perhaps the greatest enemy, you don’t have to look far.
Writing a guest piece for John Mauldin’s “Thoughts from the Frontline” newsletter, Ritholtz says the first two main enemies investors face are “Mr. Market” himself (who often stands by impartially as cheap stocks get cheaper or pricey stocks get more overvalued) and other investors (primarily professional investors, who have an array of staff and tools on their side that individual investors don’t have).
The third enemy, however, may be the worst of all: your own brain. “You just assume it knows what it’s doing, works properly, doesn’t make too many mistakes,” Ritholtz writes. “I hate to disabuse you of those lovely notions; but no, sorry, it does not work nearly as well as you assume. At least, not when it comes to investing. The wiring is an historical remnant, hardly functional for modern living. It is overrun with desires, emotions, and blind spots. Its capacity for cognitive error is nearly endless. It was originally developed for entirely other purposes than risk assessment in capital markets. Indeed, when it comes to money, the way most investors use those 100 billion neurons or so of grey matter, they might as well not even bother using their brains at all.”
Ritholtz cites a few examples, one of which involves the “Dunning-Kruger Effect”. The main idea of this tenet is that the worse you are at something, the worse your ability is to evaluate how good you are at it. “As it turns out, the same skill set needed to be an outstanding investor is also necessary to have ‘metacognition’ — the ability to objectively evaluate one’s own abilities,” he writes.
Ritholtz says that and other behavioral shortcomings help lead four out of five investors — mutual fund managers and individuals — to underperform benchmarks year-in and year-out. He says evolution has honed our survival instincts, but that those instincts are the opposite of what is needed to be a good investor — i.e., not following the crowd, not fleeing in the fact of danger, etc. “The sort of grinding market we had in 2011 only exacerbates investor aggravation, and therefore increases poor decision making,” Ritholtz says. “Facts and logic go out the window, and thinking gets replaced with naked emotions. We get annoyed, angry, frightened, frustrated — and that does not help returns. Indeed, our evolutionary ‘flight or fight’ response developed for a reason — it helped keep us alive out on the savannah. But the adrenaline necessary to fight a Cro-Magnon or flee from a sabre-toothed tiger does not help us in the capital markets. Indeed, study after study suggests our own wetware works against us; the emotions that helped keep us alive on the plains now hinder our investment performance.”
But, Ritholtz adds, humans also have the ability overcome these problems. And, he says, individual investors do have some advantages over the pros. Among them: the freedom to invest with longer-term time horizons in mind; the lack of limits on stock and position sizes; and the ability to admit mistakes and correct errors without having to worry about being fired.