Image credit: Raphael, “St. George and the Dragon,” ca. 1506, National Gallery of Art
By Jason Zweig
Nov. 20, 2014
My recent column, “The Lessons of Forex Trading: Learn from Your Losses,” reminded me of something, and I couldn’t remember what. Finally it came to me: I’d written something at least a little similar almost 15 years ago, in early 2000, right at the peak of the Internet bubble.
That earlier column looked at research led by psychologists Max Bazerman of Harvard University and Don Moore, now at the University of California at Berkeley. They found that nearly 90% of investors exaggerated their returns and that many who thought they had beaten the market had been beaten by it. A set of questions that I posed around the same time in a survey of magazine readers found similar results — in fact, a fairly large number of people were convinced that they had beaten the market although they didn’t even know what their own returns were.
Here’s the column. If you read it, let me know whether you think it still makes sense. I think it probably does.
Did You Beat the Market?
Most investors who say they do are just kidding themselves
By Jason Zweig | Money Magazine, January 2000
If you listen to CNBC, market websites, your lunch pals — sometimes even magazines like MONEY — you might think the whole point of investing is to beat the market. In my experience, many investors feel that this is not only an achievable goal but one that they are already achieving.
I hate to break it to you, but if you’re among the folks who think they’re beating the market, you’re probably wrong.
Don’t turn the page yet. I’m not trying to tell you that you’re a dope, or that you need a broker to do all your thinking for you, or that investing is more complicated than that Tom Cruise hang-from-the-ceiling maneuver in the Mission Impossible movie. What I am saying is that to succeed as an investor you’ve got to understand yourself at least as well as you understand the financial markets — and most of us don’t. In fact, I’m convinced that the single most powerful step you can take to improve your investing results is to stare long and honestly into a mirror to see whether you really are the investor you think you are.
Two groups of investors have been caught looking into a mirror recently, and the findings are fascinating. A team of professors at the Northwestern, Duke and Harvard business schools asked investors how their mutual funds had performed, then compared those answers with the funds’ actual returns (the results of this experiment were published late last year in a scholarly journal, Organizational Behavior and Human Decision Processes). And in our recent Americans and Their Money survey, MONEY asked investors whether they had beaten the market and by how much (for the survey’s other findings, see our December 1999 issue).
In both cases, like fishermen recounting the great catches of years gone by, investors wildly overstated how well they had done.
The academic study, led by Don Moore of Northwestern University and Max Bazerman, who teaches at both Northwestern and Harvard, gave 80 investors continuous feedback on how their mutual funds were faring compared with the market (as measured by Standard & Poor’s 500-stock index). Then, at the end of the experiment, the investors estimated how their portfolios had performed relative to the S&P 500 over the whole period.
Nearly a third claimed that their funds had beaten the market by at least 5%, and one of every six said they had outperformed by more than 10%. But when the researchers checked the portfolios of the people who claimed to have beaten the market, it turned out that 88% of them had exaggerated their returns. More than a third of the investors who thought they had beaten the market actually lagged it by at least 5% — and a fourth of all the self-described market beaters finished at least 15% behind the S&P 500!
“This shows a shocking lack of learning,” says Bazerman, who is also the author of a new book, Smart Money Decisions. “It’s easy to have illusions about the future if you don’t even have a grip on your own recent past.”
MONEY’s survey found strikingly similar results. Shortly after Labor Day in 1999, we asked more than 500 investors nationwide whether their stocks or stock funds had beaten the S&P 500 and the Dow Jones industrial average over the previous 12 months. All told, 131 investors, or 28%, said their portfolio had outperformed the Dow, and 108, or 23%, claimed to have beaten the S&P.
Next we asked how much their investments had returned, and then we compared those answers with the actual gains of the Dow and the S&P to see how accurately our participants had sized up their own performance.
Four percent didn’t know how much their investments were up — but they were sure that they had beaten the Dow anyway. Roughly a tenth reported that their portfolio had gone up by as much as 12%; a third claimed to have earned between 13% and 20%; another third said they had gained between 21% and 28%; and a quarter thought their portfolio had risen 29% or more.
But over those 12 months, the Dow was up 46.1% — vastly outperforming more than eight out of 10 of the investors who claimed they had beaten it. When we compared what the investors said they earned against the S&P 500, which was up 39.8%, the results were essentially identical.
Separately and decisively, these studies show that the overwhelming majority of investors are kidding themselves when they claim to beat the market. “Everybody wants to believe they’re better than average and they can beat the market with their own special something,” says Don Moore of Northwestern. “It’s remarkable how this illusion persists even in the face of evidence to the contrary.”
Part of being human is to think we’re better than we really are — at just about everything. In general, if you ask a group of people “who’s above average here?” roughly three-quarters will stick up their hands — even though, by definition, half of the group has to be below average (or the median). This view of life is like Garrison Keillor’s Lake Wobegon, where “all the children are above average.” For decades, psychologists have been amassing mountains of evidence for what they call overconfidence or “the optimistic bias”:
- A 1965 study asked drivers who’d had severe car crashes how skillful they were behind the wheel. These drivers — including those the police had found responsible for the car wrecks and even those who’d been so severely injured that they had to answer the survey from their hospital beds — insisted they were more skillful than average.
- In the 1970s, a series of studies at Decision Research, a think tank in Eugene, Ore., found that even when people said they were 99.9% sure they knew the answer to a trivia question (for example: “Which magazine had the larger circulation in 1970, Playboy or Time?”), they were wrong about 16% of the time.
- In 1985, nearly 3,000 entrepreneurs were asked to estimate the probability that their new businesses would succeed. Even though roughly two-thirds of all ventures fail in the first five years, 81% of these entrepreneurs estimated that their chances of success were at least seven out of 10.
- In late 1997, the Montgomery mutual funds surveyed 750 investors nationwide and found that 74% of them expected their own funds tobeatthe S&P 500 every year–even though most funds fail to beat it any year.
Add it all up and it’s clear: We think we’re better than we really are because it’s good for our self-esteem and it keeps us from becoming a bunch of dreary downers. Princeton psychologist Daniel Kahneman is fond of saying that if we could accurately assess how risky our actions are, we’d probably never do anything; we’d be too depressed.
While positive thinking can be useful, unrealistic optimism is not. The reality is that your odds of beating the market over time are no better than one in four, and they’re probably worse. And chasing hot funds, or hot stocks, in a frenzied attempt to beat the market is the best way I know of to get burned — or turned off investing entirely. It’s like climbing onto a treadmill that never stops; eventually it exhausts you, and you come flying off.
All most people end up with to show for this futile race is big IOUs to the IRS, their brokers and their accountants. The effort to beat the indexes is particularly misguided since there’s nothing ordinary about the S&P 500 or the Dow. Not only have their performances been spectacular in recent years, but neither one includes any real-world costs like fees, commissions and taxes — putting these so-called averages far ahead of the typical investor before the race even starts.
What’s more, the attempt to beat the market often leads investors to miscalculate their performance. You’re so eager to tell yourself or your friends that you’ve beaten the market that you forget to look at how your entire portfolio has done. The craving to beat the market can lead you to count your winners and ignore your losers: Sure, your three Internet stocks are up 171% in the past six months — but how are your Disney shares doing? Of course, ignoring your losers (“That one doesn’t count; I won’t make that mistake again”) just goads you into climbing right back onto that speeding treadmill every time it flings you off. You can’t learn from your mistakes if you refuse to admit you’ve made any; nor can youaddress your shortcomings if you deny they exist.
If you really think you’ve been beating the market, then it’s time you looked hard into the mirror by measuring the actual return of your whole portfolio: Don’t forget to subtract all your commissions, fees and taxes, and make sure you include any money you added in over the period. Chances are, you’ll find that you too — like 80% of the investors who’ve recently been studied — have been exaggerating.
While you’re at it, write down your forecasts of where you think inflation, interest rates and the Dow will be in 12 months; after a year, take a look at those forecasts and see how you did. Then consider whether you’ve got any business sitting in front of a crystal ball — or listening to anybody else who thinks he or she does.
Finally, ask yourself why you want to beat the market anyway. I once interviewed dozens of residents in Boca Raton, one of Florida’s richest retirement communities. Amid the elegant stucco homes, the manicured lawns, the swaying palm trees, the sun and the sea breezes, I asked these folks — mostly in their seventies — if they’d beaten the market over the course of their investing lifetimes. Some said yes, some said no. Then one man said, “Who cares? All I know is, my investments earned enough for me to end up in Boca.”
I can’t imagine a better answer. After all, the whole point of investing is not to earn more money than average, but to earn enough money to reach your own goals. The best way to measure your investing success is not by whether you’re beating the market but by whether your investments are growing steadily and rapidly enough to get you where you want to go. That means that staying put, in an index fund or even in a fund that is underperforming the S&P by a point or two, is better than climbing onto the whizzing treadmill of trying to beat the market. In the end, what matters isn’t crossing the finish line before anybody else but just making sure that you do cross it.
Source: Jason Zweig, “Did You Beat the Market?,” Money Magazine, January 2000
For further reading:
Definitions of ACTIVE, BEAT THE MARKET, DAY TRADER, LONG-TERM, OVERCONFIDENCE, SMART MONEY, TURNOVER in The Devil’s Financial Dictionary
Chapter Five, “Confidence,” in Jason Zweig, Your Money and Your Brain