Meir Statman, in his Wall Street Journal article, “The Mental Mistakes That Active Investors Make”, has a good catalog of the biggest mistakes that active amateur investors make (2020). According to Statman, the biggest mistake of all is believing that you can beat the market (achieve annual returns in excess of the appropriate market index). Here are just some of the indices that are used as benchmarks of how your stock picks performed:
Table 13.5. Indices
There are also appropriate indices that track a mixture of stocks and bonds. When you invest in a mutual fund, its quarterly and annual reports should inform you of the appropriate index to measure its performance against.
The only reason to invest in individual stocks or a specified portfolio of stocks is if they will beat the market. Broker fees or fees for an actively managed portfolio of stocks will be significantly larger than those for a passively managed mutual fund that invests in, say, all S&P 500 stocks. Therefore, if your fund cannot beat the S&P 500 fund, you should put your money in the S&P 500 fund and save the fees.
Statman goes on to say that for amateur investors, the best bet is low-cost index funds. Statman then asks, if amateur investors cannot beat the market, even when they invest in an actively managed mutual fund, why do so many try? He blames it on our minds. The mental shortcuts we use to make decisions, according to Statman, turn into mental errors. Below are some common errors.
Framing
According to Statman, amateur investors think of stock trading as a skill that improves with practice, like surgery, carpentry, or driving. However, this is not the case, because the amateur investor has millions of other professional traders working against them. Whereas a rising stock market can be a win/win for every investor, it would be better to frame an individual stock trade as a war. For everyone buying a stock, there is someone selling the stock. What does the seller know that the buyer does not? Also, the returns that amateur investors achieve in their trading should not be compared to zero, which is often what they do. The returns should be compared to the appropriate benchmark index, which for stock portfolios is most likely the S&P 500 Index.
Overconfidence
When asked, 80% of people think they are above average in intelligence and good looks. Of course, this is a statistical impossibility. One cause of overconfidence by amateur stock traders is that they see stock trading as a skill akin to plumbing or carpentry, instead of something more competitive, like tennis. Playing against Rafael Nadal would soon erode your confidence.
Faulty Benchmark or Anchor
If we were looking to sell our house, we would look at the prices of recently sold houses in our immediate neighborhood in order to set our asking price. Amateur investors often do the same with stocks; that is, they hold the belief that the 52-week high and low of a stock define its range of trading and buy the stock at or near its low and often sell a stock at or near its 52-week high. Unfortunately, according to Statman, this strategy fails to beat the market.
Flip of a Coin
Even if an amateur investor invests in only mutual funds, some move their money regularly to the fund that beat the market last year. This is a losing strategy. As I will detail later, research has shown that out of 3,000 mutual funds to invest in, no one beat the S&P 500 more than two years in a row. While there are some mutual funds that beat the market, it is not consistently the same fund doing so. Picking the fund that will actually perform better than the S&P 500 next year is no better than the flip of a coin.
The Availability Heuristic
The amateur investor makes decisions on the information currently available to them. This information is limited. Often, the information that is available are newspaper articles about a high-fying stock or mutual fund. There is a high correlation between news coverage of a particular stock and trading in that same stock. There are plenty of stocks we do not hear about and plenty of information we do not know. Even worse, a stock’s price per share is a function of next year’s expected earnings. How accurately can an amateur investor predict next year’s earnings?
The Thrill of the Hunt
Fidelity Investments, one of the largest mutual funds, found in a survey that 54% of amateur investors enjoy the thrill of the hunt. Further, 53% enjoy learning new investment skills, and more than one half enjoy sharing trading news with family and friends. It’s for fun and profit.
Generally, I almost always hear about the wins but not the losses of friends who talk to me about their amateur trading. As is typical in situations of incomplete information, this used to give me the feeling that I was less than competent when a stock I bought was a loser. Having since become much more aware of the actual statistics involved, I do not feel so bad anymore when I lose, and I do not feel superior when I make a winning bet on a stock. However, given the lack of information of amateur investors, they are better off at the roulette wheel.