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Investing While Incompetent – And Blissfully Unaware

1 January 2007

From Professor Richard Bales of the Workplace Prof Blog comes an interesting study on what kind of 401(k) strategy provides the best returns. The study was performed by Wharton Business School in collaberation with Vanguard, and used data from over a million 401(k) accounts. The results? The highest average returns were achieved by people who put their money in funds that automatically rebalanced themselves for the investor. The lowest average returns came people who actively traded their investments – and the more frequent the trading, the lower the returns. The explanation why was partly about transaction costs, in that as you trade more frequently you have to spend more money on fees. But there’s something else to it as well:

“A final behavioral test focuses on overconfidence. We know from our prior work that active traders are more likely to be affluent males, and other research suggests that such individuals may be overconfident generally and also overconfident with respect to portfolio trading in particular.” 

This reminded me of another, more general study on incompetence (defined not in the “you’re an idiot” sense, but in the sense that you aren’t capable of performing a specific task). The basic conclusion of that study? People who are incompetent don’t know that they are – and generally vastly overestimate how well they are doing:

Asked to evaluate their performance on the test of logical reasoning, for example, subjects who scored only in the 12th percentile guessed that they had scored in the 62nd percentile, and deemed their overall skill at logical reasoning to be at the 68th percentile.

Similarly, subjects who scored at the 10th percentile on the grammar test ranked themselves at the 67th percentile in the ability to “identify grammatically correct standard English,” and estimated their test scores to be at the 61st percentile.

That’s somewhat surprising – you’d think that someone who wasn’t competent at something would know it. But instead, the natural human tendency is to assume that you’re doing well, even when you’re failing badly at a particular task. Your incompetence actually tends to magnify this effect – you don’t know enough about what you’re doing to know that you’re doing it badly. And this same rule applies to investing. Active traders, on average, get lower returns because there are a whole lot of them who really shouldn’t be doing it – but have convinced themselves that unlike all the other amateurs, they know what they’re doing.  If you’re a person who actively trades your investments, you may well be good at it, but odds are that you aren’t. In fact, most people reading this who think they are good at investing are probably, in actuality, pretty bad at it. Investing is one of those things where it’s easy to delude yourself into thinking you’re a genius. Sometimes it’s because of luck – you bought some property in California in 1996. Sometimes it’s because the yardsticks aren’t that easy to read. You gained 15 percent on your portfolio last year, and beat the S&P! But over a 10 year period, your strategy ends up underperforming it. Sometimes you don’t keep all that close an eye on how you’re doing overall, and just see the investments going up – even though that’s what they tend to do over time for everyone.

The point is that if you’re actively trading your portfolio, you need to take another look at that strategy. It’s very hard to “beat the market” over time. Even professionals don’t do it consistently, with a few exceptions like Warren Buffet. And if you think you’re beating it, odds are that you just don’t know enough to know that you don’t know what you’re doing.

Discuss this in the Free the Drones Forums.

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    4 Responses to “Investing While Incompetent – And Blissfully Unaware”

  1. Tom Says:

    Thanks for the link, interesting study.

    Until recently I had a co-worker that fit into the incompetency picture perfectly. Not that she was utterly stupid about many things, she was also absolutely sure of herself. Gotta admire that much self-confidence ;-)

    The study also explains why these people remain where they are in their life: if you’re making many wrong decisions in your life, but don’t know they’re wrong, you can’t take corrective action. You keep on doing something stupid and keep wondering, what hit you…

  2. kneukm03 Says:

    Yep – and it’s often very hard for them to admit it and take that corrective action because they may be extremely good at something else. This is the reason doctors are often targeted for investment scams – just because you can perform brain surgery doesn’t mean you can pick a stock:

  3. TAM Money and Finance Says:

    Best of the Carnival of the Capitalists…

    Diary of a Startup hosts this week’s Carnival of the Capitalists. With all the great posts it was hard to pick out a few, but here are the highlights:

    Free the Drones reminds us we’re not as smart about investing as we think we are.
    Jeff B…

  4. Check Out The Latest Carnival Of The Capitalists Says:

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