Why So Many Fail at Investing

Published in Investing on 23 May 2011

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."

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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."

More on the markets:

> This article originally appeared on our US site, Fool.com, and was written by Morgan Housel. It was adapted for Fool UK by Stuart Watson. You can follow Morgan on Twitter @TMFHousel. 

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

BarrenFluffit 23 May 2011 , 12:14pm

Interesting.

jerryrc 23 May 2011 , 2:25pm

Quite agree - have come to realise over the years that investing is much more about 'not doing' than 'doing'.

As in the Zen approach to life, 'knowledge' and 'insight' is best gained through a period of un-learning, sripping away chatter and irrelevant noise...

jerryrc 23 May 2011 , 2:30pm

'sTripping' would be a better word !

DIYIncome 23 May 2011 , 4:02pm

Those statistics on average investor returns are quite shocking - but then there is a whole financial industry whose main objective is to separate investors from their money.

safe0steve 23 May 2011 , 4:43pm

as someone very new to investing i often wonder about how to "make a million over night", then i read some more of the excellent articles and responses on here and the key messages of fundementals, patience and a half decent dividend get reinforced, as with all things in life understand yourself before trying to understand other things!

F958B 23 May 2011 , 5:56pm

I once saw some figures from a stockbrokerage.
The figures showed that, on average:

Shares SOLD by their private clients.......
OUTperformed the index by about 3% over the following year.

Shares BOUGHT by their clients........
UNDERperformed the index by about 3% over the following year.

The figures also showed average portfolio turnover rates around 100% per annum.

The figures also involved a survey of clients, where more than three quarters of their private clients believed that they were better than average at picking shares.

....................

Private investors are generally overconfident and underperforming.

goodlifer 24 May 2011 , 12:52am

The great Ben Graham said, (p 250 of my copy) "To achieve SATISFACTORY results is easier than most people realize; to achieve SUPERIOR results is harder than it looks."
Unfotunately some people - many people? - want superior results but aren't prepared to do the legwork.

lookingforclues 25 May 2011 , 11:21am

Doesn't surprise me at all. Even on investment boards such as TMF there are a whole host of investors making fundamental mistakes. Not just over-emotional trading, frequent trading and over-confidence but even ignoring the only free lunches the market hands out wrt asset allocation and diversification.

Despite the fact that diversification is a proven way to reduce risk without compromising expected return we have plenty of 'smart' characters with portfolios of less than half a dozen shares, often in the same sector. So smart some laughingly refer to it as 'diworsification' in the belief that their own dubious stock-picking ability trumps any benefits handed out for free by the market.

The one major exception on TMF is I supect the HYP board where the same survey might even result in market out-performance.

lfc

jf2007 25 May 2011 , 7:31pm

The most widely held share in the UK is Lloyds. BT is another one. Look how they have performed over the past 10 years. Many people don't seem to realize the risk with individual shares and the media misinterpret the fact that the index usually rises over 10 year periods to mean shares always rise long term.

foolkums 01 Jun 2011 , 1:04am

I've underperformed the market badly as well but I still think it was a learning curve and will do better next time. No doubt I will be proved wrong again and the greedy financial industry will continue to separate me from my money. Oh I have a masters in finance by the way....

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